First of all, we would like to note that in contrast to the banks, US brokerages disclose much
less information and, overall, they are less regulated by the government bodies. Some very large
brokerages, such as Fidelity and Vanguard, do not disclose almost any data at all, while data
from subsidiaries of banks, such as Bank of America Global Wealth & Investment Management and
Morgan Stanley Wealth Management, are rather hard to obtain. There are only some numbers in the
banks’ 10-K and 10-Q fillings. Another thing worth mentioning is that the brokerages do not disclose
data on banks they are working with. This is actually a crucial point given that if a bank that is
being used for sweeping money overnight has a liquidity issue itself, this can result in contagion
and lead to liquidity issues at a broker.
We believe the biggest risk the brokerages face is a liquidity risk. In our view, there are two
types of liquidity risks for a brokerage company. First, as mentioned, if a bank that is being
used for sweeping money overnight has a liquidity issue itself, it can result in contagion and
lead to liquidity issues at a broker. The problem here is that brokerages do not disclose data
on banks they are working with; as a result, it is impossible to make a proper assessment of
this type of liquidity risk based on the publicly available information. The second type of
liquidity risk generally tends to arise from a fragile business model, unsustainable revenues,
weak profitability and problems with a capital position. Our methodology and ranking system
focus on an assessment of this type of liquidity risk. Recall the MF Global case:
According to an FT article,
the $6.3B trade known as a “repo-to-maturity” contract, which was related to the European
peripheral sovereign bonds, was the catalyst that sunk the company. However, such a risky trade
was the result of MF Global’s fundamental issues. Here is a quote from the FT article:
Discussing the ratio of a bank’s assets to equity, he (Jon Corzine, CEO and Chairman of
MF Global), said in a Financial Times video last year: “We have to be disciplined. We cannot
go running 30 to one leverage ratios. We need to manage risk.” Yet MF Global failed with a
leverage ratio of more than 30 to one, as regulators and rating agencies pressed it to justify
its aggressive gamble on the eurozone’s stability.
Obviously, it is a just a matter of time when a brokerage with a 30 assets/equity ratio faces a
liquidity risk. Such a fragile capital position is a result of issues with a business model. As
a result, we believe that brokerages with a strong business model, sustainable and predictable
revenues, decent operating efficiency and prudent capital management, are less likely to face
any liquidity issues in a difficult environment. As such, we reviewed brokerage firms that
provided adequate public information to assess their overall financial strength and long-term
stability based on 3 main categories: 1) Revenue generation capacity; 2) Cost efficiency; 3)
Profitability & Capital. Each of these categories is divided into 5 subcategories, which are
all crucial to sustainability of a brokerage's business model in a volatile environment:
Revenue generation capacity
Share of non-transaction revenue. We prefer brokerage companies with a high share of
non-transaction revenue. This is an important metric, given that most brokerages have already
switched to “a zero-commission” model. Importantly, this was introduced not only
by classic brokerages, but even by some crypto-focused ones (for example, Binance).
Net interest margin (NIM). This indicator is calculated by dividing a brokerage’s total net
interest income by its average interest-earnings assets. Given a falling share of
transaction-related revenue, interest income is now very important for brokerages.
Revenue on client assets (ROCA). This metric is calculated by dividing a brokerage’s total
revenue by its total client assets. That is another indicator of a brokerage’s revenue
generation capacity and is useful for comparison of brokerages with different sizes of client
Revenue per employee. This indicator is calculated by dividing a brokerage’s total revenue
by its average number of employees. The metric shows productivity of a brokerage’s workforce.
Efficiency ratio. This indicator is calculated by dividing a brokerage’s total non-interest
expenses by its total operating income. The metric measures operating efficiency. Similar to
banks, the lower the efficiency ratio is, the better a brokerage company is with managing
and controlling its noninterest expenses.
Expenses on total assets. This metric is calculated by dividing a brokerage’s total operating
expenses by its total assets. The ratio helps to compare operating efficiency of brokers with
different sizes of balance sheets.
Expenses on client assets (EOCA). This ratio is calculated by dividing a brokerage’s total
operating expenses by its total client assets. Similar to an expenses-per-ratio metric, it
is useful to compare cost efficiency of brokers of different sizes.
Expenses per employee. This indicator is calculated by dividing a brokerage’s total operating
expenses by its average number of employees.
Profitability & Capital
Pre-tax profit margin. This metric is calculated by dividing a brokerage’s
pre-tax profit by its total revenue. That is one of the most important profitability measures
for a brokerage company.
Return on equity/allocated capital (ROE). This indicator is calculated as a
brokerage’s net profit divided by its average equity. It measures a brokerage’s profitability
and its organic capital generation, which is important in a volatile environment.
Return on assets (ROA). This ratio is calculated by dividing a brokerage’s
net profit by its average total assets. That is another measure of profitability. It is used
to compare profitability levels of brokerage companies with different financial leverage levels.
Financial leverage. This indicator is calculated by dividing a brokerage’s
total equity by its total assets.. Obviously, brokerages with a higher equity-to-assets ratio
would be more resilient to potential volatility.
We used the following rating scheme:
If a brokerage looks much better than its peers in the sub-category, it receives a score of 5.
If a brokerage looks in-line with its peers in the sub-category, it receives a score of 3.
If a brokerage looks worse than its peers in the sub-category, it receives a score of 1.
Hence, the maximum possible score is 60.
While we have analyzed the individual brokerages based upon the rigorous standards we have outlined above, we want to again reiterate that we are simply unable to quantify the risk of leaving cash in your brokerage account, which often gets swept to individual large banks. So, please strongly consider this risk going forward.