Brokers Shifting ‘Sweep’ Money

As stock trading by individual investors has sagged in recent years, brokerage firms have scrounged for other ways to make money. And many firms have hit on the same idea: pay lower interest rates to customers.

For years, brokerages automatically funneled customer cash -- money that’s temporarily on the sidelines, often waiting to be used to buy stocks -- into money-market mutual funds. The introduction of such “sweep” accounts in the late 1970s was a major advance for investors because it gave them an effortless way to earn competitive interest rates on idle cash.

Nowadays, however, many brokerages are eliminating money market funds from sweep accounts, especially for investors with less than $100,000. Instead, those customers’ cash is swept into bank savings accounts that typically pay much lower interest rates.

The average taxable money market fund was paying an annualized yield of 2.70% last week, according to research firm IMoneyNet Inc. in Westborough, Mass.

By contrast, a Charles Schwab & Co. customer with a $25,000 account would earn 0.7% in that firm’s bank sweep account, while an E-Trade customer would take home 0.4% from the sweep account.

Some customers still have access to money market funds, but often they must transfer their cash in after each trade rather than be swept in automatically.

Investors forced into bank sweep accounts suffer most when short-term interest rates are rising -- which has been the trend for the last year -- because money-fund rates generally increase much faster than those at banks.

That “deprives investors of returns they were earning,” said Barbara Roper, director of investor protection for the Consumer Federation of America. “It’s just one more in a long list of things firms do that doesn’t put investor interests first.”

The brokerages’ primary motivation is to boost their own profits: Typically, the bank used for a sweep account either is a wholly owned unit of the brokerage or is partnered with it. That means the firm can profit by paying as little as possible on savings sums, while lending the money out at much higher rates for mortgages or other loans.

Money funds have an obligation to get the best possible return for investors, something that is not the case with bank accounts. And unlike money funds, many bank sweeps have several tiers in which smaller accounts earn lower rates. For example, a TD Waterhouse investor with $25,000 earns 1.36%, but someone with less than $5,000 takes home a rate of 0.25%.

The net result is that, by forcing money into a bank sweep account, a brokerage can earn 2 to 4 percentage points on the cash, according to IMoneyNet. By contrast, a brokerage offering a money market fund that is managed in-house would earn about 0.4% on the assets, if it charged the average management fee.

Over time, the dollars add up. IMoneyNet calculates that money funds have historically yielded an average of 1.5 percentage points more than bank savings accounts over the funds’ 35-year history. In that period, money-fund investors have earned $750 billion in interest, $250 billion more than if they’d been in bank deposits, said Peter Crane, managing editor at IMoneyNet.

From the brokerages’ standpoint, “the profitability of these [bank sweeps] is irresistible in an era when their trading volume is getting squeezed,” Crane said. “It’s become a competitive necessity now.”

The move to bank deposits has caught the attention of regulators at the New York Stock Exchange, who are worried that brokerages may not be properly disclosing the account shifts to customers and may in some cases be stuffing them into unfairly low-yielding accounts. In a warning to firms in February, the NYSE told them to mail clearly worded disclosures to customers about bank-sweep programs.

“In some instances, you’ve got to read through 40 pages of paper, and the print can be very small,” said Grace Vogel, NYSE executive vice president of member firm regulation.

Some brokerages say they have no choice but to trim sweep-account rates, given the dramatic falloff in stock trading by individuals and the commission price war that has thrashed the industry. They play up the fact that bank accounts carry federal deposit insurance up to $100,000 per account. Money market funds, by contrast, aren’t federally insured.

Brokerages say the extra profit they make from bank sweeps has allowed them to cut some fees and expand services.

“We put a lot of the earning strength” from bank sweeps into lower commissions, said Rob Shenk, vice president of E-Trade Bank.

Brokerages also say that money in sweep accounts is primarily for investing, and that customers who want higher-yielding parking spots for their cash have alternatives. Some of those options, such as ultra-short-term bond funds, however, can carry the risk of principal loss, while others, such as certificates of deposit, tie up money for set periods of time.

Sweeps to bank deposits took off after Merrill Lynch began the move in early 2000. Several online brokers, including Schwab, launched bank sweeps in 2003.

After founding its own bank that year, Schwab began moving investors with less than $100,000 in firm-wide assets out of sweep money funds. The firm is expanding that effort this year. New accounts of customers with household assets of less than $500,000 will go to bank sweeps as of Sept. 1.

Although it is earning more from bank sweeps, Schwab said it had drastically cut trading commissions; clients with as little as $50,000 pay $12.95 a trade, down from $29.95 in early 2004. The firm also said it had lowered minimum asset amounts needed to avoid account service fees.

“We don’t feel that we’re damaging clients by any stretch of the imagination,” Schwab Senior Vice President Rene Kim said.

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Idle-money yields

Interest rates paid on so-called cash sweep accounts at major brokerages can be significantly lower than the 2.7% investors now can earn on the average taxable money-market mutual fund.

Yields for a $25,000 sweep account

Morgan Stanley: 2.96%

Avg. money market fund yield: 2.70%

Fidelity Brokerage: 2.26%

American Express: 1.54%

TD Waterhouse: 1.36%

Merrill Lynch: 0.98%

Charles Schwab: 0.70%

E-Trade: 0.40%

Sources: IMoneyNet, Informa Research Services, company reports