Who benefits from rising interest rates?
There are a number of candidates for who should benefit from rising interest rates. Banks, just like the one example, which I will cover in another article – low interest rates compress, therefore higher interest rates decompress, interest rate margins.
The industry that people might not realize will benefit is the financial market brokerage industry. It is possible to reverse engineer from the history of MF Global. It is also inherent in the basic legal structure of the operation of the markets themselves. Earnings on client deposits and margins belong to the brokerage firm, not the client.
This may well have the biggest effect on Robinhood Markets (NASDAQ: HOOD) for reasons to which we will return, but it will also affect at least Charles Schwab (NYSE: SCHW) and CME Group (NASDAQ: CME). I have mentioned it elsewhere for Robin Hood but it is to broaden the subject to note that this affects all companies in this same market niche. It is also possible to extend this to other market players in the same niche, but this is an exercise left to the reader.
The technical point
So, people put money in their account with a broker. It could just rest before deploying it. Or they might have to put up a margin on a deal. This is particularly the case with futures of course. There is money in these accounts.
Money earns interest, so someone, somewhere is entitled to the interest earned by that money. In this case, the operation of the legal structure is that it belongs to the brokerage firm and not to the client. In that, it’s a lot like – economically, it’s the same as – floating banks. Of course, the contents of our current accounts are quite minimal and fluctuate a lot over the month, from payday to hunger time just before the next. But average over millions of accounts and that’s a big chunk the bank can lend out overnight. What theyre doing. Brokers are in the same position. There may be small amounts individually, but overall there is a substantial position that can be deployed to make a profit.
To reverse this
There is a funny story about MF Global. Back when QE started and interest margins disappeared, Jon Corzine got involved with MF Global, a futures broker. Only a portion of MF Global’s running costs came from commissions. That float, the income from it, was the other big source of income. As will happen in competitive markets, the existence of the two revenue streams pushed commissions to where they did not cover costs.
Then, tragically, short-term interest rates asymptotically approach zero and MF Global is in trouble. Corzine staged speculation in EU government bonds – particularly Greek ones – in order to increase the margin earned on this float. Nothing, in theory, wrong with the position either. It’s just that, as Keynes pointed out, the market can stay irrational longer than you can stay solvent. What he did and that was the end of MF Global.
It reverses now
Of course, as the Federal Reserve raises interest rates, we are in quite the opposite position. These floats at these brokers are now becoming more and more valuable with every quarter point on the fed funds rate. This becomes an ever-increasing source of income as interest rates rise.
Who will this affect the most?
The big stock problem in this sector is of course Robinhood. Their number of customers is down, revenues are down in this last quarter. Their near-sole source of income is payment for order flow, something that doesn’t really exist outside of US markets – in many others it’s actually not legal.
So it’s hard to see where Robinhood can go – except, as I said, there’s this whole second stream of income that comes in as interest rates go up.
I’m not saying that’s enough to make Robinhood a must buy or anything. This is something about the sector, not an individual stock. But it is true that there is something there that benefits the whole sector of rising interest rates.
The investor’s point of view
Externally, macroeconomic conditions matter and they often do so in a rash way. It’s been a decade and more since brokerage firms have made significant revenue from their floats. It’s coming back now. The single title I expect to benefit the most from is Robinhood, but it should increase revenue across the industry.