After missing the cryptocurrency wave, can 'Old Deng' Charles Schwab really make a comeback?

Through the previous article, we can attribute $Charles Schwab(SCHW.US)'s ability to achieve intergenerational growth across users to two key factors: (1) "Product Innovation" centered around all customers (2) Timely and aggressive "Price Reduction". After developing into a comprehensive financial platform with a complete ecosystem, Schwab leveraged its scale advantage to fully play the cost-effectiveness card.

However, in 2022, due to improper handling of asset liquidity (misjudging the timing of interest rate hikes and locking too much short-term liquidity into long-term treasury bonds for small gains, leading to increased risk of a run), Schwab, which had just completed the acquisition of Ameritrade, was almost dragged into the abyss. After three years, Schwab finally overcame the crisis and completed the integration of Ameritrade, but missed the opportunity to become one of the first movers in the new wave of cryptocurrencies. Finally, this year, the management team has once again raised the banner of "Innovative Growth" and is ready to go.

But with the arrival of the interest rate cut cycle, the interest margin business, which is the main pillar of income, is the first to be affected. Can business innovation offset the impact of interest rate cuts? As the leader in wealth management in the United States, does the mature Schwab have any internal growth potential beyond mergers and acquisitions of smaller firms? How to assess Schwab's investment opportunities at the turning point of interest rate cuts? Dolphin Research attempts to answer these questions through this analysis.

I. Who is the Growth Core: Returning to Scale-Driven Growth, the Impact of Interest Rate Cycles is Not That Significant

By playing the "cost-effectiveness" card all the way, Schwab's customer scale growth, although not as impressive as emerging platforms like Robinhood, has at least maintained long-term sustainable growth.

However, low prices/free services seem to also limit the efficiency of direct asset monetization. In terms of revenue/customer asset scale, Schwab is significantly lower than its peers, whether it's the all-round old-school investment banks or the relatively young internet brokerage newcomers.

Why does Schwab, with high brand value, not have a premium? Is it intentional or unable to compete? Let's look at the reasons behind it through the dissection of the business model.

1. Interest Rate Cycle Dividend of the Past Decade

After the discussion in the previous article, we know that Schwab's label has been continuously updated with its own transformation, from a discount broker to a wealth management platform, and now to a comprehensive platform that can meet the financial needs of the masses.

At the same time, the traces of transformation are also reflected in actual performance, corresponding to the main forces of revenue growth, switching from retail trading (commission, order flow revenue) to wealth management (fund management fees, advisory fees, RIA custody revenue). Then, with the start of the interest rate hike cycle in 2016, interest margin revenue (interest on deposits, loans/investment income) quickly surpassed wealth management, officially taking over the first growth flag.

Except for the relatively special period of 2020-2021, due to the quantitative easing and offline lockdowns implemented during the pandemic, which created a capital market carnival, Schwab happened to have just announced commission-free trading and the acquisition of TD Ameritrade, making the proportion of trading revenue significantly increase during these two years, squeezing net interest income to below 50%.

Net interest income perfectly compensated for the gap in trading revenue due to the trend of commission reduction, and Schwab's business model gradually took shape over the past decade—namely, through commission-free securities trading, low channel fees, zero transaction fees for fund subscriptions and redemptions, low advisory fees for intelligent investment, and no promotion fees for independent RIA custody services to attract customers, expand the overall customer asset scale (AUM), and ultimately adopt a revenue model primarily based on asset interest (interest on deposits, loans/investment income).

As shown in the detailed business situation below, apart from trading-related revenue (order flow revenue, commission revenue from futures & phone trading), financing interest, deposit interest (own deposits & segregated account funds), and investment income (financial assets invested are mostly fixed-income products held to maturity) can all belong to the large category of asset interest, with this part of revenue accounting for about 65% of total revenue. After deducting the 16% proportion of funding costs, net interest income accounts for nearly half of total revenue.

The reason net interest has become the pillar of revenue growth, apart from following the interest rate hike cycle, lies in Schwab's key operation—automatically sweeping idle funds in customer accounts into Schwab bank accounts, paying interest rates lower than the market's current rates. Then, collective deposits are used to issue loans, including margin loans, home loans, and other asset-backed loans.

In a slow interest rate hike cycle, such as when the rate hike is within 100 basis points, the current interest rate given by Schwab Bank is not much different from the market money fund yield, and the overall idle cash (including money funds) in the account is not much, accounting for about 5-10% of the total assets of 200,000, which is 10,000-20,000 dollars.

Therefore, if one really worries about whether to put this money in money funds or Schwab bank accounts, the difference in yield is about tens of dollars a year, which is insignificant for Schwab users with an average deposit of 200,000 dollars, and Schwab can dispel user concerns with the reason "putting it in the bank is safer."

But when multiplied by the "scale multiple" of millions of accounts, it becomes a huge collective deposit for Schwab. For example, in 2024, the total scale of cash deposits in customer assets is 450 billion, and every 100 basis point expansion in interest margin means a pure profit increase of 4.5 billion for Schwab.

However, not every moment of interest rate hikes is beneficial to Schwab. In 2022, to resist the inflation pressure brought by the massive liquidity injection in the previous two years, the Federal Reserve quickly raised interest rates. The federal rate increased by 144bps quarter-on-quarter in the third quarter compared to the second quarter, and increased by another 145bps in the fourth quarter. Although the rate hike slowed down afterward, it continued to rise quarter by quarter until the end of 2023.

At that time, the yield of most assets in the market also rose, and the annualized yield of money funds even reached 3% to 4%. This led to a large number of customers transferring idle money from Schwab bank accounts to money funds or other high-yield products in the short term.

Meanwhile, Schwab, during 2020 and 2021, swept a large amount of idle money into bank accounts and purchased long-term treasury bonds with relatively higher interest rates at that time. As short-term interest rates rose, the book value of these bonds quickly declined, gradually generating floating losses. Therefore, facing a sudden large-scale withdrawal, to cope with short-term run risks and reduce the confirmation of book losses caused by low-price selling of treasury bonds, Schwab had to quickly borrow some funds externally (Federal Home Loan Bank) at a high interest rate of 5%, and coupled with the rise in deposit interest rates, the overall funding cost significantly increased.

At the same time, the rise in market interest rates also increased the financing cost for investors. The liquidity crisis brought by aggressive interest rate hikes also dragged down the performance of the equity market, further affecting core revenue—customer financing trading demand. In the second half of 2022, margin balances shrank significantly quarter by quarter. Although high interest rates compensated for the scale gap, purely from margin interest income, it still maintained positive growth. But if we add the simultaneous rise in funding costs, overall net interest income declined by 18% in 2023.

In general, under normal circumstances, an interest rate hike environment is still more favorable for Schwab's net interest income, while an interest rate cut environment is slightly unfavorable. But if the interest rate changes in the later stage, the impact on interest income will be reversed, that is, a prolonged high-interest environment will suppress net interest income, while a prolonged low-interest environment will have a positive pull on net interest income.

However, a key premise is the reason for the interest rate cut. If it is a preventive interest rate cut, then when the economy is not bad, the stock market will have a trend, and only then can margin trading increase interest income. But if it is a post-recession interest rate cut, then it is the worst double-kill situation.

2. The Long-term Growth Core is Still Customer AUM

Referring to the impact rules of different interest rate cycles on Schwab's interest income, we can know that in the upcoming interest rate cut cycle, the initial stage of interest rate cuts has the greatest impact on Schwab's interest income, and there may be a half-year window period facing quarter-on-quarter decline. But as the capital market trend continues, margin trading increases, and overall funding costs decrease, interest income will quickly rebound, ultimately still growing with the expansion of the customer's total asset scale.

In other words, although the interest rate cycle will bring short-term disturbances, from a long-term perspective, the core driver of net interest margin growth is still the customer's total asset AUM. Interest business is like this, not to mention trading revenue and wealth management revenue that are directly related to AUM.

In the face of absolute "quantity," "price" fluctuations can be smoothed out. In the chart below, whether it is total revenue or net interest's quarter-on-quarter fluctuations, in a 1-2 season time window misalignment, it basically synchronizes with AUM fluctuations.

II. Future Growth Drivers: Strengthening Advisory Advantages, Regaining Product Innovation

Dolphin Research mentioned in the previous article that pursuing AUM growth has always been Schwab's first strategic goal. But the homogenization of basic financial services also leads to the need for more differentiated innovative services for AUM growth, otherwise, it is simply relying on crude mergers and acquisitions to achieve growth.

So after completing the integration of TD Ameritrade, what is Schwab's subsequent growth driver for AUM? Where is Schwab's differentiation? We may find answers in the 2Q25 conference call. The following are the management's operational actions on key sub-businesses, mainly revolving around the essential idea of how to attract more AUM:

(1) For advisory custody services, Q2 launched the portfolio management software "Advisor ProDirect" based on a membership subscription fee format (5250 dollars per quarter): Obviously, this membership fee is not intended to increase new revenue. Instead, it is to attract the customer assets behind the advisors by enriching the services provided to advisors.

(2) For the retail sector (trading, banking, etc.), continue to deepen customer relationships through advisory services (that is, expand customer asset scale, including penetrating more users, attracting customers to move more assets to the Schwab platform). In 2025, plans to open more than 10 retail branches and recruit hundreds of financial advisors and wealth management advisors. The management mentioned that customers with financial advisors bring more than twice the net new assets compared to customers without advisory services, and can more actively participate in Schwab's investment trading and banking services.

(3) For wealth management business, attract high-net-worth users or increase users' motivation to "move" their wealth by expanding product services. Q2 launched a full-service wealth management full delegation package to meet customers' all-round needs; launched a retail alternative investment platform; improved tax trust and estate planning capabilities, and launched estate planning tools.

In summary, from the above (1) to (3), Schwab's main ideas for driving AUM growth are twofold: one is to strengthen the relationship network with customers through improved product services (expanding coverage of alternative investments, cryptocurrency investments, full delegation wealth management services, etc.), and the other is to emphasize the influence of financial advisors (new offline outlets, team expansion, new tools for RIA). Compared to major competitors like E*Trade, Robinhood, and other brokerage peers, Schwab is unique in the latter, that is, the emphasis on human advisory services.

Human advisory itself is not an innovative business; it is a very mature industry. In 2024, the total asset scale managed by registered advisors (RIA) in the United States is about 145 trillion, of which the asset scale actively managed for individual users exceeds 10 trillion (excluding institutional clients' pension funds, sovereign funds, insurance assets, etc., and also excluding passive investment portfolios such as ETF assets), accounting for nearly 10% of household financial assets.

After acquiring Ameritrade, Schwab has surpassed Fidelity to become the leader in RIA custody. In terms of scale, the RIA custody assets on the Schwab platform had a market share of over 40% in 2023. Among the current 16,000 registered RIA institutions in the industry, 90% have opened custody accounts on Schwab, indirectly promoting Schwab's brand.

Schwab's advisory differentiation mainly lies in the preference for "outsourcing as the main, self-operation as the supplement" compared to traditional comprehensive financial self-built teams, with the overall team tending to operate with light assets, making it easier to expand externally. This third-party advisory model is not Schwab's original creation, with direct benchmarks such as Fidelity and Pershing.

However, according to specific service categories, third-party advisory platforms can be further subdivided, and Dolphin Research describes them as shared mode and crowdsourcing mode according to business models:

a. Schwab's advisory model provides "shared" basic services (such as fund custody, software systems, etc.) to small and medium-sized advisory companies (RIA), without participating in the daily operations of RIA companies (especially the compliance of advisory companies), so RIA can ensure its brand independence and attract customers on its own.

b. The advisory model led by LPL, on the other hand, provides a company brand that can be affiliated with independent personal registered advisors, with the platform taking care of all basic services including compliance, and personal advisors receiving orders from the platform, similar to a "crowdsourcing" platform.

The main difference between the two different models lies in the advisory groups they target, Schwab's model targets company institutions, while LPL's model targets independent individuals. Under the latter model, personal advisors need to rely on LPL, so the investment products they can choose are limited to the product range reviewed and signed with distribution agreements by LPL. But under Schwab's model, RIA can choose products from the entire market, although the products covered on Schwab's platform are already sufficiently extensive.

Although the LPL model can achieve higher asset monetization rates, due to restrictions on the investment product range and the desire of quality advisors to establish their own brands rather than relying on others, its scale expansion is affected, making it difficult to attract higher-level advisors and corresponding mid-to-high-net-worth clients.

As of 2024, LPL has nearly 29,000 personal advisors, serving an asset scale of 957 billion; while Schwab has over 1,000 self-owned advisors and over 9,000 external RIA institutions (mostly small institutions with fewer than 5 advisors), serving a total customer asset scale of 5.6 trillion. A simple and intuitive comparison shows that the average asset scale managed by LPL advisors per person (about 3,000 dollars) is significantly lower than Schwab (1P+3P combined, about 12,000 dollars).

Therefore, to attract quality advisors and strengthen platform competitiveness, LPL also introduced a similar RIA model to Schwab in 2008, compensating for the shortcomings of the original "crowdsourcing model."

III. How to Value Schwab in the Coming Interest Rate Cut Cycle?

Generally speaking, financial institutions are essentially operating balance sheets. The most fitting example is banking institutions, where the asset side represents interest income, the liability side represents funding costs, and long-term growth relies on the expansion of net asset scale.

Although pursuing asset scale increase is also Schwab's first KPI, as a comprehensive financial platform that includes brokerage, asset management, and banking, Schwab's customer assets are not entirely on the balance sheet. This leads to order flow and small commission income reflected in customer transactions, high-value-added service income, etc., not being reflected in the balance sheet, and whether idle cash is swept into Schwab's own bank or cooperative banks (such as TD Bank) also affects whether this idle money appears on the balance sheet.

Therefore, Schwab's assets and liabilities have strong volatility, and the traditional PB valuation generally applicable to financial institutions cannot show Schwab's long-term profitability and true value. Therefore, we still follow PE valuation, taking into account certain interest rate cut expectations, and refer to historical PE fluctuations under different interest rate cycles to value Schwab.

1. Revenue Side: Using Customer AUM as the Growth Axis

Schwab's revenue structure is relatively complex, with trading and asset management businesses directly related to customer asset scale, which is more favorable in the interest rate cut cycle, so we classify them as one category. The remaining net interest income, with different sub-businesses affected differently by the interest rate cut cycle, is slightly negative overall, so we classify it as another category.

The core driver of revenue growth is mainly the endogenous growth rate of net assets (NNA), with rates either stable or generally declining due to competition. Therefore, in the core assumptions, we mainly refer to management guidance (growth rate 5% to 7%), with NNA growth rate expectations of 4%/6%/8%, corresponding to different pessimistic, neutral, and optimistic scenarios.

(1) Trading Revenue: Stimulating High-Frequency Trading

In the past five years, Schwab has spent a lot of manpower and funds on integrating Ameritrade, and the work is now nearing completion. The integration effect between users on the two platforms is good, and overall user trading activity has improved, with Ameritrade customers actively penetrating Schwab's financial services. Currently, 30% of the new inflow scale on Schwab's platform comes from Ameritrade customers.

However, due to differences in risk preferences among core user groups, the trading frequency of Schwab users after integration (daily trading frequency per million dollars of customer assets) still cannot compare with Robinhood, but Schwab is not without the possibility of narrowing the gap. (In Schwab users' asset allocation, funds + fixed income account for nearly 60%, with only 40% being equity assets related to trading. Robinhood users allocate 90% of their funds to high-risk assets, with 70% in stocks and 20% in cryptocurrencies.)

Among them, enriching the tradable asset types in directions such as derivatives and cryptocurrencies is Schwab's main action in the next year's window period. In recent years, Schwab's options trading share has significantly declined, having been rapidly eroded by Robinhood. And Robinhood's cryptocurrency assets, which enjoyed dividends in 2024, cannot be directly traded on Schwab's platform, only indirectly invested through cryptocurrency company ETFs (launched in 2022, mainly investing in listed companies with cryptocurrency concepts, rather than cryptocurrency assets).

(2) Wealth Management Revenue

Wealth management revenue mainly comes from 1P fund management fees, 3P fund distribution commissions, and internal advisory fees. This part of revenue is also directly linked to the customer's total assets. Currently, the scale of assets purchased by users in funds and entrusted to advisory management generally accounts for about 35% of the customer's total assets, which is lower than the conventional structure before 2020, mainly due to the merger of Ameritrade, which is primarily trading users.

But as Ameritrade users continue to contact and penetrate Schwab's financial services, the proportion of wealth management asset scale is expected to gradually return to the previous 50% level.

Regarding unit price, since the management fee charged is generally a fixed percentage of the asset scale, from the asset monetization rate perspective, except for money funds due to fee waivers, the overall fund fees show a stable downward trend (intense competition), with the comprehensive fee rate (including money funds) calculated in 2024 at 0.17%, slowly declining over the past decade.

(3) Net Interest Income

Net interest income sources are relatively complex and most sensitive to interest rate fluctuations. But at the same time, because it relies on interest margin, the company can constrain the interest margin yield within a certain range by doing a good job of funding supply and demand control.

From historical situations, the interest margin yield over the past decade has fluctuated between 1.5% and 2.5% with the interest rate cycle. According to the current interest rate cut expectation dot plot, the market expects interest rate cuts of 75bps and 25bps in 2025 and 2026, respectively, reaching a benchmark interest rate level of 3.5% next year. Referring to the chart below, the most recent federal rate level of 3.5% was when Schwab's interest margin yield was about 2.3%, down about 40bps from the 2.67% in the second quarter of this year.

Now let's look at the scale, interest-bearing assets mainly consist of own deposits (including segregated account reserves), margin loans, held-to-maturity bonds, and tradable financial assets.

From the initial source of funds, Schwab's interest-bearing assets primarily come from idle funds swept from customer brokerage trading accounts, accounting for almost half of the total funding source. The remaining half comes from users' securities lending funds (funds obtained by pledging users' held securities to external banks), long and short-term borrowings, and other non-interest-bearing checks, etc.

Therefore, changes in the scale of idle funds directly affect the scale of interest-bearing assets, and if the underlying customer's total asset AUM increases, it will naturally lead to the expansion of these interest-bearing assets.

2. Scale Effect Brings Cost Advantage

Compared to Robinhood and LPL, Schwab's main advantage is the absolute scale of customer assets, and this "scale effect" compensates for Schwab's disadvantages in slow user asset growth and low monetization efficiency. From the final profit growth rate and profitability, Schwab's performance is rather impressive.

Like other financial institutions, Schwab's largest expense in operating expenses is employee costs, accounting for 50% of total operating expenses. Next are software technology, legal compliance, audit consulting, and other external professional fees, as well as office rent, property equipment depreciation, and other infrastructure costs, each accounting for 10%. These three items combined already account for 70% of total expenses, almost all of which are fixed rigid expenses that can be gradually spread with revenue growth, leaving more room for profit margin improvement.

While establishing its own bank, Schwab continues to maintain cooperation with external banks like TD. In the upcoming interest rate cut cycle, the cost-effectiveness of investing in bonds to obtain fixed interest income decreases, and Schwab can retain a certain scale of funds for customer margin trading financing needs while depositing excess idle funds from customer accounts into TD Bank and charging a certain fee, effectively moving liabilities off the balance sheet and ensuring ROE stability.

3. Three Assumption Scenarios and Corresponding Valuation

Finally, Dolphin Research estimates Schwab's short-term performance from pessimistic, neutral, and optimistic assumption scenarios, with the core variable indicator being the growth rate of the customer's total asset scale.

Compared to BBG's consensus expectations, Dolphin Research's neutral assumption differs mainly in single transaction revenue and net interest margin yield.

(1) We believe single transaction revenue will increase compared to 2025, benefiting from cryptocurrency trading and the introduction of more options, event contracts, and other derivative trading. Referring to Robinhood, cryptocurrency and derivative trading single transaction fees are significantly higher than stocks.

(2) We believe that with the arrival of the interest rate cut cycle, there is pressure on the rise of net interest margin rates, so BBG's expectation of a 2.97% interest margin yield is significantly higher than the current 2025 Q2, which is not reasonable under normal circumstances, but it may be due to the market's assumption of a faster repayment speed of short-term debt (funds temporarily borrowed to prevent run risks from 2022 to 2023) than we expected. However, Dolphin Research temporarily maintains the original assumption.

Specific assumptions are as follows:

According to Dolphin Research's expectations, Schwab's current market value of 170.3 billion is trading at 17.5x P/E for 2026 performance, basically fitting short-term growth, with insufficient elasticity space for valuation repair. Horizontally comparing, the valuation is still higher than the industry average (comprehensive financial platform).

However, the current valuation is still slightly lower than the valuation center level of 20x P/E before the performance collapse due to violent interest rate hikes in 2022 (due to short-term high-cost borrowing, poor market conditions, and consecutive years of trading revenue decline, net profit fell 30% year-on-year in 2023). Looking at the past three years, although performance quickly recovered in 2024 due to the high-interest environment and the capital market feast brought by AI, with net profit growing 17% year-on-year, Schwab's valuation has not returned to previous levels.

This may indicate some doubts in the market about Schwab's liquidity management ability and product innovation ability, but currently, Schwab, which has completed the acquisition restructuring and is preparing to regain "innovation," may be able to return to its former valuation heights after digesting some bearish sentiment during the short-term interest rate cut window period and with the launch of new products such as cryptocurrency trading platforms.