It sounds crazy, but this isn’t always the case. Brokerage firms can make a lot of money working the bid / ask spread on customer orders… in some cases, they can make more on customer order flow than it costs to execute the transaction. When an investor buys General Electric, he usually doesn’t worry about five cents up or down. But all those pennies add up for a market maker taking the spread behind the scenes, thousands of times per day.

Usually, though, an Etrade or an Ameritrade etc outsources this market-making activity, to a firm like Knight (NITE:AMEX), and splits the profits with them.

This is another area where a BofA has interesting synergy. Because BofA is heavily involved in trading, as most behemoth banks are, they already have the high-end technology and brainpower required to efficiently exploit bid / ask spreads. They don’t need to share market-making profits with an outsider like Knight. Theoretically, if their technology and operations are good enough, an integrated firm like BofA could offer zero commissions to its customers and still make a profit on their executions. Of course, even if BofA merely breaks even–if their market-maker profits net out the transaction cost at zero–the value of the float and bundled services still makes brokerage a compelling proposition for them.

The investors who aren’t motivated to switch are minor contributors to the bottom line. The brokerage business is probably 80/20 or maybe even 90/10… in the sense that 10% of the clients provide 90% of the revenues. The difference in activity levels between the average joe and the market addict are staggering. It’s one thing for a business to lose 10% of its clients, vs seeing that business lose 10% of its most PROFITABLE clients. A lot of times, the most profitable segment is the reason that the doors stay open in the first place. Without them, the whole operation becomes a treadmill.

I would imagine ETrade et al have been able to fend off lower priced competitors up til now because those competitors have mostly stunk. For an active trader / investor, there’s no value in going el cheapo if the service is truly horrible. Transaction costs are everything, but only up to a point. A lot of these third-rate discount houses offering super-low commissions are forced to cut their backoffice staff to the bone, resulting in horrible executions and worse service. That’s not real competition. It’s Yugo competition: yeah the car is incredibly cheap, but the engine has this annoying habit of melting on the highway.

BofA, however, is another story. If they can offer cheap-to-free AND passable service and execution, then the Etrades and Ameritrades could be in deep doodoo as their profit center customers go bye-bye (leaving the headache customers behind).

I’m reminded here of how Circuit City and Best Buy sell CDs at close to cost because they don’t really care about making money on CDs. They just want you in the store more often to tempt you with the big-ticket items. If a BofA or whoever figures out that they can offer cheap-to-free commissions, pair it up with genuinely decent service and execution, and make their profit elsewhere–say, on bundled services and scaled-up float–then all of a sudden Etrade et al starts looking like Tower Records. Or if not Tower Records, maybe Amazon.com… a company that has perpetually burned its investors while showering its customers with largesse.

jest me .02