| BUSINESSWEEK ONLINE : FEBRUARY 22, 1999 ISSUE | ||||||||
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| COVER STORY
Who Needs a Broker? Brash new online firms are turning the traditional world of Wall Street on its ear THREE YEARS AGO, IT WAS AN ALMOST INVISIBLE BLIP. TWO YEARS LATER, IT WAS HARD TO MISS. But the major brokerage firms continued to ignore the exploding phenomenon of online trading. Today, online trading has caught Wall Street's attention with a vengeance. Fueled by the bull market, Internet brokers have attracted a deluge of new customers. Online brokers' stocks have soared, with Ameritrade Inc. (AMTD) up 118% since Jan. 4. Some 14% of all equity trades were executed online last year, up 50% since 1997. The online brokerage industry has doubled customer assets, to $420 billion, and doubled accounts, to 7.3 million, reports Piper Jaffray Inc. Now, the Internet brokers and the full-service firms are headed toward a face-off that could lead to nothing short of war. The Net poses the most serious threat to the established industry's economics and primacy since the unfixing of commissions on May Day, 1975, when deregulation created the discount-brokerage business, threatening, but not vanquishing, a cozy oligopoly. Now, the oligopoly is being battered by new technologies. ''The Internet is fundamentally changing the story of investing,'' says Gideon Sasson, head of Charles Schwab & Co.'s electronic brokerage unit. The online firms' biggest advantage: radical cost savings. Online commissions have plummeted--down 50% in 1997 alone--as competition has mounted. Now buying 200 shares of a $20 stock costs $8 at Ameritrade, $14.95 at E*Trade (EGRP), $29.95 at Schwab, and $116 at a full-service firm. Yet the full-service firms have so far stuck to their full commissions, and don't even offer online trading yet. ''When Southwest cuts fares, airline execs don't say they're unsure about what's causing the increase in volume,'' says Bill Burnham, Credit Suisse First Boston Corp.'s online analyst. ''We've opened the world's biggest back door into the market. We're seeing a permanently higher level of activity.'' The dean of do-it-yourself investing, Charles Schwab himself, says the big Wall Street firms are hopelessly behind the times. ''It's a lot like the guy with the buggy whip. Four wheels? What's this thing called an automobile?'' mocks Schwab. He says the Internet poses a basic challenge to Wall Street's consumer-unfriendly way of doing business: ''I don't think they've ever embraced anything that has empowered the individual investor.'' ''HOG HEAVEN.'' Cheap prices are only part of the Internet's influence. An avalanche of mostly free financial information is readily available to investors. True, this information ranges from Securities & Exchange Commission filings to the murky world of chat rooms. But investors are entranced with online investing. Martin Fox, a 63-year-old small-business CEO who trades online through National Discount Broker, says: ''Having immediate access to unfiltered information is great. I woke up in hog heaven.'' Adds Cambridge Group partner Navtej S. Nandra: ''The balance of power has shifted to the investor.'' The rise of this cheaper, self-directed, fee-based, performance-oriented model of investing sure looks like bad news for traditional Wall Street, which relies on a commission-based, proprietary, paternalistic model of investing. The commission system produces a high cost structure for the industry with results that are not necessarily good for the investor. Change is difficult because the firms earn billions from brokers, who in turn are very powerful within their firms. And full-service firms don't always live up to their names. Some 40% of brokers are inexperienced and undertrained, according to Cambridge Group. But the full-service firms are finally beginning to counterattack. Their first steps will be to add online trading to their information-only Web sites this year, with a better deal for their more active customers. They can be expected to mobilize their enormous advantages: They have the most affluent customers, the best research analysts, a lock on the market for initial public offerings, vastly heftier capital bases, Internet technology expertise, and powerful global brand names. Morgan Stanley Dean Witter has the big advantage of owning online broker Discover Brokerage Direct. Says Philip J. Purcell, MSDW's chief executive officer: ''I'll match our technology and our customer service with any of them. We're ready. We'll go compete with them.'' Online investing will ultimately push full-service firms to respond with bigger changes. The major brokers over time will have to wean themselves and their brokers away from hefty commissions, change the way they price their wares, and improve the performance of their brokers. Several big Wall Street firms, including PaineWebber Inc., are planning to provide customers with account performance data and performance benchmarks, novelties in the full-service world. ''We are going to have to be more service-oriented,'' says Merrill Lynch Vice-Chairman Launny Steffens. ''It raises the bar for the financial consultant. We're going to add more value.'' Meanwhile, online firms, despite their rapid growth, are far from invincible. They are facing greater scrutiny as more of their customers suffer serious service problems and discover they can lose big money day trading. John Tyler, a real estate agent in North Attleboro, Mass., who tried to play Internet IPOs through Schwab, says he lost $25,000 due to an error Schwab made in his account and from being put on hold for 20 minutes in a fast-moving market. ''I'd rather pay a guy $100 a trade than pay Schwab $25,000,'' says Tyler. A Schwab spokeswoman says Tyler was trying to buy a large block of an illiquid stock and that Schwab did ''everything appropriate.'' Finally, the current online frenzy is narrowly dependent on ''Internet users at Internet trading firms buying Internet stocks,'' says CSFB's Burnham. The real test of these firms will come when the market plunges. This battle for the hearts and minds of American investors is just starting. Whoever prevails, it is consumers who will come out the biggest winners. The fighting will foster a plethora of new products, services, and pricing options as firms compete for market share. And it will force both sides to continually justify their value to their customers. The growth of the online firms has been nothing short of phenomenal. In just three years, they have gone from ''an insignificant technological curiosity'' says James Marks, online analyst at Deutsche Bank, to a band of more than a hundred online brokers. Online investing has become so popular that it is topped only by online pornography. ''Sex is number one and financial services is number two,'' says Schwab's Sasson. Also driving growth is a generation of uncompromising, control-oriented adults who are nearing retirement. ''If the Internet didn't exist, the baby boomers would have to invent it,'' says Daniel O. Leemon, Schwab's chief strategist. The online industry is still tiny on the basis of transactions, accounts, or assets. Its $420 billion of assets in customer accounts is dwarfed by Merrill Lynch & Co.'s $1.4 trillion. But Deutsche Bank's Marks expects online accounts to double to 14 million by the end of 2000. SNOOZE AND LOSE. Wall Street isn't the first industry to believe it could control the uncontrollable forces unleashed by the Internet. Microsoft Corp. ignored the Net for years because it undermined its all-important Windows software, and Barnes & Noble Inc. was loathe to address the threat posed by Amazon.com. Full-service brokers ''have the mistaken impression that they are in the driver's seat,'' says CSFB's Burnham. Their delay let the likes of Ameritrade and E*Trade Group establish themselves and create valuable franchises. ''We should have been squashed from Day One,'' says E*Trade Chief Executive Christos M. Cotsakos. ''They had the depth and breadth of products and services and customers. They had a great chance to be a great leveler. We had no help except from the customer. Now we've spawned an entire industry.'' Online brokers, such as Fidelity Investments, got their start from shifting their do-it-yourself customers from trading on the phone to trading on the Internet. Schwab, the largest online broker, with 27% of the online market, responded to cheaper online brokers by lowering its commissions to $29.95 for all online trades, compared to an average of $55 for phone trades. A key question: How much of the boom in online customers is coming from full-service firms? Many of these customers are new to the market, so it's unclear how many are defecting from big firms. In general, customers of full-service firms are older and far more affluent than online customers. For example, E*Trade's average customer is 39 years old and has $25,000 in his or her account, while the average Merrill Lynch customer is 52 years old and the average household has $200,000 in assets. This is why full-service firms say they aren't interested in grabbing the less-lucrative market segment. SUBTLE MUTINY. But there is ample reason for concern. Many full-service customers are also opening accounts at online firms. PaineWebber surveyed its customers over a year ago and found that 8% had already opened online accounts. Some 30% said they planned to in the next year. Says Marc J. Defant, a geology professor in Tampa who has about $300,000 with E*Trade: ''I came close to signing with Merrill Lynch. At the end of the day, I chose not to because it was very expensive.'' Online brokers are also expected to move up the food chain in the next year or so. Led by Schwab, they will attempt to lure full-service customers by offering them far more than just cheap trades. ''Internet trading will turn out to be a footnote in the history of Internet investing,'' says Schwab's Leemon. This explains why online brokers are now racing to provide research and initial public offerings. Wit Capital Corp., an Internet investment bank, just hired a Merrill Lynch analyst to start its research department. Retail access to IPOs has been a powerful lure. Online brokers are scrambling to get their hands on this hot commodity for their online customers. Schwab has agreements to offer H&Q's, CSFB's, and J.P. Morgan's IPOs. So far, online investors can't expect to get into many hot deals. ''The amount of IPOs going through the Internet today is de minimis,'' says James F. Higgins, president of MSDW's Individual Securities unit. The other area that online brokers are working on is analytic tools for asset allocation, stock selection, and financial planning. These tools are designed to replicate the more sophisticated ones that brokers have and the brokers themselves. For example, Schwab just rolled out its Signature Service account that ditches the firm's traditional hands-off, do-it-yourself model. Customers with more than $100,000 can get advice through a team of brokers who are paid on salary rather than commissions. ''Advice is the big question they face, and that's one thing we've got,'' says Hardwick Simmons, CEO of Prudential Securities Inc. Full-service firms justify charging heftier commissions because their customers are getting a living, breathing, advice-giving broker rather than just pressing a button on a computer and executing a trade. Many customers, especially older, wealthier ones with more complex finances, want guidance on everything from stock-picking to estate planning. ''Information is not advice,'' says Norman Epstein, chief financial officer at ILX Systems, a data provider. ''I like my broker to tell me, 'That's a dumb idea.''' Adds saleswoman Patricia H. Aughavin: ''I like working with A.G. Edwards, frankly, for the advice and products they offer because I don't have time to look into all the different options.'' The main interest of the full-service firms seems to be hanging on to their own wealthy customers. And they are finding that their customers have had their appetites whetted by their Web sites, which let them see their account information in far more detail than was possible before. At Morgan Stanley Dean Witter, the 60,000 customers that use Clientserv have four times the assets and five times the revenue of the average account. ''We were floored. It's been consistently our best clients,'' says Ray Drop, marketing director for MSDW's Individual Securities unit. Nevertheless, the full-service firms are proceeding very cautiously in offering online trading. They are moving toward charging flat fees like a money manager to trade online. This is not an across-the-board price cut, but frequent traders should be able to execute trades online at online prices. FREQUENT-FLIER MILES. For example, Morgan Stanley Dean Witter, which has 4 million customer accounts and about 600,000 core central asset management accounts, is rolling out online trading to just 20,000 customers who have a Choice account. Customers with $50,000 to $250,000 in their accounts are charged a flat fee of 2.25% a year on their assets, and get 56 trades. (That fee drops to .30% for assets over $10 million.) They can enter trades online or through their broker. But they must use their broker to buy options, stocks on margin, or short a stock. The idea is for the broker to protect them from doing something foolish. Prudential Securities is going a little further. It is testing a program that allows clients with more than $100,000 with the firm to trade online. They are charged a flat 1% fee a year. In addition, they pay $24.95 per online trade or broker-assisted trade. The broker shares in the 1% fee, but not in the $24.95 charge. Prudential's Simmons says: ''Essentially, we've separated the financial advisers' advisory role from the execution role of the firm itself. I think you're going to see many more pricing alternatives along these lines.'' Wall Street is closely watching Merrill Lynch because of its reputation as a retail marketing powerhouse. Merrill has said for the past two years that it will offer online trading. In early February, Merrill's Steffens said the service would be available by March. Steffens is also trying to build customer loyalty by rolling out a high-end client reward program on its credit card. And he has been busy negotiating deals with retailers so that Merrill customers can get discounts and frequent-flier miles on everything from flowers to gourmet foods purchased on Merrill Lynch Online, which reaches 400,000 households with $300 billion in assets. ''The ability to take this credit card and use it as a payments system on the Internet is clearly what we're attempting to do,'' says Steffens. The main reason the full-service firms have been reluctant to tamper with their business model is because it remains so successful. Morgan Stanley Dean Witter says it opened 950,000 new customer accounts in 1998, up 35% from the prior year. And Merrill Lynch pulls in $327 million in retail assets every day. ''People need advice and guidance. Some of that market will be in place forever,'' says Steffens. But the online world has tremendous momentum. Consider Tyler, the first-time investor who signed on with Schwab six months ago. Even though he lost a bundle trading with Schwab, guess what? He's still a customer there. As they say on Wall Street, you can't fight the tape. By Leah Nathans Spiro, with Edward C. Baig in New York _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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