BUSINESSWEEK ONLINE : JULY 10, 2000 ISSUE
FINANCE

Real-World Brokers: Take That, Cyber Boy
Traditional outfits are landing some body blows

For months, it had been a major embarrassment for Wall Street's financial juggernauts: No matter how many financial services they put online, tiny Net-savvy discount brokers continued to rule the Web.

Now the tide is turning. The Internet is blurring the distinction between pure e-brokers, discount brokers, and full-service firms. And just when it looked as if midtier and pure online brokers would stomp all over the big guys' territory, Wall Street is striking back with deals and comprehensive real-time advice at more affordable prices.

Indeed, traditional brokers have captured 28% of total online assets traded and 11% of active online accounts--up from practically nil last year, according to Internet financial-services consultant Celent Communications. Another consultant, Boston's Cerulli Associates Inc., expects the six biggest full-service brokers together to have more online accounts by the end of this year than all of the 100 or so pure e-brokers combined, including Ameritrade, Datek, and E*Trade.

SHIFTING BATTLE ZONE. The behemoths are trying to act simultaneously as both trusted online advisers and discounters. Now, clients who typically pay about $100 to trade 100 shares through Merrill Lynch (MER) or as much as 3% of their transaction at Morgan Stanley Dean Witter (MWD) can trade online through those companies at the same $29.95 price offered by midtier brokers. Or they may opt for unlimited trades and access to proprietary research and advice for an annual fee. Merrill charges a minimum of $1,500. That works out to just $30 a pop for an investor who makes 50 trades a year. ''Their defensive measures have slowed the outflow,'' says Frank J. Petrilli, president and chief operating officer of TD Waterhouse Group Inc.

The battle zone is shifting for online-brokerages. Until recently, young day-traders were the prized target. But as online trading becomes mainstream, the number of online investors should nearly triple over the next three years, to 14 million. More of them will be conservative investors who seek the Street's specialty--advice. Consequently, ''full-service brokers are poised to dominate the next phase of the online brokerage market,'' says Sang Lee, an analyst at Celent Communications.

Traditional brokers may have another ace in the hole: their customer service. Smaller online brokers have been struggling to serve their swelling roster of clients. A recent study by market researcher Jupiter Communications Inc. showed that nearly a quarter of all online customer-service requests are either ignored or not properly handled. ''If you're Merrill Lynch or PaineWebber (PWJ), you have more flexibility,'' observes Robert Sterling, an online financial-services analyst at Jupiter. But smaller online brokers ''get swamped by growth.''

The rush is on to step up services. Merrill Lynch is rolling out everything from market-watch video broadcasts to home pages for its branch offices and its army of financial consultants. Morgan Stanley Dean Witter is putting online kiosks in branches. And it is encouraging clients--especially those with accounts at Schwab (SCH) or Fidelity Investments--to open MSDW Online accounts.

Wall Street's heavyweights are also preparing to stake out new online territory. Later this year, Goldman, Sachs & Co. (GS) plans to go head-to-head with J.P. Morgan & Co. (JPM) and launch an online advice service tailored to investors with more than $1 million in assets. Prudential Securities has formed a special division, PrudentialSecurities.com, to design an online service that will offer advice on everything from stocks to real estate by early next year.

''A BUST.'' To keep new competitors out of other key businesses, big brokerages are even working with archrivals. Goldman Sachs, Merrill Lynch, and Morgan Stanley Dean Witter, which together control 35% of all bond underwriting, for instance, are jointly launching a multitrillion-dollar online marketplace for corporate, junk, and municipal bonds, called BondBook LLC.

Of course, such offensives won't squash online rivals overnight. Since traditional brokers were so late to the party, many discounters are now strong enough to duel with big brokerages. Schwab, for example, has almost as many online accounts as all of Wall Street's traditional brokers combined, estimates Cerulli Associates. ''E*Trade (EGRP) now has $65 billion in customer assets. That's as large as the 10th-largest bank in the country,'' observes James Marks, an online brokerage analyst for Credit Suisse First Boston Corp.

Moreover, the market is still growing rapidly. By 2003, Celent projects, traditional brokers should have as much as 35% of $3 trillion in online assets. But that still leaves discounters with around $2 trillion in assets, up from almost $1.5 trillion today.

Discounters insist that they will win the war, although traditional brokers may score some victories. They concede that mainstream investors may stay with old-line players whose offerings have improved. But ultimately, the discounters believe they will capture younger investors, who prefer to be able to choose from a wide variety of products offered by unbiased midtier players rather than rely on traditional firms' proprietary information and armies of full-commission brokers.

Discounters also claim that Wall Street's big guns' dramatic increases in online assets mostly reflect transfers of existing accounts to the Web. That could be damaging because it risks cannibalizing the companies' own business and generating lower commission income. Says Jerry Gramaglia, president and chief operating officer of E*Trade Group Inc. of Merrill Lynch's online service: ''For the most part, they've been a bust. If you ask how many net new customers have come in online, it's been a disaster for them.''

That might have been true once, but no longer. James Gorman, head of Merrill Lynch's U.S. private client group, says recent numbers show that 38% of Merrill's new assets in its annual fee-based online Unlimited Advantage program are new clients, up from 19% when the service was first launched last July. ''I think we're going to see the pendulum swing back to the true value of a relationship, which is the adviser,'' says Gorman.

Moreover, analysts believe traditional brokers will eventually improve the quality of their earnings by conducting more of their business online. Instead of depending on commissions in volatile markets, they will get an annually recurring flow of fee income.

CHASING PARTNERSHIPS. However dismissive discounters and pure online players are of traditional brokers' offerings, they are also scrambling to add more advisory services. It will be easier for full-service firms to build online services than for newcomers to develop armies of investment bankers, brokers, and qualified equity analysts. So the upstarts are chasing after partners. Schwab has merged with U.S. Trust Corp. to offer portfolio management to affluent clients. And E*Trade is not only setting up branches, but entering partnerships with accounting firm Ernst & Young to offer financial planning and with Prudential Securities Inc. to manage institutional clients' employee stock-option plans.

But Wall Street's onslaught is gaining momentum too, and for good reason: Preeminent brokers have a lot to lose. Offering strong online services affects more than their online assets. Without a competitive Web offering, even white-shoe firms risk losing both traditional and Net-savvy clients. Until Merrill Lynch introduced its fee-based online financial services last July, it gathered fewer new assets in the United States than discounter Schwab, even though Schwab lacks an institutional business. Since then, Merrill has gained ground, taking in $48 billion in net new assets in the last quarter, compared with $44 billion in total at Schwab.

For Wall Street, it's a nerve-wracking proposition. If big firms fail in the race to capture new online clients, they risk becoming also-rans in a market where the rules are fundamentally changing--and where they once ruled supreme.

By Emily Thornton in New York

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