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Broker.com Fred Lizotte
Vocabulary • Full-service Broker - A broker that provides a large variety of services to its clients, including research and advice, retirement planning, tax tips, and much more. Of course, this all comes at a price, as commissions at full-service brokerages are much higher than those at discount brokers. • Discount Broker – A stockbroker who carries out buy and sell orders at a reduced commission, compared to a full-service broker, but provides no investment advice.
Definitions cont. • Online Broker - A brokerage which provides trading services to its clients over the internet. An online broker may or may not be a unit of a traditional brokerage. • Bp – Base point is 1/100 of a percent (100 bp = 1%) • May Day -May 1, 1975 – U.S. Securities and Exchange Commission deregulated brokerage commissions • Underwriting - The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).
Impact of the Internet on the Brokerage industry • Between 1997 and the end of 1999 the number of trades executed on the Internet has grown at an annually compounded rate of 111%. • The U.S. Retail commission revenues grew online from 2.2% in 1996 to almost 10% by 1999. • The internet posed a threat to existing brokers • It became cheaper in both fixed and variable costs • New companies could create new systems to easily compete with the larger companies legacy systems. • These new companies were able to charge as low as 1/10 of what the larger competition was charging for full-service brokers.
Internet impact cont. • Lombard and E*Trade and other online Brokers challenged discount brokers in price. • A price war broke out and both the online brokers and discount brokers cut their per trade cost many times. • The average charged by online brokers changed from $53 to $18.50 just between 1996 to the end of 1997 • Online brokers could now bridge the gap between full-service and discount brokers. This led to a new breed of investors. These investors could generate their own strategies from the vast information resources these online brokers offered and trade for less then the discount broker could give them. • The full-service and discount brokers started realizing the added benefits, or at least the pain of not jumping on the online boat.
Internet Cont. • Merrill Lynch a full-service broker jumped on board. They offered $29.95 per trade fee for trading online. By this time Charles Schwab, a discount broker, also offered the same price. • This is when we realize that there is a crossroad in this industry, and something big is going to have to change for things to work out. • Merrill Lynch was realizing a loss of revenue by taking on this venture, and it showed. Their stock went down 10% almost immediately after the announcement.
Brokerage industry Developments • Traditional model of Brokering before May Day. • Full-service brokers offered a bundle of all of this together. • A large commission was realized on every trade to be able to provide this bundle of services.
Brokerage Industry Developments cont. • After May Day brokerage commissions were deregulated. • This change caused a new breed of brokers to come up. These were called the discount brokers. • These brokers got the benefit of grabbing consumers who were looking for a low price, and offered them the basics; price quotes and trade execution. • By the end of the 1990’s online brokers broke down this whole value chain into separate pieces and offered them each at a cost so investors can pick and choose what they wanted. • Investment research – 2-5bp, asset allocation advice for 1-10bp, and quotes and trade execution for 2-5bp.
Brokerage Industry Developments cont. • By the end of the 1990’s it was obvious that full-service brokers had to change in order to keep up with its competition. • One large problem faced with these traditional full-service brokers was the fact that legacy systems did not fit in with new technology that was emerging fast.
Investment Growth • There was something big on the horizon in the 1990’s. A new breed of customers were emerging. • Baby-boomers became the new consumers in this industry. • These were a hard bunch to keep happy, mostly because they demand high quality and low price. • The good thing for the brokers is that this generation is holding most of the money in America. • There was a great opportunity for the brokers to gain an increase in the amount of money that is invested.
Online Investors Average age was 39 and about 44% of them completed 4 years of college. 78% of online investors use personal computers at work. Offline Investors Average age was 52 and about 36% of them completed 4 years of college. 43% of offline investors use personal computers at work. Characteristics of Investors
Characteristics of Investors Cont.Forrester Research • Active affluent (AA) – Young, middle aged investors who possess the highest household income and net worth. Rely on Magazines and TV for information. They are traditional and have a hard time adjusting to the online industry. • Active moderate-wealth (AMW) – Young, moderate to high income, well educated investors grew up on the internet. Strongly self-directed and were risk tolerant. These are the “get rich quick”
Forrester Research cont. • Buy and hold affluent (BHA) – Oldest and have a great net worth. These are the people who are the most risk-adverse and the least self-directed segment. This group traded infrequently. If they did trade, they preferred in person transactions. • Buy-and-hold moderate wealth (BHMW) – Average, middle-class American families and accounted for neatly half of all investors. This group wont want to pay for professional advice and are forced to be self-directed. This group traded on average less than one trade per year. The web had a very little affect on this group.
Characteristics of investors cont. • Self-directed – 15% of population. They wanted to make their own decision and found low-cost, do-it-yourself brokers. • Opinion-seeking – about 50% of all investors. They make their own decisions, but sought some information and advice. • Fully-dependant – about 33% of investors. They preferred relationship-oriented brokers, who would become their financial guardians.
Brokers and Advice • Traditionally Investment advice was offered by commission based brokers and by Registered Investment Advisors. • RIA’s would charge an hourly fee or a fee based on the assets under management.
Commission-based Brokers • Full-service brokerages had these people on board because they made the customer want to trade and in turn pay a commission for it. • Brokers also promoted the firms proprietary and profitable products and received a large commission for it. • Top performers were sought after and paid very generously • Even average performers were making $175,000 in 1999
Registered Investment Advisors • 1940 Registered Investment Advisors Act came into affect. This allowed only qualified, and educated people to be able to advise. • RIA’s do not work on commissions, they are paid either hourly or by a fee based on the assets under management. • Unlike Commission-based Brokers RIA’s do not promote proprietary products for companies. • RIA had a small chunk of the pie, holding 120 billion in 1992 for the entire RIA industry. • To compare, a single company Merrill Lynch had 151 billion in 1992.
RIA’s Cont. • By 1999 RIA’s managed more than $700 billion in assets. • RIA’s were sole proprietor ships or partnerships. • Most RIA’s charged an annual fee of about 1-2% of the size of the portfolio that they managed.
The Internet • In the late 1990’s the huge change of trading online became a reality, challenging both the discount and full-service brokerages. • Online brokers were well on their way leaving the brick and mortar brokerages behind. • Discount brokers such as Charles Schwab and full-service brokers Merrill Lynch, Morgan Stanley Dean Witter, and PainWebber all responded to the Internet in various ways that we will find out.
Charles Swab & Company • Charles Schwab, a Stanford M.B.A., founded Charles Schwab & Company in 1971. • This Company was known to be an innovator. • May Day in 1975, created a change in Charles Schwab. This was the moment that they became a discount Broker. • Schwab took apart the value chain and offered the basics to investors. It was simple, they offered investors a place to buy and sell securities. • Schwab was on the leading edge of technology, so they came up with Telebroker.
Schwab cont. • Telebrokerwas a fully automated telephone system that allowed customers to retrieve real-time stock quotes and place orders. • SchwabLink was a service to provide fee-based financial advisors with back-office custodial services and the capability for RIA’s to plug into Schwab’s computers to trade. • RIA’s became a very key part of Schwab. By 2000 Schwab had 5,900 affiliated RIA’s and controlled about 30% of Schwab’s assets. • Mutual Fund OneSource program –1992, this allowed customers to purchase no-load mutual funds without paying commissions.
Shwab and the Internet • By 1995 Schwab realized the benefits of the online channel. • e.Schwab was launched January, 1996 • e.Schwab charged a fixed price of 39.95 for up to 1,000 shares. • e.Schwab customers had to open a new account separate from the brick and mortar Schwab. • They could trade through a toll free number • e.Schwab customers were kept separate from Schwab customers, e.Schwab customers couldn’t go to Schwab branch and receive service.
Schwab and the Internet cont. • Web trading went live on March 31, 1996. • Initially web trading customers could only check balances, buy and sell stocks, and get real-time stock quotes. • Schwab was aiming for 25,000 customers by the end of the year, but got this goal in two weeks. • Schwab dropped the price of Web Trading down to $29.95, but kept the restrictions that e.Schwab had.
Schwab Internet cont. • One thing that Schwab quickly realized is that their dual-pricing strategy only confused and irritated customers who didn’t want to decide whether they wanted service or price. • In 1998, Schwab offered Web Trading for $29.95 for everyone for up to 1,000 shares. • Schwab made a bold move and pushed all of their customers to their online channel. • They maintained a brick and mortar presents and allowed the customer to choose how they wanted to trade freely between these channels. • Schwab’s brokers now earned a salary instead of commissions.
Schwab Internet • For more growth Schwab looked into purchasing its growth. • U.S. Trust and CyberCorp was aquired and used extensively. • These acquisitions allowed Schwab to sell more broad securities and gain enough technology to keep up with active traders trading online. • Schwab encouraged active traders, by giving them a smaller commission of 14.95. • More programs were put into play to also encourage traders with large amounts of investment wealth.
Merrill Lynch & CO., Inc. • Full-service Broker • Charles Merrill, a wall street bond salesman, opened an underwriting firm in 1914. Edmund Lynch joined him as a partner. • During the Great Depression, the firm sold itself to E.A. Pierce. • Merrill came back in 1940 and made Merrill Lynch a great success. • Merrill Lynch invented the Cash Management Account. • This combined Money Market checking account and debit card. Later also bringing credit cards in the CMA.
Merrill Lynch cont. • The CMA is said to be one of the greatest retail financial product and it also generated tremendous growth for Merrill Lynch. • In the 80’s Merrill Lynch’s underwriting business skyrocketed, making them a global leader in new offerings. • In 1990’s, They acquired Smith New Court and Mercury Asset Management. • Merrill Lynch also established its presents in many other countries. • By 1999 Merrill Lynch was the leading brokerage, with 15,000 brokers serving over 5 million accounts.
Merrill and the Internet • Merrill Lynch was slow to embrace online brokerage • Global Advisor – 1996 Merrill Lynch had many legacy systems that were going to get in their way with the online channel. They got the TGA to replace their current systems with new terminal applications. • TGA could do financial and portfolio modeling, news, market data, analysis, research, e-mail, fax, and multimedia tools. • Brokers could view research reports and historical data side be side with external databases and news sources, enabling them to plan, help clients, and manage money more effectively.
Merrill Lynch and the Internet cont. • November 1996, Merrill Lynch Online was launched. • This allowed clients to view multiple accounts, examine their portfolio positions, and browse statements and research reports • On November 1998, AskMerrill was launched, this allowed clients to be able to see research. This was launched as a way to gain more clients and give them the research they need to make decisions on trading. • By 1999, with 90,000 AskMerrill registered users, 2,000 of them became new Merrill clients.
Merrill Lynch Internet cont. • In February, 1999 Merrill Lynch aquired D. E. Soft, providing a platform for investors to actually trade stock. • In 1999 Merrill Lynch offered Unlimited Advantage, which charged .2-1% annual fee starting at $1,500. • This provided full-service, and unlimited trading – online or offline. • Merrill Lynch Direct, in 1999; This offered investors to trade for $29.95 per trade. • Services were optional, and with each additional service the investor would pay a fee for it.
Merrill Lynch Transition • Merrill Lynch restructured its entire business. They used the technology as much as possible to provide the consumer with a choice of how they want to do business. • Merrill Lynch also started doing business in Europe, especially for the online channel. • Merrill Lynch used partnerships extensively, they also had some e-commerce services for these partnerships to sell through Merrill Lynch’s online portal. • Merrill Lynch in 1999 had 15,000 brokers, the largest U.S. broker force. • Merrill Lynch was the first full-service brokerage to change its broker organization fundamentally in response to the internet and other industry forces. • In 2000, Merrill Lynch lost a large amount of brokers due to this change.
Morgan Stanley Dean Witter Discover & Co. • In 1997 Morgan Stanley and Dean Witter Discover companies merged. • By late 1999 MSDW was offering financial services and products ranging from traditional brokerage and asset management to mortgage loans and insurance. • Dean Witter was one of the early movers in online brokerage. • In 1995 it was already offering transactions through its website. • It charged 14.95 for electronic trading. • When the merge occurred this online electronic exchanges was renamed Discover Brokerage Direct.
MSDW cont. • Dean Witter purposely kept its online channel separate from its offline channel. • MSDW was not publicizing that they were connected to Discover Brokerage Direct. • They believed that the customers in the online channel were in a distinct demographic group and connecting the business’s would not give any added value • It would in fact, delute the Brand of MSDW being a full-service brokerage. • The difference that DBD did was they did not compare traditional brokers to online brokers, of course MSDW wouldn’t do that to their own company, they instead explained in terms that a person off the street could go and make a couple of bucks.
MSDW cont. • The Problem that DBD ran into is that it lost ground to competitors like E*Trade, despite its online channel being more sophisticated than the competition. • One of the reasons could be that DBD was in coexistence with MSDW. This could of constrained their growth. • In 1999, MSDW started iChoice. This was a fee-based account and a self-directed account with online trading in addition to the traditional full-service account. • DBD was thrown out and iChoice became the new platform. • This platform costed the user a minimum of $1,000 for unlimited trades. Fees varied based on the size of assets, level of service, and type of investment. • Their broker force was watched closely, they did not want them to loose money. Once the fears of the online channel were resolved, their brokers were happy to be a part of it.
PainWebber Group, Inc. • Founded in 1879, it was one of the largest and best-known full-service securities firms in the United States. • By 1999 it moved to the 4th largest. • Its primary mission was to serve the investment and capital needs of individual and institutional clients through its broker-dealer subsidiary. • PainWebber decided to stay small while other brokerages were offering a broad range of things. • They stayed focused on the domestic market and retail segment.
PainWebber cont. • PainWebber went out of bounds in its traditional way of doing business • They targeted customers that had a net worth of between $100,000 and $500,000 net worth. This group was growing at a rate of 9% per year. • This proved to be successful and the companies assets grew at a compound rate of 24% from 1994 to 1999. • Most of their success and revenue was from the fee-based accounts that paid commission. • In 2000 UBS AG bank bought PainWebber for $10.25 billion.
PainWebber and the Internet • In 1997 Painwebber used the internet as a channel to provide communication and information on trading. • In 1999 Painwebber turned this online channel into one that was able to do online trades as well. It was called InsightOne • They needed to have a minimum account balance of $100,000 and pay a fee of at least $1,500. • PainWebber exploded the high income middle age class, by taking care of the 401K, and stock of many companies. • PainWebber also used these employees investment data to learn about their trading behavior.
PainWebber’s Broker Force • By 1999, PainWebbers Broker force reached 7,500 with an average assets per broker of $60 million. • They had to change how they paid their brokers • They took a 1% payout cut for the year and offered another 1% if they surpassed the goal set for them for the year. • Some brokers were happy, and others were more realistic • Some brokers realized that the unrealistic goal was not motivating at all.
Summary • This case demonstrates a great channel conflict that technology brought on. • In the beginning there was only full service brokers, then discount brokers became to be. • When technology and the internet came to be, online brokers came in and took customers out of the competitions hands. • Full-service brokers and discount brokers were left with the fact that they needed to change or they would get eaten up by the competition. • Each of these companies reacted in different ways, all had a hard time reacting to the changes that have changed how trading works.
