With the NASDAQ notching one of its worst performances ever, 2000 may not have been a stellar year for technology investors. Nonetheless, investors continued to embrace technology and the Internet – especially when trading stocks. Today, there are an estimated 18 million online trading accounts in the U.S. And online equity trades constitute about 25% of industry-wide trades. First offered in the 1980s, mainly through proprietary networks, online trading caught fire in the 1990s. By allowing consumers to bypass their personal brokers and place orders online, thus saving on trading costs, online discount brokers attracted millions of customers in the past several years. The spectacular growth of the Internet in the mid-1990s encouraged brokers of all sizes to focus on the provision of Internet trading. And as investors became increasingly comfortable with Internet trading, firms ranging from AmeriTrade to Web Street Securities hastened to offer their clients the ability to trade stocks online.

 

The Evolution of Online Brokers

The first discount brokers emerged in the late 1970s as a result of deregulation in the U.S. securities industry. From 1792, the year in which the New York Stock Exchange (NYSE) was established, to 1975, NYSE members charged for their services on the basis of a minimum commission schedule. The NYSE had the authority, subject to permission from the Securities & Exchange Commission (SEC), to set minimum commission rates on stock transactions. This fixed commission regime limited price competition among brokers. Consequently, fixed commissions led to high rates, market fragmentation, and an oversupply of ancillary services.

Robert Schwartz, a finance professor at the Zicklin School of Business, points out that in large orders, the broker’s profit could be as high as 90% of the commission. To circumvent the fixed commission structure, large traders were sometimes induced to turn to regional exchanges, or to the third and fourth market, thus fragmenting the market system. Furthermore, the absence of price competition led to fierce non-price competition and an oversupply of potentially redundant ancillary services. Commissions alone often paid for an entire package of products, including order handling, advisory services, and research reports. Therefore, brokers effectively offered indirect rebates to customers in the form of services, rather than a direct rebate in the form of dollars.

In 1968, the NYSE appealed to the Securities & Exchange Commission for what it thought would be a routine rate increase. But the U.S. Justice Department unexpectedly intervened, questioning not only the need for an increase, but also the very existence of a fixed commission structure. After an investigation, the SEC finally eliminated fixed commissions on May 1, 1975 – now referred to simply as “May Day.”

The effect of deregulation on prices was dramatic. As brokers started to compete on price, rates fell sharply. At first, however, the new structure benefited mostly major institutional investors. For example, Schwartz notes that the commission rate for large institutional orders (orders larger than 10,000 shares) fell to 0.31% of principal in December 1978, from 0.57% in April 1975 – a 45% reduction.

Individual investors didn’t get such breaks until discount brokers emerged. In the mid-1970s, firms such as Charles Schwab and TD Waterhouse sprung up, operating with a fundamentally different business model than established brokers. These discount brokers sought to lure customers by providing inexpensive trading commissions, not by providing a range of ancillary services. Since they eschewed the creation of large research departments, discount brokers were able to offer more affordable, no-frills service. Aggressive marketing and attractive pricing allowed them to create a new market niche and drove the sector’s growth through the early 1990s.

 

Technological Factors

The tremendous spread of the Internet in recent years transformed discount brokers into online brokers and encouraged a host of new entrants into the field.

Online brokerage services were first introduced in the early 1980s. But they were initially offered through proprietary networks, like CompuServe and the General Electric Network for Information Exchange (Genie). In the mid-1990s, the growing use of the Internet induced online brokers to launch Internet trading. In the years since, several discount brokers, as well as pure electronic brokers, entered the new business segment and fought aggressively for market share.

The Internet offered such firms essentially two technological advantages.

First, online brokers can provide less expensive trade execution than their offline counterparts. Placing orders online allows investors to circumvent personal brokers, reducing transaction costs. As a large number of investors established Internet connections, the web became a ubiquitous network that can be used as a communication channel between a brokerage firm and its customers. Online trading also lets brokerage firms automate their order placement process, thereby economizing on personnel time and effort.

There’s reason to believe financial supermarkets may not be viable in the long run. Customers, for example, may be reluctant to aggregate their accounts because of security and privacy concerns.

Secondly, the Internet contributed to the emergence of online trading by becoming a medium for the transmission of information. Large groups of consumers became increasingly sophisticated and more able to direct their own financial affairs without the help of a personal broker. The Internet facilitates the diffusion of information, eroding one of the main advantages of professional brokers: their access to superior information.

The use of the Internet has led to a sharp drop in trading costs. Bill Bernham and Jamie Earle of CS First Boston point out that the average commission charged by the top-10 online trading firms fell from $52.89 at the beginning of 1996 to $15.75 in 1999 – a 70% reduction. The attractive pricing has stimulated great growth. According to the ABA Banking Journal, the number of online accounts rose from 0.3 million in 1995 to 9.3 million in 1999. Greg Smith and Adam Townsend of Chase H&Q noted that at the end of 2000 there were approximately 18 million online trading accounts in the U.S. Furthermore, the ABA Banking Journal pointed out that daily online trades as a percentage of all equity trading soared from 8.5% in 1997 to 15.9% in 1999. And Smith and Townsend note that today online equity trades account for approximately 25% of industry-wide trades.

 

Levelling Off

There is reason to think that this explosive growth trend may not continue. To begin with, many of the most active investors have already embraced Internet trading. According to Henry McVey of Morgan Stanley Dean Witter, less than 5% of all online accounts account for more than 50% of all online trades.

Economic theory points out that in building a network, firms often tend to establish the most valuable connections first. In this respect, online firms initially focused on attracting the busiest traders. However, as new accounts start contributing less trading activity than existing ones, online brokers may find expansion an increasingly costly task. It is easier to attract a small number of large customers than a large number of small customers.

A McKinsey & Co. report found that 63% of all investors that opened online accounts earlier than a year ago now execute at least 13 trades a year. However, only 41% of investors that went online recently are likely to execute 13 or more trades a year. In this respect, practitioners point out that the acquisition cost per customer has increased considerably in the online brokerage industry.

Furthermore, the explosive growth of online trading has attracted many entrants to the industry, leading to intense competition. In addition to discounters and pure electronic firms, traditional full-service brokers like Merrill Lynch and USB Paine Webber offer online services. The proliferation of online firms may thus lead to even deeper price discounts and tighter profit margins.

 

Exploiting Assets

The rapid development period for electronic trading may be ending. However, several online brokers have already invested in important assets, such as strong brand names and large installed customer bases. Online brokerages believe that these assets may allow them to maintain their growth by leveraging their power to other online financial sectors.

In particular, electronic commerce sectors, like the online brokerage industry, offer large economies of scale. When the consumer network is large, a firm can enjoy scale advantages and supply a greater number of ancillary and complementary products to customers at a lower price.

Furthermore, customers of e-commerce firms often face “lock-in” as the costs of switching from one company to another may be substantial. Changing to another brokerage firm requires transferring one’s assets and familiarizing oneself with the web site of the new firm. As customers complain, switching brokers can sometimes take months. Even when switching costs appear to be low, in comparison with the commissions for stock transactions, they may be significant.

The existence of scale economies and customer lock-in thus induces e-commerce firms to sacrifice early profits to aggressively seek new customers. For e-commerce firms, building a large customer base quickly is of utmost importance, since the market is one of scale. In the early stages, firms invest heavily in price discounting, advertising and marketing to attract more customers. Once a web site becomes successful in selling one product, it can often branch into others.

It follows that online brokers with a strong brand name and a large customer base possess valuable assets. The importance of the online brokers’ installed customer base is highlighted by the fact that stockholdings currently make up a larger share of overall household wealth than ever before. In the first quarter of 2000, stockholdings accounted for 40% of household wealth, up from 35% in the first quarter of 1998. The control of such assets can potentially be the powerhouse that drives electronic brokerages’ future development, allowing them to expand to other activities and maintain a high growth rate.

 

Branching Out – Figuratively

Thus far, online brokers have focused mainly on their core product – trading over the Internet. However, the provision of more integrated financial services is a natural evolution from their core activity of providing electronic trading. A number of online brokers have therefore launched ambitious expansion initiatives, some of which are aimed at providing one-stop financial services: online checking accounts with ATM cards and printed checks, savings accounts, certificates of deposit, credit cards, loans, bill payment services, insurance plans, portfolio management, financial planning, and securities underwriting. The companies that manage to pull together electronically all these services on a single web site will likely gain a significant competitive advantage.

Integration of financial services may take three forms. First, a brokerage firm may expand its own operations by supplying a broader gamut of products itself. The broker, for example, may open a banking or an insurance division, as EtTrade has done with its EtTrade Bank. Alternatively, a brokerage firm may form an alliance with a range of outside suppliers, offering their products on its web site, as Charles Schwab Corp. has done with its mutual fund supermarket. Then, the site serves as an integrator, pulling together a group of different financial companies under one roof. Or, thirdly, the broker may act as a “screen scraper,” gathering information and completing transactions on behalf of its customers at all rival institutions. With the customer’s consent, a screen scraper can pose as the customer herself, gaining access to a customer’s accounts at all financial companies. The screen scraper organizes and displays this information on a single web site, through which customers can handle all their financial affairs. AmeriTrade, for example, has launched a subsidiary, OnMoney, for the sole purpose of providing screen scraping services.

The objective of several brokers is, thus, the creation of online financial supermarkets that offer a broad array of services. Once a customer visits a supermarket, she can handle all her personal financial needs. Competition for the provision of integrated services is one of the main driving forces in the current wave of mergers and strategic alliances in the online industry.

 

Branching Out – Literally

Aside from possessing cutting-edge online capabilities, some electronic brokerage firms also intend to establish a limited physical presence. Customers may want to have access to their supermarket through various channels, like, for example, at a physical branch, by phone, or over the Internet. Integrated shopping can be the key to attracting mainstream customers. For instance, since customers still rely on cash for several daily activities, online financial firms will probably need to develop the ability to deliver cash or accept cash deposits. Several online brokers, thus, aim at supplementing their potential expansion to one-stop Internet services with the creation of a modest physical distribution channel. Charles Schwab’s “clicks and mortar” strategy is a good example of how the physical and online distribution channels can be linked.

 

Benefits of One-stop Financial Services

Financial supermarkets can afford their customers greater convenience and superior product quality. In a recent American Banker/Gallup consumer survey, for instance, about 50% of consumers expressed interest in aggregating their financial accounts and having online access to this information.

One-stop services can become more user-friendly than separate products by putting every type of transaction just a “click” away from the customer. A customer, for example, can easily transfer money between her checking and stock trading accounts or use money from her checking account to buy an insurance product.

More important, online financial supermarkets will likely enjoy the advantages of superior information. When a customer uses a single web site for most of her financial transactions, the site will be able to map the financial profile of the customer and offer appropriate, or even tailor-made, products. For example, a financial supermarket will be in a better position to help customers set financial goals consistent with their risk preferences, choose a suitable portfolio of assets, or seek the most appropriate loan arrangements. Combining their superior access to information with their online technological capabilities, financial supermarkets will have the opportunity to offer “integrated personal financial management,” managing online their customers’ assets and liabilities on a continuous basis. Each customer could eventually have a personalized web page.

 

Competition from Other Sectors

Online discount brokers believe they are in a good position to thrive in the market for integrated financial services. Several brokers have already built a strong brand name and a large customer base through their core trading products and aggressive marketing campaigns. They now expect to leverage this asset to other online segments, providing one-stop services.

However, in the new technological environment, firms from other sectors are also investing in the provision of integrated financial services. Aside from online brokers, the companies that actively contend for market share in this segment include online banks, traditional banks and brokerages, and general e-commerce portals. In the presence of such intense competition, it is not clear that online brokers will actually reap the benefits of integration.

Furthermore, there are concerns that financial supermarkets may not be viable in the long run. Customers, for example, may be reluctant to aggregate their accounts because of security and privacy concerns. Or, consumers may prefer to buy financial products from “specialists,” rather than from supermarkets, because they are willing to deal with “experts,” rather than with generalists.

Despite these implications, several online brokers feel comfortable coexisting with firms from other sectors in the provision of one-stop services. Electronic brokers expect that their nimble structure and state-of-the-art efficiencies, as well as their brand name and customer base will enable them to prosper even in the face of intense competition from other sectors.

It is too early to predict how the new technological environment will reshape the online brokerage industry. And it is equally difficult to divine which of today’s players will emerge as long-term survivors. One thing is certain, however. The real long-term winners of the technological, regulatory, and attitudinal changes that helped create online brokerages will be investors, who will reap the rewards of better and more inexpensive products and services.

 

Chris Stefanadis has a Ph.D. in economics and finance from NYU Stern and is a research economist at the Federal Reserve Bank of New York.

The views expressed in this paper are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.