The prospect of Internet trading has powered the e-commerce activities of many of the world's leading financial services institutions for two or three years. It has also spawned a myriad of exclusively online brokerages in many market segments and market centers.
The recent slowdown in financial markets has put a damper on earlier enthusiasm in this area. The markets' recent disdain for all things technological has been something of a double whammy.
Current sentiment has it that, at best, the jury's still out for retail online brokerage - and as a standalone business, that's probably true. But electronic trading through the Internet - whether as part of a wider, 'clicks and mortar' retail strategy, or as a cost-effective way of dealing with institutional clients - is here to stay.
Retail electronic brokerage burgeoned between 1997 and last year, when Nasdaq finally buckled and the dot.com bubble gave its first indications of bursting. Names like TD Waterhouse and E-Trade emerged as significant players. And heretofore discount brokerages like Charles Schwab turned into powerhouses that the mainstream brokerages could no longer ignore. It's no coincidence that many full-service brokerages have spent the past two years or so trying to emulate systems such as Schwab's: this was a growth segment that many had missed the ball on.
But the current outlook for standalone electronic brokerages is mixed at best. Schwab, it's true, is well regarded. Its recent spate of layoffs was seen as a prudent response to the prospect of a market slowdown. And it has continued to add functionality - in terms of high-quality content and applications now available to its investing customers - in an apparent move to shake off its 'discount' roots.
Others, however, haven't fared so well. Datek recently cut its staff by 23 percent after trading volumes slumped. Datek reported average daily trading volumes of 97,185 during the first quarter of 2001, down 20 percent from a year earlier. Ameritrade and CSFBDirect have also laid off at least nine percent of their staff in recent months. As a result, questions about the ongoing viability of the current structure of the market have arisen.
However, many analysts believe there is still potential for growth, despite the recent travails of the market, particularly in Europe. There, the number of online brokerage accounts is continuing to rise, gaining 13 percent during the fourth quarter of 2000, compared with only four percent growth in the more mature U.S. market, according to research by J.P. Morgan. The investment bank is predicting growth in online accounts from four million now to 15 million in 2003.
Not surprisingly, online brokerages have drawn some encouragement from predictions such as this. Market analysts reckon that shares will constitute a growing portion of overall portfolio holdings, as a more sophisticated investor community relies less heavily on state pensions.
Many of the major electronic brokerage firms continue to hold plans for expansion into Europe. They are taking a more conservative approach, however, than they were six months ago, with some placing plans on hold while they wait for the market to recover. It appears, though, that the majority believes that a recovery will rekindle demand for electronic trading. The question is whether they can ride out the storm.
In the US, meanwhile, analysts believe a resurgence in the bull market will be required if the online brokerage business is to make good on its early promise. That promise was indeed, substantial. Jupiter Research has estimated that assets in online investment accounts will rise to USD5.4tr by 2005, from usd1.5bn at year-end 2000.
To make sure they're still around to grab a piece of this action, some online brokerages are diversifying. Schwab, for example, is now a major distributor of mutual funds and will derive one-third of its 2001 revenues from asset management. E-Trade has migrated into banking, institutional brokerage and insurance. Meanwhile, Ameritrade, which has remained true to its online brokerage roots, has seen its share price tumble as a result.
The future of online brokerage as part of a broader strategy in the retail marketplace may be on firmer ground. Certainly, many of the major retail brokerages, such as Merrill Lynch, are augmenting their traditional brokerage operations with all manner of electronic facilities, including transactions. Even those brokerages with a more advisory approach to client relationships, like Peel Hunt, see value in offering an electronic execution system for clients who might otherwise have looked elsewhere.
One issue that's called into question the appeal of Internet trading has been that of the sophistication of retail investors. Many high- and medium-net-worth individual investors have traditionally relied on full-service brokers offering advisory and even discretionary brokerage services. In particular, the investors with the most money, and hence the most value to brokerages, tend to be older. Do these older investors have an aversion to the technology required to participate in Internet-based trading?
The answer isn't clear. But according to research commissioned by Investhink, the high net-worth individual bracket of the marketplace is becoming increasingly diverse, with many technology-savvy thirty- and forty-somethings having joined the club during the bull market of the past eight years (although that number may have slipped a little given recent market conditions!). Whatever the case, concerns about selling strawberries to donkeys - providing service functionality that's lost on an unsophisticated audience - are no longer valid.
Now, investors have access to more information, more context about their investments. In short, they are better-educated clients who have more confidence in using technology to help in the decision-making process right through to the transaction itself.
Another factor has been a lower element of fear among the brokerages themselves of cannibalizing their existing client bases. In the 1980s, Bloomberg paved the way for sell-side institutions to sell more product to their buy-side clients, by providing a sales tool that helped both sides of the trade look at the market through a common set of parameters. Today, retail brokers are recognizing the need to supplement their brokers' conversations with clients, with real market information. This may take the form of their own proprietary research or trading recommendations, or increasingly through offering expert neutral analysis provided by speciality third-party suppliers. Rounding out the offering with the means to execute simple trades electronically is becoming an obvious choice for many institutions.
Electronic retail brokerage is here to stay - although perhaps in the market structure that exists today. But institutional electronic execution is well established, and has been for many years. What's changing is the acceptance of the public Internet as a means of reaching the end user.
A decade ago, technology and execution were uneasy bedfellows. While digital technology was making all manner of things possible in the trading room, the actual transaction and many of the processes surrounding it, remained largely manual. Outside of the efforts of a few pioneers, people like Instinet and Autex, concerns about the reliability of existing technologies precluded widescale acceptance of the concept of using electronic mechanisms for transactions.
A few highly publicized failures didn't help matters. Some high-profile projects ended in disarray and delay, and served to draw attention to the substantial material losses that could be incurred by execution system failure.
But at the same time, the extraordinary potential of electronic execution drew many into the development arena. Across all asset types, the early 1990s saw massive development in the area, both among market participants themselves and vendors seeking to provide service offerings.
The result was that by the mid-1990s, electronic execution was no longer the pariah it had once been. Institutional trade execution has since become a byword. Many initiatives continue to emerge - some involving groups of institutional players. Others are the work of individual firms. All seek to advantage from the low-cost ability to attract liquidity, and the promise of major cost savings via straight through processing, or STP.
Internet-based electronic brokerage was pioneered by the players in the fixed income market. Tradeweb, a consortium of brokerages offering transactions to corporate clients, was among the first to offer bond trading on the web. Today, more than 50 percent of all execution facilities on the public Internet are predominantly bond market facilities.
Much of the institutional action now seems to be focusing on the foreign exchange marketplace. A number of foreign exchange market portal sites have emerged, all seeking to offer corporate treasurers access to the foreign exchange services of participating market-making banks. This year will see the emergence of such players as Atriax, Fxall and Currenex as systems offering this kind of service via the Internet.
But the proliferation of electronic transaction systems on the Internet raises a new question: How do firms differentiate their offerings? The problem is that electronic trade execution is a low-cost alternative to what have always been human processes. Therefore, as the enabling technology becomes ubiquitous, the pressure rises to reduce prices to customers, in order to protect market share. The result is lower commissions and fees.
Certainly, firms are beginning to do something about this situation. They recognize that much can be learned from the public Internet. Financial services organizations essentially provide access to pools of liquidity, offering a 'destination site' where investors of all kinds have reasonable confidence of being able to make a transaction. A key driver in their success, then, must be firms' ability to attract investors to the pool. The more investors, the greater the utility of the pool, and the better likelihood of attracting more investors.
The Internet has introduced the one-stop shop, the online magazine where one can learn about products ('browse'), alternatives and markets, before electing to execute a particular transaction. In our market space, contextual pre-trade information will become a differentiator between competing pools of liquidity.
The result will be the evolution of financial institutions into the new redistributors of financial information.
They'll achieve this by adding market prices, news and decision-support tools, from all manner of specialist providers, to the execution facilities they currently offer. New business models mean that this can be done at surprisingly low cost per user.
The firms will go a step further by adding interactivity at all levels. Electronic transactions are but one form of interactivity. By monitoring their clients' online activities, firms will learn more about them, allowing them to sell more targeted products.
The benefits of this approach are manifold. Adding context to the trade decision increases client utility. It's also a defence against competitive pressures and hence helps avoid commission spiral. Context also broadens the appeal of such a service, making STP a more realistic prospect. It keeps customers loyal, by underscoring the value that the institution brings to the table. And it throws up opportunities to sell a broader range of services to the existing client base.
Despite the current doom and gloom of the marketplace, and the markets' specific disdain for all things technological, financial services companies continue to invest in leading edge solutions. Electronic execution is the path to efficiency, both in terms of reducing transaction costs and providing the lifeblood of the next Holy Grail - straight-through-processing - at all levels of activity.
Electronic brokerage - retail or institutional - is anything but dead. As one of my favorites from the 1970s goes: "You Ain't Seen Nothin' Yet."
