The new economy's impact on the securities industry

Technology is causing a reinvention among the players in the securities industry. For example, the Internet is a tool that dramatically lowers the cost of communication and is radically altering industries that depend heavily on the flow of information. It dramatically reduces the cost of doing business within companies, while giving them direct customer contact. Ultimately, the Internet can boost the rate of innovation by increasing the speed at which ideas spread between companies, within economies and across countries.

The evolution of the New Economy has not necessarily taken the path expected by many industry participants. Originally, the dot.com New Economy was to make all branch offices obsolete, and all middlemen would no longer be necessary. Of course, this has not been the case. The result has been a mixture of the Old and New Economies, requiring each to adapt to a new environment as well as coping with changes in original expectations.

Over the past six years, the US brokerage industry has opened 18 million online accounts, generating millions of transactions for increasingly automated exchanges and alternative trading platforms. E-business initiatives have become pervasive on the corporate side of banking, complementing the rise of business-to-business (B2B) networks for information services and product procurement. These changes have created the beginning of an irreversible change in the securities industries.

Discount brokerage firms were one of the first sectors to go online in their attempt to quickly capture the retail business from old line full-service firms. While commission rates were aggressively lowered by discount brokers and continue to shrink, insufficient levels of customer service and periodic operational glitches continue to plague this segment. After initially ignoring the Internet and suggesting it was nothing more than just for day traders, full service firms have been quickly catching up and have grown to realize the appropriate use of the Internet may not be the answer to growth and retention of their retail customers. However, the Internet has rapidly become a major distribution channel, although not their only channel.

While forcing process change, technological advancement is often accompanied by risk. The New York Post currently has a column, "Dead Dot-Com of the Day". Companies have begun to realize that while the Internet is growing in importance as a distribution channel, an e-commerce strategy is necessary for survival. In many industries, however, pure play Internet business models have floundered; some have perished; and those with remaining venture capital or public funding are re-evaluating strategies.

Why has the world changed so quickly? Two powerful themes, richness and reach (the ability of the Internet to deliver highly specialized, customer specific information to a global audience instantly) and the power and flexibility of today's business webs, account for these developments and can be combined. Methods like telemarketing could deliver highly individualized content, but only to the immediate phone participants. Mass mailings include global audiences, but are not customized.

Furthermore, the Information Economy has allowed "business webs", Digital Capital's term for an interconnected network of communities of customers, suppliers, product manufacturers and infrastructure providers. They provide best-in-brand products at the lowest costs possible and form the backbone of B2C and B2B e-commerce. Contrast this phenomenon with the conventional vertical business process that characterized the Industrial Age corporation (e.g., Ford Motor Company built cars and owned rubber plantations and shipping fleets). Furthermore, business webs allow New Economy participants to form global linkages to sell or deliver products to common customers. Unlike traditional business processes, business webs can be formed and dissolved almost instantaneously.

Major value drivers

While embracing the New Economy's technology, the securities industry, more than most other sectors, is still not completely different from its Old Economy operations. Investment bankers, broker-dealers, traders and clearing and settlement personnel are still required to make the business work. While not all trading and sales are executed electronically, the securities industry continues to be transformed and must adapt to significant value drivers, which are technological innovation, globalization, deregulation and consolidation. These continue to force changes in the way securities industry participants relate to each other. No aspect of the industry, including initial distribution, secondary trading, asset allocations, clearance and settlement, remains untouched by recent events. Global financial services firms continue to expand product offerings, obtain new delivery channels and fill gaps that may exist in individual organizations. Capital markets participants will continue to either merge (e.g., CSFB/DLJ Direct and Pershing; UBS and Paine Webber), acquire or develop business webs to respond to these value drivers.

The reach and depth of online brokerages continue

The information and volume demands of the securities industry continue to fuel the transformation of online brokerage.

Number of households trading online (millions)

	1999	2000	2001	2002	2003	2004	2005
Long-Term Investing	2.00	4.10	7.60	11.40	14.10	16.10	17.20
Short Term Active Trading	2.10	2.68	3.19	3.63	3.91	4.08	4.14
TOTAL	4.10	6.78	10.79	15.03	18.01	20.18	21.34

(Source: The Forrester Brief, Forrester Research, Inc., 9/8/00)

More than 21 million US households, two-thirds of US retail investors, are expected to trade online by late 2005. For this same period, online assets are expected to balloon to USD11.9tr.

Total assets in active online accounts by type of asset gatherer (USDbn)

	1999	2000	2001	2002	2003	2004	2005
Full Service Broker	184	526	1,220	2,171	3,156	4,152	4,912
Mid-tier Broker	327	658	1,221	1,890	2,568	3,317	4,079
Deep Discount Broker	249	447	745	1,055	1,319	1,568	1,776
Mutual Fund Direct	46	142	342	536	734	919	1,095
TOTAL	806	1,773	3,529	5,652	7,777	9,957	11,862

(Source: The Forrester Brief, Forrester Research, Inc., 9/8/00)

More investors than ever before are trading securities via the Internet. Most notable is the composition of the customers, who are changing and shifting away from day traders and aggressive high-net-worth individuals to more long-term portfolio management investors. Online brokerage firms continue to consolidate and merge their business models, and combine across sectors (e.g., E*Trade and Telebanc, Charles Schwab and US Trust).

Although discount firms are more advanced, full service firms are moving forward as they adapt their commission-based sales distribution channel. Historically, this channel has been expensive and is becoming harder to justify. With more than 200 broker-dealers providing retail investors the ability to trade online, the market is being dominated by a handful of major players: Charles Schwab Corp; TD Waterhouse Group Inc.; E*Trade Group Inc; FMR Corp. and Ameritrade Holding Corp. Recently, market values and trading volumes have declined, causing broker-dealers to husband their IT resources and to ensure all channels are supported effectively.

Online discount broker-dealers realize more than one distribution channel is necessary for the future. Some broker-dealers are establishing branches to diversify their distribution and integrate Wall Street with Main Street (e.g., E*Trade Zones at Target stores). "Given the success of the E*Trade Zone at our Roswell, Georgia store, we anticipate that guests at these additional 20 SuperTarget stores will embrace this concept," said Jerry Storch, Vice Chairman of Target Corporation. He continues, "We have always believed strongly in the union of physical stores and the Internet, and the E*Trade Zone at Target is one more example of this strategy at work."

Charles Schwab, Merrill Lynch and CSFB have developed or purchased online investment or trust services, and FleetBoston and American Express continue to broaden their services. American Express recently began offering clients free trade executions and research with a minimum account of $25,000. Tradescape, a day-trading firm, started paying its retail customers $0.01 per share for orders placed and executed over its electronic communication network (ECN), MarketXT.

Online primary market and Initial Public Offerings (IPOs)

The online primary market has expanded over the last year and includes equity IPOs and fixed income securities. "New entrants and new business models are challenging the established tenets of the (investment) banking business," states Adam Singer, an e-investment banker with J.P. Morgan Chase. Investment banks are developing IT-based business plans that offer new issuers an additional avenue to raise new capital. Witt Capital, Bear Stearns and WR Hambrecht & Co. have all developed online sites for new offerings, and these issuers are no longer just middle market or dot.com companies. While the Old Economy process of issuing new securities remains the prevalent mode of capital raising, Old Economy firms, such as Dow Chemical, are beginning to raise money via the Internet (they raised USD300m in an Internet bond offering in August 2000).

Online private equity offerings and road shows have been developed. EarlyBird Capital is using this method to attract new investors to the private equity market, including high net worth professionals, as an alternative funding source for issuers in the private market. Institutional investors, including investment companies, pension and hedge funds, may no longer have an exclusive monopoly on this market. Yahoo! NetRoadShow has proved to be a successful tool, especially for new issues or tranches being distributed globally. Over 7,000 institutions have used the electronic road show service for public issues and private placements.

Mutual funds

Interestingly, the investment management sector appears to be following the lead set by the brokerage industry. For example:

Other Financial Uses of the Internet by Mutual Fund Shareholders, 2000

(% of U.S. Households Owning Mutual Funds and Using the Internet)

Financial Uses	Households (%)
Check Stock Prices	60
Read Online Financial Publication	49
Collect Information on Retirement or Personal Financial Planning	44
Access Bank Account	32
Seek Investment Advice	25
Send e-mail to Professional Financial Advisers	20

(Source: Fundamentals, Investment Company Institute Research in Brief, 7/00)

U.S. Online Brokerage Customers Accessing Other Financial Products Online

Account Type	% of Respondents
Bank Accounts	53
Credit Card Accounts	39
Mutual Fund Accounts	35
Retirement Accounts, including 401 (k)	22
None of the Above	14

(Source: Bulletin: U.S. Online Brokerage 2000-2004 Forecast and Analysis, IDC, 2000)

Many mutual fund complexes have added a discount brokerage service as a defensive measure for client and asset retention as well as a tool for financial planning and execution and as a tool to add new clients (e.g., FMR Corp., Vanguard). Profit margins for online brokerages are thinner, ranging from 12%-20% as compared to mutual funds with a range of 30-40%. Client retention is less costly than client replacement. T. Rowe Price, Strong, American Century and Scudder have added online services to speed their entry into this sector while clearing firms are offering an online private label turnkey brokerage operation. Investment companies have found this to be preferable as opposed to building a new operation. Pressure for additional services is likely to increase as investors are offered build-your-own personalized mutual funds that will compete with the Old Economy firms and stock market indexes, FOLIOfn, SmartLeaf and E*Trade. This service offers an option to purchase customized baskets of stocks in whole or fractional shares, allowing control of timing of purchases and sales. Vanguard is offering free financial advice to its 401(k) customers and plans to extend this offer to its entire retail base later this year.

ECNs and the changing national market system

ECNs have expanded with equity systems being dominated by approximately six major players. Since 1997, U.S. fixed income ECNs have grown from 11 to 70 and in Europe to 5 as of year-end 2000. This expansion and increased trading over the past eighteen months, garnering up to 30% of the Nasdaq trading volume, has caused regulators, Congress, all OTC market makers and the exchanges to debate an overhaul of the national market system. The concern was that competing systems and exchanges were fragmenting the market to an extreme, thus creating a market characterized by isolated pools of liquidity and a decline in price transparency. Some participants wanted to create a centralized marketplace to consolidate dealers and ECNs and enable all customer orders to interact together through a Central Limit Order Book (CLOB). This concept was presented by Merrill Lynch, Goldman Sachs, Morgan Stanley, Edward Jones and ABN Amro. Other dealers and ECNs suggested other reforms to improve the functioning of the national market system while leaving the basic structure intact. Nasdaq also introduced the SuperMontage, a new trading system for the OTC market. Nasdaq's proposal for their Order Display Window, popularly known as SuperMontage, was amended several times, and the SEC gave final approval in January 2000. SuperMontage is expected to be operational by year-end 2001.

Operational efficiency

Future gains will come from restructuring workflow within companies. The cost of processing a trade continues to dramatically decline, and technology continues to commoditize clearing and settlement operations. Mergers, such as the Depository Trust Clearing Corporation, can be expected to occur globally, along with the potential integration of payment systems). As online trading grows globally, country or regional clearing, settlement and payment system procedures will need to upgrade, adapt or merge to adequately support the growth of 24/7 trading. To reduce further back office costs, broker-dealers are demanding regulators to standardize rules and requirements for clearing, settlement and payments so their service can become more commoditized. The SEC is focusing on improving the internal controls at broker-dealers to ensure continued back office rationalization does not lead to a damaging increase in operational risks.

Future trends

• Internet's power is defining speed and is removing or adapting the middleman in transactions, which provides more opportunities for firms to have a customer-centric focus. Access to new technology will be required to adapt distribution channels and allow customer retention.
• Initially, the expectation for the Internet was too simple. Changes continue to challenge and modify the infrastructure of the industry and will ultimately create a more complex and integrated technological environment.
• The regulatory environment continues to adapt by providing guidance about the industry's new operating environment. While technology has been the primary driving force in metamorphosing the financial services industry, changes in the regulatory structure have allowed all financial institutions to enter the broker-dealer market.
• National borders are becoming more transparent, and investments are being distributed globally in a virtual environment. All regulators need to keep pace and work closer together, and country specific regulations need to be standardized globally.

• Size continues to be important and provides a competitive advantage. Firms are seeking additional products as well as enhancing technology to support and make service offerings more efficient.

• We are in the age of the "telecosm" - the world enabled and defined by new communications technology. Although chips and software continue to make contributions to our industry, the action is elsewhere - in communication power or bandwidth, the amount of data that can pass through a transmission media. Technological innovation is enhancing the speed of the transmission and delivery of data and information. According to George Gilder, "Bandwidth is exploding and its abundance is the most important social and economic fact of our time.

  Communication, banking and investments will be available via "the telecomputer, a device that will be portable as a watch, as personal as a wallet."

    To realize the full potential of the Internet, broadband communications are critical. US wireless web users are currently projected to increase 86.6 million in 2005. These elements are significantly impacting the industry and are broadening the quantity and quality of customers and financial institutions' interactions.

• Significant industry changes include Straight-Through Processing; shortened settlement cycles; increased automated trading volume; greater use of standardized protocols and improved communication with an increase in wireless and digitalization. Standardized clearance and settlement timeframes worldwide are required for 24/7 trading to become truly seamless and cost-efficient.

  The first wave of dot.coms has passed. The future encompasses the formations of alliances - hub and spokes - and the creation of global patchworks and business webs. Suppliers, customers and content providers are coming together on a transactional or relationship basis and forming a continuous business web or global Ethernet that will enhance revenues, reduce costs and increase shareholder value. Whatever has an imbedded chip will become part of this global web!

The future securities firm

Ultimately, this industry will remain customer-centric - whether individually, institutionally, or other intermediary focused (e.g., a distributor for a product manufacturer). Each institution will have an economic model built around its targeted business and will benefit its shareholders and clients.

The securities firm of the future will require infrastructure support and utility participants - specifically with technology and transaction processing - to execute customer strategies. How they address these needs will vary, whether they internally build, buy, outsource, create a joint venture or business web, or have a mixture. The emergence of a heavily techno-centric utility servicing the industry is likely to develop.

As firms become more customer-centric, the use of advanced client relationship tools will lead to more effective client profiling, which can increase customer loyalty and retention. Technology will be essential to customizing the retail and institutional investors' experiences and to deliver their selections of individualized products. As customers' needs change, the financial intermediary will replace one or more offerings with new ones based on customer demand and cost efficiencies. The firm will need to remake itself on a continuous basis to retain clients and prevent them from migrating to competitors.

Although no firm has yet identified "markets of one", many are making rapid advances using the Internet as a distribution channel. Ownership of the customer relationship should lead to significant value. Control of customer relationships, with real time consumer feedback, will speed new product developments. Ultimate winners will envelop the customer like a hub with spokes, offering client specific service. The future will leverage human capital and utilize technology to make these events occur.

Roger Coffin is the Lead Partner for the Securities Industry Regulatory and

Business Advisory Practice with PricewaterhouseCoopers in New York City.