The emergence of on line tradi
The emergence of on-line tradiAll the enthusiasm in the brokerage industry no longer centers on mutual funds as it did before internet became an everyday household word. Now, much attention surrounds on-line investing in the brokerage industry. On-line investing has only recently begun to expand at astronomical rates. As personal computers become nearly an essential part of life, consumers are beginning to manage their portfolios on-line. Full-service brokerages may now be facing competition from their cyberspace counterparts as these Internet firms expand into their market. With the proliferation of new firms in the industry, consumers are becoming exposed to increasingly lower trade prices. As in any industry, the growing role of technology will lead to many changes. The structure of the industry as well as the conduct and performance of the firms within it will give an idea of where this industry may be moving. From my research and analysis, it seems evident that the industry is growing due to the emergence of on-line investing. Also, on-line brokers and full-service brokers are converging towards a middle ground as the industry adapts to this new technology.
First, it is necessary to give some background information on this industry. As of September 1998, there were 5,591 firms in the industry. The Securities and Exchange Commission (SEC) and the NASD Regulation (NASDR) regulate these firms. "The Nard's responsibilities include establishing rules governing its broker/dealer members' business conduct; setting qualification standards for securities industry professionals: examining members for their financial and operational condition, as well as their compliance with appropriate rules and regulations; investigating alleged violations of securities laws and the NASD's own rules; discipline [these violations]; and responding to inquiries and complaints from investors and members" (nasd.com). The jurisdiction of the NASDR is limited to the NASD members and their investors. The SEC handles matters outside the NASDR jurisdiction. The SEC is an independent quasijudicial regulatory agency that administers the federal securities laws. The two most important of these laws are the Securities Act of 1934 and the Security Exchange Act of 1934. The Securities Act of 1933 requires that investors receive financial and other information regarding securities being offered for public sale. The Securities Exchange Act of 1934 prohibits companies from participating in fraudulent and unfair behavior. It also requires that investors have access to current financial information regarding securities. These laws entitle the SEC to oversee the securities markets, register and regulate brokerages, and review new products in the industry. Thus, a potential entrant must seek the approval of the SEC and possibly the NASDR before it can enter the industry. This is only one of the entry barriers facing this industry.
The entry barriers in this industry were much higher prior to 1975. At this time, all stock exchanges were required to charge fixed minimum commissions for trades. These fixed minimum commissions had ultimately caused the industry to become almost entirely composed of full-service brokerages. The competing firms had the lowest price set, so they competed with the services they offered. Once the fixed minimum commission was nullified, commissions became negotiable. An unbridled market emerged as firms took the opportunity to unbundle their services. The unbundling of their services allowed the firms to charge lower commissions. Their previous commissions had to compensate for their research, investment advice, and a larger labor component. As new entrants scrambled into the market, prices dropped significantly. Firms began to unbundle their advisory services from their execution services. This unbundling led to the emergence of the discount broker, which is still popular to this day. These firms can execute trades at a lower price since they have a lower cost. They also can charge their customers on an a la carte basis for more services if the customer is in need in further assistance in making a transaction. Another effect due to unbundling is the specialization of firms. Since consumers no longer had to pay their brokers for their investment advice, firms began to specialize in investment advice. One of the most popular ones today is zacks.com. Due to the lower prices, the quantity demanded of stock trading increased, as investors became more active traders.
As more consumers started investing, more efficient ways were developed. In the late 1980s and early 1990s, the personal computer industry opened consumers to a whole new world. As a result of advancements within the computer industry, consumers have become much more proficient and comfortable with their use of this new technology. The use of this technology to facilitate financial transactions is growing at an accelerating pace. Some firms have taken the opportunity to form specialized on-line investment firms. Ameritrade was the first firm to offer trading services over the net in 1994. Today there are over 50 on-line brokerages. These firms initially only offered trades on their sites. They were able to offer the lowest commissions since they had the lowest costs. Of course, these low prices attracted consumers. Consumers who were using Merrill Lynch could save more than one hundred dollars per trade by switching to an on-line brokerage. Consumers using discount brokers could also save since the new firms had lower costs than the discount brokers. Also, the volume of transactions that these firms administered and the profits they were reaping attracted new firms into this specialized area. With relatively low marginal costs, heavy price competition ensued in the industry as more firms entered.
As price competition has become the dominant conduct of these firms, the difference between marginal cost and price has decreased significantly within the industry. Today, Brown & Co offer the cheapest trade. They lowered their price to an unprecedented $5 a trade (down from $19) in response to Ameritrade offering trades for $8 in 1997. Most other firms have also lowered their prices within the past year also. In addition, many on-line firms have substantially lower minimum investments. Most on-line brokerages require a minimum $1000, whereas most full-service brokerages will not touch an account that is less than $5000. These increasingly lower prices have attracted the most casual investors. Consumers have immediate access to real time quotes, easily accessible research, and quick trades through the Internet. Forrester research contends that the number of on-line accounts will rise from 3 million in 1998 to 14.4 million in 2002. They also forecast that the assets managed on-line will rise from $120 billion to $688 billion, respectively. "Access to a broad range of financial information and advice has decreased the necessity for full-service brokers" (SEC.com). Thus, the on-line brokerages are attracting new investors and taking customers away from full-service brokerages as they pursue their price war.
Currently, the entire brokerage industry is trying to take advantage of the Internet. Forrester research found that roughly 80% of firms offered on-line investing services and that by the end of 1999 almost 100% will take part. With the proliferation of free information on the web, it seems to some customers that they are being charged for free information when they use full-service brokers. In response to these prevailing attitudes, Merrill Lynch announced that it might start offering its analysis and research for free. Merrill Lynch has the reputation of catering to high net-worth individuals, but current strategy seems to center on attracting a new customer segment, as its web site becomes more expansive. However, full-service brokerages contend that their commissions are set well when compared to on-line brokerages because of the services offered. Full-service brokerages offer their own research, continual advice, and hands on counsel when the market gets crazy. On-line brokerages seem to be order takers with no research of their own. Other full service firms are offering services on the web to increase the recognition of the firm. To stay competitive as technology expands, Internet services are crucial to the survival of full-service brokerages. In a Forrester survey, 34% of the firms cited generating new business as their reason for expanding on-line. The least common reason was cost saving. Only 6% of the full-service brokerages cited this reason. This data hints that full-service brokers are looking to move in on the on-line brokerage industry.
This restructuring in the industry is not limited to full-service brokerages, however. Many on-line brokers see how full-service brokers are expanding into the net domain. In response, on-line brokerages are offering more services and products. Smartmoney magazine, thstreet.com, and many other investment sources continually take polls and surveys which they use to rank the on-line brokerages. These rankings are mostly base on price, breadth of products, research links (on-line brokerages do not offer their own research), account information, real time quotes, and technical assistance. Consumers are no longer blinded by the low prices that originally drew them into the investing world. Now consumers have become aware of the problems associated with on-line brokerages. The speed of trade executions, the availability of account information, and the responsiveness of the web site all have become major factors in the quality of the on-line brokerage. These brokerages are starting to compete in the quality of their services more aggressively. With the extreme volatility of the stock market recently, many investors have realized the importance of quick trade executions. Heavy market activity seems to make on-line brokerages slower than normal. Orders take longer to process and consumers have trouble logging onto their accounts. All the on-line brokerages use brokerage software vendors. No firms seem to be attempting to integrate their services with the software vendors. As of now there is an overabundance of brokerage software vendors; so most attempts to integrate would be frail. The costs of research and development would most probably outweigh the benefits of integration. Instanex is one of the more popular systems in use. It is a high speed, automated order-processing system and can execute trades as quick as six seconds. Several firms are no longer overlooking the importance in performance within this industry. The on-line brokerage Datek now offers free commission if the trade takes longer than sixty seconds. Firms such as E*Trade have expanded their web sites to offer more services. Thus, the recent performance of the young on-line industry is proving to be beneficial to consumers as they receive better quality and lower prices.
The Internet has not forgotten the mutual fund industry. Product differentiation on-line seems to have no limits. With daily on-line trades averaging 253,000 in the third quarter of 1998 and a 33% increase from the first quarter of the year, according to Credit Suisse First Boston, the importance of an on-line presence can no longer be ignored. On-line brokerages are expanding into this market to compete amongst themselves as well as with full-service brokerages. Almost $1 trillion poured into the funds between 1994 and 1997 according to Smartmoney magazine. Growth opportunities, customer demand, and competitive pressures will ultimately bring mutual funds to all on-line brokerages. Mutual funds themselves have started to move in on the Internet. These sites typically only provide financial information and track records though. Investors will choose a brokerage to buy these funds. With an increasingly amount of information on the web, an investor looking for a mutual fund may need to only look on the internet to find the right mutual fund for him. The investor then can buy it using the cheapest online broker. This action is contingent on the fact that the investor can translate all the technical jargon involved with researching mutual funds. If the investor is uneducated with investing vocabulary or does not understand the significance of a mutual fund's financial information, he may be better off with a full-service broker.
Long term investing is one aspect of the industry that on-line brokerages are focusing on. To compete with full-service brokerages, on-line brokerages must move further into the long-term investment sector. The low trade costs of on-line brokerages have attracted a large number of investors who are looking for quick gains in their portfolios. These investors are taking more risks because the cost of doing so is less. Most of the accounts in on-line brokerages have a lower value than the majority of full-service accounts. To prove this point, consider Merrill Lynch once again. It contends that they have nearly $500 billion in assets under management. At the beginning of 1998, only $120 billion in assets were managed by all the on-line brokerages. Merrill Lynch is only one of the major full-service brokerages. There is still Smith Barney and the Lehman Brothers with billions of dollars in assets being managed under their sleeves. The on-line brokerage industry still has much potential for growth if they can find more compelling ways of competing in the long-term investment sector. The only threat to the full-service brokerages is the projections of analysts that believe that assets managed on-line will grow 475% by 2002. As of now, full-service firms are just starting to take some incentive to the on-line brokerage industry. Their lagging behind may be attributed to a large amount of their assets fixed under long-term maturation. Hardly any full-service firms allow investors to trade on-line. Their structure and performance amongst themselves thus is on another level.
Competition amongst themselves may be keeping full-service brokerages from effectively competing with on-line brokerages also. Smartmoney magazine recently ranked the full-service brokerages in its fifth survey. They were ranked on the criteria of stock research, range of services, breadth of products, commissions and fees, mutual funds, account information, and staying out of trouble. The first three criteria mentioned were double weighted because of their importance. The amount of stock research done by each firm depends much on the labor force of the brokerage. The more researchers and analysts, the more effective research tends to be. Also, the range of services offered by the full-service firms is extremely important. This is what consumers look for when they choose a full service broker. To attract consumers, full-service brokers have to offer the most services as possible. The full-service brokerage industry is much older than the on-line industry, so new advancements are not as frequent. When they arise though, full-service brokerages need to acquire the service quickly to avoid losing customers. Since the price is so much higher then discount brokerages and on-line brokerages, the firm must justify their prices with these services. One reason many full-service firms may not offer on-line trading is perhaps the fear of traditional investors becoming comfortable with Internet trading. If these traditional investors who have consulted a broker over every transaction in the past start to trade on-line, the need for full-service brokerages may dissipate. Some full-service firms have opted for a different approach that will be discussed later. It consists of leveraging their research and many analysts to serve the Internet based investors through subsidiary firms. In addition, full-service brokerages have recently increased their advisory services with estate planning and tax counseling. Most of these firms also have brokers assigned to specific accounts. The breadth of products is much broader in the full-service sector than in the on-line and discount sectors. Full service accounts offer initial public offerings, futures and commodities, and mortgage financing. Discount and on-line brokerages keep their prices down by limiting what they offer. As full-service firms began to expand on the Internet and discount brokerages and on-line brokerages expand their services, a new model of competition may evolve to encompass the entire securities industry.
First, brokerages as a whole need to do customer analysis as they compete between sectors. By analyzing the customer market, the firms can run more efficiently by allocating their resources to accommodate the customer base or bases that they serve. In my opinion investors can be classified into three broad categories. First, there is the habitual trader. This type of trader typically trades at least once or twice a month. They are usually college-educated and keep up to date with what is going on in the economy and in the stock market. They are usually young and early in their professional careers. Their assets are usually relatively small, so capital gains tax is usually not a large concern. Their purpose in trading is to make short term gains and reallocate their assets when necessary. Another type of trader is the high net-worth trader. These individuals have a relatively large value of assets. Most of these individuals are looking for long term investments to avoid huge capital gains taxes. They typically do not keep up with current market data because most of their money is locked away for specified periods of time. These investors typically trade a few times a year and check on their portfolios only after alterations to it. Some of these individuals have too much value in their portfolio that is nearly impossible for them to manage it and keep a full time job concurrently. The last type of investor in the market is the novice trader. This trader can be compared to a kid in a toy store. They have several options of what to do, but they pick up the new toy and try to figure it out. They have seen the new toy on TV, in comics, and their friends have bragged about how they have it. Now they want to have it before really knowing anything about it. This novice trader can be of any age and of any net-worth. High net-worth individuals may attempt to out perform their brokers. Their education can range from a GED to a Ph.D. This type of trader is basically characterized by their personality. They are "do-it-yourself" consumers who are driven by propaganda. Their main purpose in trading is to try something new. Secondarily, they are looking to make gains in their portfolios. In a broad sense, this is the customer base that brokerages face. The firms must produce strategies to attract the desired customer bases.
One strategy that firms use to attract customers is the use of advertising. The main method of attracting customers in the brokerage industry is through advertising. Firms can use advertising to inform consumers about their prices and how their product differentiates from other products within the same industry. Advertising has played an important role in the growth of new accounts and revenues. Many brokerages use in-house advertising agencies to minimize the expense of advertising expenditures. As with any industry, advertising creates an outward shift in the demand curve facing the firm. The amount of the shift is dependant on the amount of advertising and how effective it is. In figure 1, it shows how advertising may effect the brokerage industry. The demand curve shifts from D (Q, A) out to D (Q, A'). This outward shift causes the marginal revenue curve to shift out also. The change in profits can be monitored by setting marginal revenue equal to marginal cost before and after the demand shift. Profits increase by area B and C due to the increase of the sale (Q'-Q). The price also rises from p to p', so the firm earns additional profits on the first Q units sold (p'-p)(Q). Thus, the total increase in profits is D+B+C. As long as the increase in profits exceeds the amount invested in advertising, the strategy pays off for the firm. Almost all industries realize the potential that advertising holds in raising profits. The brokerage industry is no stranger to this fact. Largely due to the emergence of on-line brokerages, investing advertisements have proliferated everywhere. Most firms have taken advantage of the information age and put a great deal of concentration in the Internet. Consumers can probably not surf the web for more than fifteen minutes without running into a brokerage advertisement. Also, I doubt consumers can watch a cable news program without seeing an advertisement. Of course, the brokerages are only going to spend money advertising in areas where potential consumers can be reached. A brokerage could not strategically focus their advertising expenditures on Saturday morning cartoon commercial breaks to maximize profits. As technology has taken a hold of the brokerage industry, strategic advertising has become essential to a firm's survival.
In reference to the types of investors, different types of brokerages are allocating their advertisements in their respective places. On-line brokerages focus much advertising on the computer savvy. On nearly all of the news based web sites, research sites, and banking sites, there will be at least one on-line brokerage advertisement. These advertisements are intended to draw in new customers to the brokerage industry as a whole. On-line brokerages appeal to other customers through advertisements in business and financial publications. These advertisements focus on the competition between full-service brokerages as well as competition amongst the on-line brokerages. These advertisements have drawn in much of the novice investor sector of the customer base and also a large portion of the habitual traders. On the other hand, full-service brokerages divert their attention to business, financial, and luxury publications. These firms do not offer much in an Internet sense, so they have no reason to waste much of their advertisement expenditures on the Internet. They are concerned in attracting the high net-worth investors. However, that may all change soon. Charles Schwab and Co., a huge brokerage, has recently expanded their Internet capacity. Paine and Webber has recently announced its plan to offer on-line trading as well. As increasingly more firms move on-line, advertising by all types of brokerages will soon follow. After the industry adapts to the change that technology has brought to the industry, the market shares of the firms will reflect how effective their advertising was. By careful analysis of customer response to advertisement campaigns, brokerages can attribute new accounts to specific advertisements and thus maximize the efficiency of its advertising.
With expectations of more firms entering the brokerage industry and technology playing a greater role, the industry may be headed for a plethora of changes. One change is the emerging involvement of banks. These banks are consolidating with all sectors of the brokerage industry. Their objective seems to function as one-stop financial centers. "They can buy instant expertise and instant expertise in the booming discount arena" (smartmoney.com). Brokerages, on the other hand, get access to capital that will help them battle for more market share. In the past year alone, Toronto Dominion Bank
has bought Jack White and Waterhouse Securities. Also, Fleet Financial Group has bought out Quick and Reilly. Laws and regulations dealing with the banking and brokerage industries and changes in these laws and regulations may lead to changes in the competitive positions of different sectors of the brokerage industry. Resulting from these aforementioned changes and certain changes in other factors such as technology, many other financial institutions such as banks, insurance companies, and savings associations have bought or formed their own brokerages. Currently, these other types of financial institutions already compete with the brokerage industry by offering an array of financial services and products and offering commission discounts to their retail customers. According to Forrester Research, "banks are seeking to bolster their advisory role. Firms like First Union and Wachovia aim to be trusted one-stop financial providers. After years of treating brokerage subsidiaries as poor stepchildren, banks now strive to link brokerage and banking services to win back assets from fund companies and cash management accounts." The future of the securities industry looks bright for the banks such as First Union. Banks such as this one possess distribution strength. With already huge customer base and distribution strength, banks have the potential of becoming a financial supermarket. Forrester contends that they will be able to provide third-party brokerage, bank, and insurance products. The full effect of banks on the brokerage industry will be felt in the long run.
The most radical changes in the brokerage industry are taking place internally. The ultra-competitive market has attracted many firms. As mentioned earlier, there are over fifty strictly on-line only brokerages currently. Once again, these are firms that only have Internet based transactions with no rendered advice. Forrester believes that this number will fall to five by the year 2002. Currently, consumers have the option of choosing what type of account they want. Their choices are largely dependent on the sector of the customer base they are in. Some individuals have multiple accounts in different types of brokerage accounts. For example, high-net value traders may keep most of his assets in a full-service account. The remainder of his assets may be in mutual funds and/or he may dilly-dally with them in an on-line account with rock bottom commissions. Consumers such as this may no longer exist in the near future if Forrester's prediction comes true. The reduction in the number of firms ultimately means that they are not making enough profit to entice entrants into the market. Thus, their costs will rise in the future. For the survival of these companies, they must strengthen their advisory services and increase their breadth of products. This might necessitate an increase in prices for on-line transactions as firms start to offer their own research and advice. In effect, these firms must move up towards the full-service domain. On the other hand, full-service firms are going to have to reach down into cyberspace. Full-service firms may have to start leveraging their capital and labor into subsidiary firms to serve on-line traders. Dean Witter has already made this move with its Discover Brokerage Direct, which has unsurprisingly performed extremely well in the market. Discover Brokerage Direct has consistently placed high in several rankings such as Smartmoney's 1998 on-line broker ratings for which it placed third. Thus, as more full-service firms reach down and on-line brokerages reach up, a middle ground will establish itself. The accelerating growth in technology will leave this middle ground in the Internet. This middle ground between strictly on-line and full-service will consist of investors who need advice only to make sure that they are not making any mistakes. The prices of unbundled products and services will be menu driven. Thus, there will be fewer firms when the dust settles in the near future. High-end users will use on-line brokerages to execute quick transactions. Low-end users will want to use firms such as Merrill Lynch to manage their accounts. The consumers in the middle ground will merely be ones with fluctuating demands. Firms unwilling to conform will ultimately be bought out by rivals higher up the brokerage hierarchy.
Finally, the growth in financial assets held by a consumer is growing. With a large number of baby boomers investing their money for retirement, the securities industry is reaching record highs continuously. Successful advancements in technology and creative advertising are helping to transform the industry. Technology, namely the Internet, has accommodated for lower prices, better service, and improved efficiency. I had predicted that some sort of "medium" would form in the industry when I chose this topic, but this was merely a guess. After thorough research into the industry, I found that many analysts had predicted the same conclusion. It seems that there has been a gradual blurring of the lines between full-service brokers and on-line brokers. Jack White foresees the day when consumers will have access to all their financial needs on the Internet. I believe that these blurred lines between different sectors of brokerages are fleeting. After these firms finish "duking it out", price will nearly equal marginal cost. Banks will thus take this opportune time to move heavily into the market through a series of consolidations and acquisitions.