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case nine

Online Broking Strategies: Surviving the Downturn at Merrill Lynch, Charles Schwab, and E*Trade
Anjali Bakhru and Ann Brown
INTRODUCTION

The advent of online broking in the mid 1990s re-drew the map of the broking industry. New entrants included both established brokers and new rms attracted by the potential of reaching new customer segments drawn to the on-line brokerage business model. However, the rapidly growing on-line brokerage industry, estimated to include up to 150 rms in the United States, was soon faced with a different market environment. Following the downturn in technology stocks in May 2000, global stock markets remain weak. The once buoyant brokerage industry has been reeling from the decrease in market volumes at the end of a decade-long bull market, intensifying competition in a dwindling market. Investor condence has been further eroded by a series of extraordinary events that include accountancy scandals and potential conicts of interest in nancial houses acting as advisors to companies whose shares they are also selling. The three companies Merrill Lynch (Merrill), Charles Schwab (Schwab) and E*Trade described in this case represent the main types of entrant in the online broking industry. Merrill is a successful traditional full-service brokerage rm, while Schwab has its origins in the 1970s as a pioneer of the discount brokerage model. Finally, E*Trade is a pure play entrant and a pioneer of online trading. The three companies have pursued successful, albeit different, strategies during the emergence of the online broking market. Given prolonged market weakness, this case examines the strategy pursued by each rm in the years since the beginning of 2001. With no immediate prospect of an
This case was prepared by Anjali Bakhru of Open University Business School and Ann Brown of Cass Business School, City University. Copyright 2005 Anjali Bakhru and Ann Brown

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upturn to share trading, it remains to be seen how well their strategies will serve them in the future.

CHANGING THE MAP OF THE BROKING INDUSTRY WITH ONLINE TRADING

The early expectations for the power of the Internet to transform share trading were high. Even the survival of traditional brokerages was considered to be under threat. It is not too difcult to appreciate the basis for these views, when the characteristics of the Internet are so well-suited to trading shares. The Internet offers a new channel through which trades can be transacted the core operations of a broker but it also offers a rich medium for communication, where customers are able to access and manipulate information. The webs reach and the potential to offer a 24-hour broking service reduce the limitations of geography and maximize customer convenience respectively. The business model is an efcient one with the potential to simplify operations through the electronic capture and transmission of transaction data, thereby offering cheaper administrative costs and, hence, lower fees for the execution of trades. New investors can enter the market with far lower capital resources than had previously been possible. Any Internet user can obtain real-time stock market information, previously only available to professionals, and existing investors can manage their own portfolio directly through the Internet. The broking industry can be considered to consist of three main market segments: advisory, discretionary, and execution-only. Although brokers tend to specialize in one of these three segments, some are full-service brokers, such as Merrill Lynch, offering all the main types of service. Advisory services are where clients receive personalized advice on their investment strategies including advice on stock selection, while discretionary services tend to be offered to high net worth investors, where brokers are responsible for managing the clients equity portfolio. Finally, execution-only services are essentially no frills services: in return for lower costs, investors do not receive investment advice and a broker will simply act upon the investors trading instructions. Essentially, online broking is a sub-segment of the execution-only segment (see gure 9.1). The online brokers at their most basic level of service, offer support for their customers to manage their own investments (DIY model of investing) and execute trades as specied by the client. Contact with the company is mainly online, where customer support includes access to research and market data as well as software-based investment tools. Key to this business model is customer condence in the reliability and security of the IT systems that execute trades and the quality of customer support. However, the threat to the traditional broking industry has never materialized as expected. On one level, the threat posed by alternative electronic trading systems, such as Direct Access Trading (DAT), has yet to develop. DAT allows a client to trade directly with an exchange such as NASDAQ or through an Electronic Communication Network (ECN), where the latter are essentially private trading systems that potentially will provide the platform for global access to 24 hours-a-day, real-time trading.1 Similarly, while the onset of Internet trading witnessed the growth in new online entrants, few traditional brokers disappeared and few new entrants were start-up rms. The online 168

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New (hybrid) model Advisory Face to face services Telephone

Telephone/ Touch-tone

Exchange

Clients

Level of personal service and price

Broker Non-advisory services Clients

(Real-time) (new; old) Convenience

Internet

Figure 9.1 Broker business models

market developed primarily through existing rms enhancing their existing offerings to include online broking services. New online business models appeared to co-exist successfully with other more traditional broker models. While the online business model has an intrinsic appeal to more active, semiprofessional investors or day traders, many of whom were already clients of the discount brokers, the appeal to other customer segments of the online business model has been signicant. The attraction of online investing has created an expansion in the retail customer segment with new customers, who have never dealt directly in stocks and shares, now opening online accounts with brokerages. The development of web sites, like www.fool.com, www.stockhouse.com, www.moneyextra.com, that not only offer stock market information and comment but have also created chat rooms for their registered visitors, is another new feature of the market. The ordinary investor can now talk to others and exchange experiences. They can further follow company news and obtain research and analysis at a time and pace of their own choosing. At the same time, the development of online broking coincided with the growth in the mass afuent segment of the population. The mass afuent have been generally dened as those households that have at least 70,000 or approximately $100,000 to invest in the market. This group began to be identied in the late 1990s as a potentially lucrative market. More than 10 percent of all households in developed economies fall into this category. However, the long-term impact on the market of these growing customer segments is far from clear; it is still an open question as how best to service each of these customer segments to meet their needs and generate prots for the broker.

ACHIEVING COMPETITIVE SUCCESS

Like other dot.com companies, new entrants in the online broking market accepted the need to go for growth in customer accounts. They spent hugely on marketing to obtain brand recognition and market share. In general, marketing spend has seemed to yield results in terms of growth in the number of customer accounts. The argument for this strategy however was based on more solid grounds than for many other dot.com companies in other industries. Traditional brokers generate income from three main 169

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sources: commission on trades, interest income derived from the difference between interest payments to clients on their cash balances and the interest earned on margin loans, and a portion of the market-makers bidask spread. It is the same for online brokers. In other words, total income is signicantly affected by trading volumes and the size of clients investment assets. At the same time, the automation of transaction processing implies high xed costs but relatively low marginal costs and, hence, economies of scale exist. In addition, there is the critical mass argument. There is a point at which brokerages can reach a critical number of accounts such that the rm breaks even in terms of costs and revenues with zero trades and, hence, without the benet of commission income. With a growth in the number of client accounts, noncommission revenues increase, although admittedly at a diminishing rate. However, the rms marginal costs are also decreasing, usually at a faster rate. It was thought that rms achieving a critical mass of accounts rst would be in a dominant position. This led to further speculation that only a small number of online brokers would survive when this point was reached. Price competition was erce in the early years; E*Trade alone cut commissions seven times in the four years up to 1998. The lower costs of transactions online made this possible but the strong belief in the need for volume fueled the entrant rms commitment to this policy. The most exploited aspect of the Internet its ability to disseminate information to any number of individuals simultaneously and almost instantaneously is central to the online business model. The growth in the range and scope of information provided both by online brokers to clients and by investors to other investors is one of the most extraordinary features of the online broking sector. Even the distributive power of the Internet has been exploited. Investors can download or access software tools, like portfolio management packages, that help them manage their own investments. The importance of the performance of the technology supporting online transactions was recognized early. Customers valued security, reliability, speed, ease of use, and integrity of data records. System failure for any reason could be a major factor in losing clients.

THE MAJOR EVENTS OF THE DOWNTURN

Since May 2000, retail investors faith in equity investment has been challenged with the dot.com bubble bursting, persistent stock market weakness, concerns over company reporting, and the issue of corporate governance in general. Its no surprise that the bear market has taken its toll, but the sheer intensity of investors gloominess is remarkable, observed BusinessWeek.2 According to a survey held by the magazine at the end of 2002, investors were tired of investing in stock markets following a threeyear bear market. Investor pessimism appeared to have reached new lows, with 36 percent of investors regarding the stock market as overpriced despite the markets low levels, and only 24 percent of investors were planning to invest a lot or somewhat more in stocks or mutual funds in the following six months (down from 47 percent in 1999). The dot.com collapse marked a new era for Internet companies with a shakeout of rms in many online sectors. At the same time, venture capital (VC) investment in online rms was signicantly reduced and there was a collapse in the number of rm 170

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Figure 9.2 Performance of Dow Jones Index

IPOs (Initial Public Offerings). The potential for unprecedented share price rises was no longer an added attraction for investors new to equity investment. Other sectors were not left unscathed, and the bursting of the dot.com bubble was closely followed by the news of massive over-investment in the telecoms sector, creating conditions in which share prices soared and then fell by unprecedented amounts along with many company failures. Investors were left with the bewildering impression that VC and company management lacked an understanding of the business they were in. Moreover, the continuing high level of directors fees or severance pay, even as the rm reported losses, left many commentators disillusioned. With the growth in stock market indices slowing (see gure 9.2), and even going negative, other problems began to emerge, notably dubious accounting practices that had tended to overvalue some share prices. This culminated in a series of highly public company scandals of which Enron and WorldCom are probably the best known. In both cases, the accounts of the late 1990s had been shown to overstate prots and assets, leaving Enron bankrupt and Worldcom on its knees. The courts have yet to decide the degree of criminal behavior that was carried out by the top management of these companies, but many senior managers have been charged. Many investors in the United States, however, have suffered twice from the consequences of direct share investment as well as from the impact on 401(k) pension plans that are heavily invested in the rms they are working for. Perhaps one of the most spectacular events was the demise in 2002 of Andersen, auditor to Enron and one of the major accounting rms, as a result of their apparent collusion in the fraudulent accounting at Enron. The public discussion of accounting standards has underlined the problems of conict of interest for auditors and the difculty of representing a rms intangible assets in particular. The Sarbanes-Oxley Act was passed by the US Congress with the intention of cleaning up the auditing process. This act became law in July 2002. The investment banks have also been subject to erce criticism in relation to their investment recommendations. The inherent conicts of interest for a bank when it acts both as a corporate broker for a company and as an investment advisor to other clients became acute in the dot.com boom and crash. In the publicity surrounding the aftermath, it seems likely that many shares were knowingly misrepresented. The average investor, reading the business press and watching his or her shares lose value, is left with the perception that corporate management has little interest in protecting the shareholder, that accounting standards are inadequate, and that accounts may fail to represent the true position of a rm, while analysts are likely to have a vested interest in overselling shares. 171

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THE THREE COMPANIES

For those companies that have embraced Internet share dealing, the reduction in trading volumes over the past two years has been serious. Their revenue and business growth were based on growth in transactions. The loss of volume has adversely affected both revenue and marginal costs. In the following subsections, we describe recent developments at each of the three brokers Merrill Lynch, Charles Schwab, and E*Trade in terms of two periods, where the end of 2000 can be considered to mark the impact of market decline on the broking rms. Figure 9.3 compares the share price performance of the three rms over the period since 1998.

Merrill Lynch
Investment banking giant Merrill Lynch & Co., Inc. has ofces around the globe, total client assets of around US$1.46 trillion, and its origins date back to 1820. For a private client broker like Merrill, with its army of 17,000 brokers, online broking would seem a threat to its core business. It was a late mover and it was not until December 1999 that a web-based service was developed, helped along by the acquisition of D. E. Shaws discount brokerage in early 1999. period one: market growth For Merrill, the opportunity provided by the Internet has effectively been twofold. Development of online services has enabled it to retain its existing client base as well as attract new clients from the fast-growing afuent customer segment and, additionally, the knock-on effects of embracing Internet technology have tended to be signicant for Merrills institutional business. Merrill has two main online services: Merrill Lynch OnLine and Merrill Lynch Direct. The former service offers clients, by its own admission, the best of both worlds the convenience of online account access and the advice of a Merrill Lynch Financial Advisor while the advisory service is not offered with the latter. Product pricing is simple: for fee-based, full-service customers using Merrill Lynch OnLine, trading is free; while for clients of Merrill Lynch Direct, the cost is $29.95 per trade for US equities, where clients can also have online access to cash management services and Merrills research (see table 9.1). With regard to the former, a fee is charged at a blended rate of 1 percent of equity and mutual fund assets and 0.3 percent of cash/xed income assets for a minimum annual fee of $1,500, with fee percentages declining as assets grow. In return for this fee, clients receive a personalized service from a Merrill nancial advisor as well as unlimited broking transactions at no additional charge, where orders can be placed via a consultant, the telephone or Internet. Merrill offers a variety of sophisticated tools, such as personalized watch lists and securities trackers. Clients can also consolidate information from all their nancial service providers on My Financial Picture, which is regarded as an easy way of 172

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Merrill Lynch

1998

1999

2000

2001

2002

2003

Charles Schwab

1998

1999

2000

2001

2002

2003

E*Trade

1998

1999

2000

2001

2002

2003

Figure 9.3 Comparison of broker share prices Source: www.morningstar.com.

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ONLINE BROKING STRATEGIES: SURVIVING THE DOWNTURN Table 9.1 Comparison of broking fees at April 2003 Trade commission Merrill Lynch For fee-based, full-service customers, trading is free; for anyone else, $29.95 per trade. $29.95 per online trade; $54.95 for broker-assisted trades; $49.95 for automated phone trades. Schwab Accounts service fee of $45 per quarter per account for investors with account size less than $10,000; no service fee for accounts larger than $50,000. Minimum margin of $1,000 for cash accounts. Other

Charles Schwab

E*Trade

$19.99 for listed and Nasdaq stock trades. Additional $3 orderhandling fee for customers trading fewer than 27 times per quarter.

sharing this information with their advisors to enhance the level of advice and guidance received. Research and information can also be received in a wireless version from Merrill Mobile. Since new customers are likely to be those drawn to the Merrill Lynch Direct service, Merrill offers the Merrill Lynch Educational Channel on its web site, to afford investors the opportunity to learn the basics of nancial planning and investing. Given that Merrill is already a full-service broker, which is part of a larger investment banking group, its online services have been largely developed internally. However, at the end of 2000, Merrill outsourced its mortgage origination and servicing operations to Cendant on a private label basis to provide an enhanced array of services to its clients nationwide. period two: market decline Merrill is one of the most successful and largest securities houses, although group net earnings of $2.6 billion compare unfavorably with those of nearly $4 billion in 2000 (see table 9.2). The group was not left unscathed by the market downturn in 2001, with Merrill stating at the end of June that second quarter revenues would be approximately 15 percent lower than rst quarter revenues in 2001.3 Although market weakness negatively affected trading volumes, Merrill is protected to some extent by its pricing system with a large part of brokerage earnings being fee-based rather than transaction-based. 2001 was a difcult year for Merrill. It was caught in the scandal over analysts misleading clients over share recommendations; the private opinions of analysts appeared to differ substantially from the bullish share recommendations that they issued. The 174

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ONLINE BROKING STRATEGIES: SURVIVING THE DOWNTURN Table 9.2 amounts) Merrill Lynch: consolidated statement of earnings (in millions, except per share Year ended December 31 2002 Revenues: Commissions Asset management fees and admin. Investment banking Interest revenue, net of interest expense Principal transactions Other Total Expenses excluding interest: Compensation and benets Communications and technology Occupancy and related depreciation Brokerage, clearing and exchange fees Advertising and market development Professional fees Ofce supplies and postage Goodwill amortization Other Research-related expenses (Recoveries)/expenses related to Sep 11 Restructuring and other charges Total Income before income taxes and dividends Income taxes Net income Diluted earnings per share No. of private client advisors No. of employees 4,626 4,914 2,444 3,533 2,340 751 18,608 9,426 1,741 909 727 540 552 258 611 211 (212) 8 14,771 3,837 1,069 2,577 $2.69 n/a 50,900 2001 5,266 5,351 3,539 3,266 3,930 528 21,880 11,269 2,232 1,077 895 703 545 349 207 902 131 2,193 20,503 1,377 609 573 $0.57 16,400 57,400 2000 6,977 5,688 4,049 3,111 5,995 967 26,787 13,730 2,320 1,006 893 939 637 217 1,328 21,070 5,717 1,738 3,784 $4.11 20,200 72,000 1999 6,355 4,753 3,614 2,101 4,752 746 22,321 11,337 2,053 953 779 783 571 227 1,412 18,115 4,206 1,319 2,693 $3.11 18,600 67,900

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rm nally settled a case brought by the State of New York, agreeing to pay a $100 million ne in May. By the end of 2001, Merrills newly appointed President, Stanley ONeal, was offering thousands of non-brokerage employees a buyout package. This led to a reduction in the rms workforce from a peak of 72,000 to 55,000. At the same time, the group announced its strategy to exit unprotable businesses at a time of a slowing global economy. The direct results of this new strategic emphasis included the sale of its South African brokerage division to Investec and its Canadian brokerage and asset management business to the Canadian Imperial Bank of Commerce. The rms overseas online operations were also targeted. In May 2001, Merrill set up a new UK online banking and stock broking joint venture with HSBC (www.mlhsbc.co.uk) aimed at the mass afuent, self-directed investor. Potential investors were required to make a minimum investment of 10,000 in cash and/or shares. Clients had access to their accounts online, by telephone, as well as through a physical network of investment centers. Within a short period of time, the venture had expanded its operations to other countries, including Australia and Canada, and had planned to operate in 21 countries by 2004. However, as early as December 2001, the winding down of the venture was announced, even though the joint venture was not expected to make a prot for four years, given that fewer than 4,000 investors had been attracted to the service since its May launch.4 Merrill nally pulled out of the joint venture in May 2002 after a total investment of $200 million. Since the beginning of 2002, Merrills rationalization plans are unchanged and its brokerage operations in Japan have been severely reduced with the closure of several branches. Prolonged market weakness has forced Merrill to question its overall strategy and reassess its online strategy. The company appears to have exited unprotable businesses with a renewed focus on its core operations. While the company maintains a commitment to a multichannel strategy, it remains to be seen how central its online strategy is to maintaining the customer relationships that are the heart of its private client business.

Charles Schwab
Charles Schwab was incorporated in 1971 and entered the discount brokerage business in 1974 prior to the US Securities and Exchange Commissions abolition of xed commissions in 1975. Always a leader rather than a follower, Schwab began online trading in 1984, although it didnt go live with Internet trading until 1996. At the end of September 2002, Schwab had more than 8.0 million active customer accounts with total assets worth $727 billion. Of these accounts, 4.1 million were online with 84 percent of all trades conducted online. (See table 9.3.) Schwab pursues a multichannel strategy, aimed at providing a wide selection of choices for its clients investment needs and offering online and telephone broking through to advisory services provided via its network of ofces. Telephone access is provided in two forms: through automated telephone channels or through a service that allows customers to talk to a rm representative. The latter is organized primarily through regional client telephone service centres and online client support centres that operate both during and after market hours. Online broking services for retail clients 176

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ONLINE BROKING STRATEGIES: SURVIVING THE DOWNTURN Table 9.3 The Charles Schwab Corporation: consolidated statement of income (in millions, except per share amounts) Year ended December 31 2002 Revenues: Commissions Asset management fees and admin. Interest revenue, net of interest expense Principal transactions Other Total Compensation and benets Other compensation Occupancy and equipment Communications Advertising and market development Depreciation and amortization Professional services Commissions, clearance and oor brokerage Merger-related goodwill and other impairment charges Goodwill amortization Restructuring and other charges Other Total Income before income taxes Income taxes Net income Weighted average common shares outstanding diluted Diluted earnings per share Dividends declared per common share No. of employees 1,206 1,761 841 184 143 4,135 1,854 22 471 262 211 321 177 71 61 2001 1,355 1,675 929 255 139 4,353 1,875 56 490 339 246 338 193 92 2000 2,294 1,583 1,237 570 104 5,788 2,414 39 415 353 332 255 255 138 69 1999 1,875 1,220 820 500 71 4,486 1,888 307 279 248 169 184 100

373 144 3,967 168 71 109 1,375 $0.07 $0.0440 16,700

66 419 104 4,218 135 57 199 1,399 $0.06 $0.0440 19,600

53

12

234 4,557 1,231 513 718 1,404 $0.51 $0.0407 26,300

200 3,387 1,099 433 666 1,373 $0.49 $0.0373 20,100

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primarily centre on www.schwab.com, although there is also CyberTrader, an integrated software-based trading platform for highly active investors, which the rm is continuing to develop, and its wireless service PocketBroker, which has not taken off as expected. period one: market growth The launch of Internet technology provided Schwab with an opportunity to tap into new customer markets, where it pursued a bricks-and-clicks strategy, with more than 70 percent of new accounts being opened at its branches. Customer education was a key component of Schwabs online offering. WebShops, which were introduced in 1999, were the rst in a series of educational workshops designed to help investors increase their skills in using Schwabs online services. However, Schwab began to reorient its customer focus to include the growing mass afuent customer market both in the US and overseas. Surveys showed that up to a quarter of mass afuent investors are prepared to make their own nancial decisions with little or no advice, with almost half of these wired to the Internet.5 Since the launch of its Signature Services program in 1999, Schwab has designed new products targeted at mass afuent investors. SchwabAdvisorSource was also launched, which refers customers with more investable assets who seek a higher level of investment advice. In this case, clients must have a minimum of $100,000 to use the service, which offers referral to over 400 advisors. Schwab does, however, face a number of hurdles with regard to its market repositioning: its acquisition of US Trust in mid-2000 could be viewed as direct competition to Schwabs substantial investment advisor client base. Schwab provides custodial, trading and support services to nearly 6,000 independent investment managers, who had guided the investments of around 1 million Schwab accounts containing $224.2 billion in assets at the end of March 2001. Technology has been core to Schwabs online strategy, ensuring that the company is able to expand and improve upon existing services, such as Mutual Fund One Source. This makes nearly 1,300 funds available from around 250 fund families with no-load, no-transaction fees. During 2001, StockExplorer was developed as an online screening tool which enables clients to identify equities that meet certain screening criteria according to the investment strategy selected. Essentially, it is a tool that mimics the advisory function of a personal broker. At the same time, systems have to respond to the challenge of varying capacity demands. 1999 was a major growth year for Schwab, with total customer assets up 48 percent on the previous year to $725 billion, and with the number of new accounts opened up by 1.5 million to a total of 6.6 million accounts at the year end. This growth was reected in a $126 million investment in systems capacity, which doubled trade processing capabilities as well as enabling the web site to handle single-day records of 78 million hits in December of that year. It is not surprising that, given Schwabs focus on multichannel delivery, the company has tended to focus on internal development of its technology to ensure a greater level of control. Its move to work more with outside providers was justied by the companys need to enhance existing services; its MyAccounts service utilized technology provided by Yodlee Inc. to aggregate online nancial information for clients and enable them to

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analyze and manage that information in one password-protected site. And most notably, in 2000 Schwab entered into a technology alliance with Ericsson to develop wireless trading applications. period two: market decline Weakness in equity markets tends to have a negative impact on retail brokers. Clients of retail brokerages, unlike wealthier private clients, are likely to have share portfolios that are a much smaller percentage of their total investments and, hence, are more likely to withdraw from equity markets in a downturn. Schwab is a successful company with net income of over $718 million in 2000 (table 9.3). However, Schwabs trading revenues in the rst quarter of 2001 were down 51 percent year-on-year, with total revenues down 30 percent. In addition, the total number of daily average trades was down substantially during the same period. For Schwab, the impact of market weakness was rst felt in early 2001, when Schwab began encouraging its employees to take time off in an attempt to avoid layoffs. By March, however, the trading situation had worsened, and Schwab announced that it was going to re 13 percent of its employees. By the end of 2001, the rm had reduced its workforce by nearly a quarter, the rst layoffs since the market crash of 1987. The one exception to all this was the marketing budget; it was reported that Schwab was still going to spend the same amount on marketing in 2001 around $330 m as it did the previous year.6 Trading volumes did not, however, recover in 2002, with Schwab announcing that the number of trades in August was down 25 percent on July. The company continued to lay off staff throughout 2002. With the total number of employees at 16,700 at the end of 2002, Schwab had laid off approximately 35 percent of its workforce since the end of 2000. While the reduction in staff in 2001 was aimed at reducing capacity in its retail business and technology units, along with the sale of substantial amounts of computer hardware, the rm said that the recent staff cuts were focused on streamlining the companys structure and eliminating middle management.7 Despite continued market weakness and ongoing conicts of interest with its advisor client base, the rm continues to conrm its commitment to target the mass afuent customer segment. In May 2002, Charles Schwab himself announced moves aimed at capturing the most protable customers of the likes of Merrill, Morgan Stanley Dean Witter, Salomon Smith Barney, and UBS Paine Webber afuent clients with $500,000 to $5 million to invest. As a result of this, the company has launched its own private client service, where, for a at fee, customers can talk with a personal advisor on a wide range of issues from asset allocation to stock selection as well as receive equity research from investment bank Goldman Sachs. Clients pay an annual fee of 0.6 percent of assets subject to a minimum fee of $1,500, although the advice offered does not cover legal, tax, or estate-planning advice. These clients constitute an estimated $11 trillion investment market, or about half of all the investments made by Americans.8 Other new services include a stock-rating system to aid investment decisions. More than 3,000 stocks are graded on an A to F scale based on 24 measures, such as a

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companys cash ow and sales growth. The company claims that the potential of the system to outperform the S&P500 stock index is proven in recent trials. At the same time, since the beginning of 2002, Schwabs marketing campaign has emphasized that its brokers are not paid on a commission basis and has focused on the impartiality of the rms investment advice given that the rm is not part of an investment banking group. The company further plans to launch insured banking products, aimed at encouraging nervous investors back into the equity markets. However, cost pressures have caused the company to reappraise its fee structure, with an extra $3 transaction fee being added to online trades. To date, Schwab has pursued a successful multichannel strategy, where the use of technology has been central to its strategy of enhancing its offering. Given continued market weakness, the rms positioning towards the mass afuent investor does, however, carry risks. Will it maintain its leading position as a retail broker or will investors view it as a diluted version of a private client broker, unable to compete with rivals like Merrill Lynch?

E*Trade
E*Trade is both the pioneer of Internet trading and a pure-play entrant. Its success has been rapid; transaction revenues were over $739 million in 2000 (see table 9.4) and the company was listed on the New York Stock Exchange (from NASDAQ) in early 2001, less than ve years since its IPO on August 16, 1996. From a reported 91,000 customer accounts at the time of listing, E*Trade reported 3.725 million active customer accounts with total customer assets of $47.9 billion and 3,800 employees by March 2001, when the level of customer accounts had approximately doubled over the previous year. Despite the market downturn, the rm has continued to expand and diversify. By early 2003, the company described its principal activities as offering . . . personalised and fully integrated nancial services solutions that includes investing, banking, lending, planning and advice. period one: market growth The company launched its new nancial portal site, Destination E*Trade, in late 1998 along with a state-of-the-art new customer support centre. This was followed by the opening of a Knowledge Centre in 1999 for the benet of customers, many of whom were young and new to investing. Clients were offered two types of accounts: an E*Trade account or a PowerE*Trade account. The latter is for more active investors in which the more you trade, the lower your commissions, with these as low as $4.95 per trade for 75 trades or more per calendar quarter. However, the company has continued to expand the services it offers. It acquired Private Accounts to provide low cost, direct access to nationally recognized money managers and timely access to portfolio information. It also launched E*Trade Personal Money Management, an online investment resource that allows investors to search for, compare, and hire professional money managers via the Internet a service that is available to customers with a minimum of $100,000 to invest. 180

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ONLINE BROKING STRATEGIES: SURVIVING THE DOWNTURN Table 9.4 amounts) E*Trade: consolidated statement of operations (in thousands, except per share
Year ended December 31 2002 Revenues: Transaction revenues Net interest International Other Provision for loan losses (Post-2000) Brokerage Revenues: Commissions Principle transactions Other brokerage related Brokerage interest income Brokerage interest expense Net Brokerage Revenue Banking Revenue: Gain on sales of orig. loans Gain on loans held Other banking related Banking interest income Banking interest expense Provision for loan losses Net Banking Revenue Net Revenues Cost of Services Operating Expenses: Sales and marketing Technology developments General and administrative Amortization of intangibles Merger-related expenses Facility re-structuring/nonrecurring Executive loan settlement Total operating expenses Total cost Operating Income (Loss) Income taxes Extraordinary items Net income (Loss) Weighted average common shares outstanding diluted Diluted earnings per share No. of Employees 2001 Year ended September 30 2000 739,078 359,496 166,061 107,686 (4,003) 1999 355,830 153,622 124,233 40,546 (2,783)

301,778 216,544 178,744 182,103 (12,515) 866,654 128,506 83,953 46,184 763,890 (548,659) (14,664) 459,210 1,325,864 567,224 203,613 55,712 210,646 28,528 11,473 16,519 (23,485) 502,736 1,069,960 255,904 85,121 1,555 (186,405) 361,051 $0.52 3,500

377,704 157,949 156,690 305,581 (86,489) 911,435 95,478 75,836 38,587 854,290 (692,786) (7,476) 363,929 1,275,364 595,590 253,422 88,717 236,353 43,091 11,174 202,765 30,210 865,732 1,461,322 (185,958) (19,885) 480 (241,532) 339,315 $0.73 3,500 1,368,318 515,571 521,532 142,914 209,436 22,764 36,427 671,448 302,342 325,449 79,935 102,826 2,915 7,174

933,073 1,448,644 (80,326) 85,478 (181) 19,152 301,926 $0.06 3,800

518,299 820,641 (149,193) (31,288) 4,651 (56,769) 272,832 $(0.21) 2,000

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E*Trades origins stem from its development of proprietary transaction processing technology, and the companys technological infrastructure is based on a modular architecture which is scaleable to handle increasing transaction volumes. Enhancements to its broking service included the development of E*Trade AccountExpress (the rst real-time account opening and funding service that allowed customers to open and fund an account electronically) by increasing the cash amount that new customers could initially invest as well as enabling faster and easier transfer of additional funds to E*Trade. MarketCaster, a new applet product which provides brokerage customers with free, streaming, real-time stock quotes, was also introduced. With this product customers are able to set up one or more customized watch lists and monitor the performance of stocks without having to refresh their computer screen. MarketTrader is a tool providing all PowerE*Trade customers with streaming NASDAQ Level II quotes, integrated trading, and personal account information on a single screen. It is offered to the most active traders, namely those who trade more than 30 (PowerE*Trade) and 75 times (Platinum Level) per quarter respectively. Convenience of access has been central to E*Trades strategy. Customer access has been enabled via the Internet, CompuServe, Prodigy Internet, Microsoft Investor, WebTV, direct modem connection, and TELE*MASTER, their touchtone and speech recognition telephone investing system. An integrated wireless banking and brokerage service was launched in October 2000. Expansion of services has been afforded by the companys emphasis on developing content, technology and distribution alliances including Bond Exchange (bond trading), Instinet (after-hours trading), Brieng.com (research), InsWeb (insurance), Critical Path (e-mail services), and EveryPath (wireless application provider). At the same time, E*Trade acquired a number of companies including Private Accounts (which provides low-cost, direct access to nationally recognized money managers), VERSUS Technologies (software supplier for global cross-border trading), Card Capture Services (to expand the array of nancial transactions and, ultimately, online brokerage via ATMs), Telebanc (the nations largest pure-play Internet bank), and ClearStation (a nancial media site that integrates technical and fundamental analysis with community discussion to offer investors ideas, analysis and opinion). Also, E*Trade together with Ernst and Young announced a joint venture in 2000 to provide a personal electronic advisory service to help prepare clients for major nancial events such as buying a home, tax/estate planning, funding a childs education and preparing for retirement. period two: market decline At the beginning of 2001, E*Trades average customer balance was $17,500 vs. $106,000 for Schwab and $180,000 for Merrill.9 The rm is vulnerable to a reliance on brokerage commission, especially given that its low trading prices imply a higher critical mass (i.e. the point at which the rm is protable while charging no commissions at all). The company increased its physical broking presence in the US, including the development of E*Trade Zones, in conjunction with retailer Target. The rm is

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further attempting to diversify its sources of revenues. The company has expanded geographically, predominantly via joint ventures and acquisitions, with operations across the globe serving customers in many countries including Australia, Canada, Denmark, Hong Kong, Israel, Japan, Korea, Norway, South Africa, Sweden, the UK, and the US through branded web sites. Telebanc, acquired in 2000, was relaunched as E*Trade Bank, the largest pure-play Internet bank in the USA. Integrated banking and broking services were provided with access to the third largest ATM network in the USA (with around 9,600 ATMs). The success of the bank is owed, in part, to gains from crossselling efforts to the broking customer base. Mitchell Caplan, Head of Banking Division, said in April 2002:
Last quarter, half our new bank accounts came from existing brokerage customers and 29 percent of the mortgage business came from existing banking and brokerage customers.

Since the beginning of 2001, E*Trade has nevertheless suffered a signicant decrease in broking volumes and revenues. It has sought to expand its broking services. Following the public condemnation of research analysts at investment banks like Merrill, E*Trade has taken the opportunity to provide its own research to clients, given that it is not compromised by the potential conicts of interest facing investment banks. In May 2002, the rm hired a group of analysts from investment bank Credit Lyonnais to provide clients with unbiased advice. However, its core broking business remained under pressure and, by October 2002, the rm began to extend an offer of $9.99 per trade to those customers averaging 27 trades per quarter. It is not surprising that Christos Cotsakos, CEO, came under criticism from shareholders for the very large compensation package awarded to him for 2001, an unprotable year for the company. Despite relinquishing part of his compensation package, his nal pay still stood at $64m, the highest in the US broking industry. E*Trade has come a long way since its pure-play origins. The company has sought to extend and adapt its broking service in line with changes in customer tastes and in response to the market environment. At the same time, the rm has sought to grow and protect its revenues by diversifying its online nancial services offerings. The rm has successfully managed to survive the market downturn so far. The question remains: how long will it take for the company to translate this once again into prots?

SUMMARY
The application of Internet technologies to traditional markets has led to the emergence of new, online markets, where new customer segments have been created by the transformation of existing business models. What is interesting about the broking industry is how all segments of the retail broking industry appear to have embraced the new technology and added new online services to their existing service offering. However, private client brokers, such as Merrill, may prove to be the exception in terms of the direction of their online strategy, given the greater resilience exhibited by the very rich than the mass afuent in the current market downturn.

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QUESTIONS
1. 2. What has been the impact of the Internet on the broking industry? During the period of market growth, how did each of the three brokers compete? 3. E*trade can be considered to be an Internet-based e-commerce business. Identify the type of e-business model that it has developed over the growth period. Is this a viable model? 4. How well has each company performed during the downturn? 5. How have each of the three brokers responded to the market downturn? Do you think they will be successful in surviving the downturn and why?

USEFUL WEB SITES

US Securities and Exchange Commission: Company websites: http://www.sec.gov/cgi-bin/srch-edgar (Edgar Archives) www.ml.com www.schwab.com www.etrade.com

NOTES
1. 2. 3. 4. 5. 6. 7. 8. 9. http://www.tradefreedom.com/features/freedom.html. BusinessWeek, 30/12/02. Merrill Press Release, 06/26/01. Financial Times, 12/07/01. Financial Times, 06/22/01. Financial Times, 03/28/01. Financial Times, 18/9/02. BusinessWeek, 3/6/02. Forbes Global, 10/01/01.

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