Are Superdeep Discounters As Cheap As They Seem?

Listening to Everett F. Lang, one almost can't help thinking he belongs astride the prow of a boat or rattling a saber before a crowd of infidels: "Our goal is to be the place America trades its stock!" he cries. "We've carved the niche, and we'll defend it mightily!" Lang, the president of Manhattan-based National Discount Brokers (NDB), is indeed thigh-deep in a battle--a fierce price war being waged by the rapidly growing breed of superdeep-discount brokers. It's an assault that has traditional discounters fighting to maintain market share at a time when trading volume and commission revenue are down. And while consumers may win lower commissions, they sometimes wind up paying a higher price for their stock.

Lang is at the forefront of an aggressive effort to capture investor trades with offers of commissions as low as $25 to trade up to 20,000 shares of a $5 over-the-counter stock. Offers like that are not only giving grief to the full-service brokerages--such as Merrill Lynch & Co., which could charge more than $1,500 for such a 20,000-share trade--but are also forcing the discount industry into a price war. "NDB is having a major impact on the industry," acknowledges Jack White, president of San Diego-based discounter Jack White & Co. These superdeep discounters are creating a three-tiered industry (table): traditional discounters, led by Charles Schwab & Co.; a middle tier of firms, including Muriel Siebert & Co.; and the growing ranks of superdeep discounters. To meet the competition, some of the traditional discounters have launched their own deep-discounting operations.

TRADING SHOTS. The commission wars are fought with a barrage of advertising from the upstarts. NDB and a Boston-based competitor, Brown & Co. Securities Corp., which is owned by Chemical Bank, are in pitched battle. NDB advertised a $30 rate for certain trades. Brown responded with a $29 rate. NDB fired back with a $25 offer. Enter a new firm, Washington Discount Brokerage Corp. It advertises a limited-time offer of $17.76 on all trades up to 5,000 shares.

Another attack on the deep discounters comes from Muriel Siebert & Co. The firm is launching an assault on both Schwab and "the new guys" in television ads that refer to "untested Johnny-come-latelies, with lowball rates, unexpected charges, and restrictions." The new ads also note that the firm's pricing is "70% below Schwab's" and "consistently less" than Fidelity Brokerage Services Inc.'s and Quick & Reilly's.

The battle of the discounters is as intense as it is because the winners will take home many millions. In recent years, discounters have been one of the most profitable groups in the securities industry. Discounters that are members of the New York Stock Exchange averaged a pretax return on equity of 39.1% in 1993. Discounters have steadily eaten bigger bites of their full-service peers' lunch, moving from a market share of 4.6% in 1983 to over 14% in 1993. And it's a big pot: Retail commission revenue in 1993 was $9.1 billion.

How can the deep discounters charge so little for trades--and still make a buck? The "secret" is that commissions are the icing on the cake. The big rewards come from what is known in the business as "payment-for-order flow." In order to attract trades, market makers--firms that stand ready to make markets in over-the-counter stocks--often pay 2 cents a share to a broker for sending orders their way. While many consumers aren't aware that such payments are made, NDB gives full disclosure in its brochure, stating that NDB "can afford to charge one flat $25 fee for all NASDAQ/OTC transactions because of the income it receives from other dealers on these transactions."

Who really pays that 2 cents a share? Is it the customer? "Investors get a fair price," says Robert Forker, president of Seattle-based Oxford Deep Discount Brokerage. "It's not a rip-off." Market makers pay the brokers out of the, say, 12.5 cents per share--or 1/8 spread between the bid and ask price--that they may make on transactions. The defenders of order flow argue that the customer gets the best executions available, and, in effect, the order-flow payments are a free lunch allowing discounters to offer such low commissions.

But some of the traditional discounters say there's no free lunch. "It looks like the public is getting something for nothing, but they may actually be being charged more," says discounter White. He questions whether trades done by firms that make markets (hold inventory) in the stocks they take orders on always give the discounter's customers the best price. NDB's Lang says such claims are sour grapes: Because he has a deep-pocketed parent, Sherwood Group, that helps fund the firm's heavy advertising, "our economies are different" from other firms, he says. Lang stresses that orders are automatically routed to the best bid and offer available.

Perhaps. But that's not always the case with discounters of any stripe. A broker who works for a traditional discounter--not a deep discounter--acknowledges that customers don't always get the best price. The broker cites a recent trade where an investor wanted 2,000 shares of a $15 stock. On the New York Stock Exchange, the bid was 15 and the ask was 151/4, but "on the exchange, you could get a price of 151/8, between the bid and ask," says the broker. In the third market, however, there was no middle ground, so a buyer would pay 151/4. And that's where the client's order went, since routing the trade to a market maker meant $40 of profit for the discount brokerage.

An exhaustive 1993 study of stock market transactions handled both on the exchanges and on the third market, by University of Michigan professor Charles M.C. Lee, backs up the broker's contention. Lee's article in the Journal of Finance found that "...during 1988 and 1989, off-Board dealers paying cash inducements were able to recoup those payments in the form of higher effective spreads"--that is, by charging the investor more.

Whether or not consumers who are using discounters are getting less than they bargained for, the low commissions are alluring. Are full-service brokers feeling the heat? Merrill Lynch says it is not transaction-oriented and thus does not consider deep discounters competition. Full-service brokers' main challenge comes from traditional discounters, which are adding ever more bells and whistles to their offerings.

That may indeed be true. But traditional discounters are also guarding their flank. For the first time, Schwab is advertising and marketing a beefed-up program that it has had for active investors since 1984, called the Schwab 500 Brokerage. Depending on how much trading a user does, the customer can get a discount of up to one-fifth more than Schwab's standard discount commission on the next quarter's trades. As with most firms, traders get an additional 10% off if they place orders through an automated computer or touch-tone telephone service.

CANNIBALS? But traditional discounters realize they have to offer deep-discounting services, too. Take Fidelity Investments. Along with Fidelity Brokerage Services, the firm owns a deep discounter, Spartan Securities Corp., which may charge less than half the commission levied by its higher-priced cousin. Fidelity views the service as a value-added product to satisfy active traders and says it is advertised a fair amount--even if, as Fidelity recognizes, it does wind up cannibalizing the higher-priced service.

That possibility may explain why the chairman of Waterhouse Securities Inc., which recently launched deep discounter Washington Discount Brokerage Corp., tried to deny that it owns the firm. Indeed, when BUSINESS WEEK asked Lawrence M. Waterhouse Jr. for information about the new discounter, he feigned ignorance: "It's not ours. I have no idea who they are. Do they clear through us?" When BUSINESS WEEK reminded him of the firm's filing with the SEC--and that his daughter is president of the company--he relented. The launch was just a training exercise for one of the firm's divisions, Waterhouse explained. "We wanted to test doing fully disclosed clearing, so we figured we would test it on ourselves, and then when new discounters came out over the past year, we thought we'd have fun with that."

Maybe so. But in the future, the escalating assault by deep discounters is likely to cause him--and the rest of the established discounters--more of a headache than a belly laugh.

      The three-tier market in commissions
                                     Transaction cost*
                                1,000 shares    5,000 shares
      Firm                            at $25    at $10
      CHARLES SCHWAB                 $155.00    $290
      FIDELITY BROKERAGE              154.50     245
      JACK WHITE & CO.                 63.00     133
      MURIEL SIEBERT & CO.             50.00     100
      BROWN & CO.                      29.00      29
      NATIONAL DISCOUNT BROKERS        25.00      25
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