Online Trading: Do I Hear Two Bits A Trade?

A price war is slashing commission rates

Their ads are everywhere--flashing on the TV screen during major sporting events, blaring out of the radio, splashing across the pages of major magazines and newspapers, piling up in mailboxes. Their pitch: Trade hundreds, even thousands, of shares, for under $10 per trade. Online brokers are up to their eyeballs in the biggest price war and advertising blitz the securities industry has ever seen. "In the past year, online trading has gone from a little niche opportunity to the single biggest market share grab in financial services," marvels Julio Gomez, president of Boston-based Gomez Advisors Inc., which specializes in Internet brokerage.

Old-guard discount brokers are being forced to restructure and refocus their efforts. Online competitors are also causing commissions at full-service brokers to look huge by comparison. That's encouraging those firms to switch to fee-based management, and increasing their willingness to discount trades for good customers. "It's given them a swift kick in the pants to focus more on financial planning and advice rather than processing trades," says Bill Burnham, an analyst with Piper Jaffray Inc. "They're all scheming how they'll have online offerings without enraging their brokers."

The number of online trading firms has mushroomed from a handful three years ago to more than 35 today. More rivals, including banks and insurers, are sure to jump in. For firms with their own clearing operations, or units that are affiliated with a stock exchange and can handle the settlement of securities transactions, analysts estimate that commissions are profitable until they fall around $5 per trade. And rates are likely to fall further. Says J. Joe Ricketts, chairman of AmeriTrade Holding Corp.: "I can see a time when, for a customer with a certain size margin account, we won't charge commissions. We might even pay a customer, on a per trade basis, to bring the account to us."

BIG SQUEEZE. The decline in commissions has been breathtaking. DLJdirect, a unit of Donaldson, Lufkin & Jenrette, Inc., sparked the most recent price war in June by cutting commission rates in half, to $20 per trade. In mid-August, Fidelity Brokerage Services Inc. weighed in by setting its first-ever Internet price at $28.95, which was 30% to 40% less than its standard commissions. The next big move came in October, when AmeriTrade launched an ad campaign to trumpet that, at $8, it had "the lowest commissions in the business." Soon after, Fidelity and Quick & Reilly Inc. cut pricing to $15 to $20. In November, Quick & Reilly Inc. launched a new unit, Suretrade, with $7.95 commissions. Web Street Securities goes further, executing 1,000-share or more Internet trades of many NASDAQ stocks for free.

Sure, Internet trading amounts to only about 138,000 trades, or about 90 million shares, a day. That's a small fraction of the total volume traded on major exchanges. But volume is exploding: Average daily trades increased 44% in the last six months. Cambridge (Mass.)-based Forrester Research Inc. estimates that online investing accounts will rise from 3 million, representing $120 billion in assets, at yearend, 1997, to 14.4 million, representing $688 billion, in 2002.

Online trading can be quite lucrative, with margins running at 15% to 20% or sometimes more. Even though online brokers aren't exactly losing money at $8 per trade, it's not the actual trading that provides some of the biggest profits. Firms make money not only from lending stock held in accounts and from the interest on margin loans but also from the cash balances in accounts. Many trades don't fall in the $8 range, anyway. Active traders tend to do a lot of options trading, which is more expensive.

But with commission rates plummeting while marketing expenses soar, the industry's fat profits may come under pressure. "The further south you go of $10, the margin for error, in terms of your ability to ultimately earn a profit, decreases dramatically," says Burnham. The swing factor in profitability is advertising. The traditional discount broker spends about 4% to 7% of total revenues on advertising, he estimates, whereas online discount brokers spend 15% to 20% and sometimes much more.

To add to the squeeze, a significant income stream, the few cents per share that discounters get for directing trades to certain market-makers, is drying up as the gap between the bid and ask prices on NASDAQ stocks shrinks. E*Trade Group, for example, which recently leapt to the No.2 market-share slot, saw its so-called payment for order flow decrease by 64% in the third quarter, compared with a year ago. The increase in trading volume since August has compensated for that lost revenue, however. "The volume increase has been so staggering that it has much more than offset shrinkage in profit margins," says Richard X. Bove, an analyst at Raymond James & Associates.

Still, there are some big gambles being made. "If you cut costs as low as AmeriTrade, you're dealing with significant reduction on margins in the clearing part of the transaction," notes Bove. Because of its marketing push, AmeriTrade expects to post losses in the first two quarters of its fiscal year.

"PRECARIOUS." Once AmeriTrade gets its customer, however, the profits start rolling in. AmeriTrade not only self-clears but has a cost advantage over other firms because it developed its own data-processing software rather than paying $1 to $3 per trade to an outside vendor. On top of the $8 commission, it still gets a few dollars per trade in payment for order flow, and net interest revenue falls between $8 and $10 per trade, according to analyst Scott W. Appleby of ABN-Amro Chicago Corp. Credit Suisse First Boston analyst James Marks believes that AmeriTrade's efforts will lead to account growth and compound into much higher earnings in fiscal 1999.

Charles Schwab & Co. is one of the holdouts in the recent price war. Says Burnham: "That's a potentially precarious position to be in while other firms such as Quick & Reilly and Fidelity are motoring south to offer trades in the $15 to $20 range." But Schwab appears resolute. Says company spokesman Tom Taggart: "Schwab has no intention of entering a price war with an $8 broker. We have become the largest online broker through a combination of valued services at a fair price."

Even full-service firms are testing out Internet trading. But they have to be careful not to alienate brokers. Discover Brokerage Direct, a unit of Morgan Stanley, Dean Witter, Discover & Co., is targeting the Discover card base. V. Eric Roach, the firm's president, says the firm will launch a "dramatic advertising campaign" in January but says he is after "a long-term value solution" and that "price-cutting is a dangerous strategy." For the first time, the firm will appeal to the Discover card base of more than 40 million consumers via direct mail.

CHOICES. DLJdirect is also moving on the Internet, and it launched a $20 million ad campaign a month ago. "There's a general realization that this is the way the brokerage business is going to be done by a large part of the population in the future," says K. Blake Darcy, the firm's chief executive. In the second half of 1998, retail powerhouse Merrill Lynch & Co. is planning to offer online trading for clients that are in its fee-based asset-management plans.

As long as volume remains high, aggressive strategies could pay off big for online trading firms. The biggest winners, though, may be customers, who will be able to choose whatever combination of price and service they want from the fiercely competitive online brokers. And who knows--maybe one day soon, consumers will be paid to trade.

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