Troubles await online brokers

When Roger Robinson left the Navy after seven years of service, he had saved about $70,000 and was itching to see it grow.

During the past 15 years, he shifted his assets from a full-service brokerage house to a discount broker, and then to the emerging world of online trading.

"As a young investor you don't really know what to do, so you listen to your broker," said Robinson, who began using an online broker two years ago. "Once you start making your own decisions, it just doesn't make sense to go through a broker and to pay their huge commissions."

Robinson is part of an explosion of people who have ventured into cyberspace to buy, sell, and research stocks. But as online trading comes of age, it is undergoing some substantial growing pains that will increasingly challenge younger companies in the promising industry.

Web-based online brokerages--the industry pioneers--will face more competition next year when full-service firms such as Merrill Lynch, PaineWebber, and Prudential Securities offer online trading. Moreover, discount brokers with an online trading presence are jumping ahead of Net brokerages such as E*Trade with higher growth rates.

Other firms that do business exclusively online, such as Datek, DLJdirect, Suretrade, and Discover, saw their average daily online trading volume rise a mere 6 percent collectively in the third quarter, while traditional discount brokerages such as Charles Schwab, Waterhouse Securities, and Ameritrade, along with mutual fund powerhouse Fidelity Investments, posted a 20 percent rise as a group, according to a Piper Jaffray report.

Gaining ground
"What happened was that as markets became more volatile, the new, online-only firms found it tougher to grow than the existing firms," said Bill Burnham, vice president and senior research analyst for electronic commerce at Credit Suisse First Boston Technology Group. "The existing firms benefited from the fact that they have a huge reservoir of customers that they have yet to convert to online trading."

Fidelity, for example, jumped over E*Trade in the third quarter to seize the No. 2 spot for firms with the largest average daily online trading volume. Schwab, meanwhile, still retains its top status.

The growth prospects for online-only firms remain strong, however, because the market is booming.

In 1996, the number of online trading accounts totaled 1.5 million, according to Forrester Research. The total is expected to soar to 12.7 million in 2001. "We refer to it as blasting off," said Michael Gazala, an analyst at Forrester.

High expectations
The demographics of online customers also are expanding. "The early adapters were the fairly sophisticated active traders," said Phil Leigh, an analyst with Raymond James. "Now it is moving into the mainstream."

Online trading is most likely to attract clients with assets between $300,000 and $500,000, he said. But industry executives say they've also seen an increase among wealthy long-term investors who bank $1 million in their accounts.

Online brokers have added services to help draw the larger account holders, marking a shift from the cut-price mentality that ruled the industry in its early years.

"What extras can you offer for eight bucks?" Ameritrade president Michael Anderson asked rhetorically. "People are expecting more and, in some cases, my competitors are offering more. I have to be able to address that."

Some firms are offering premium services that provide analysts' research reports, breaking company news, and pricing based on how actively you trade.

"There's a shift in mentality among the online brokerage sites. They're offering more financial products with the goal of capturing more of the consumers' assets from mutual funds to online bill paying to credit cards," said Steve Franco, an analyst with Piper Jaffray.

Brokerages also want to insulate themselves from volatile markets. "People may slow down their trading during these times, but they will always still have to pay bills, so some firms like Datek are looking into online banking," Franco said.

Persuading consumers to go along won't be easy. Although brokerages may want to manage all of their customers' assets, it may be tough to get them to give up multiple online accounts at various brokerages.

Growing pains
One of the biggest challenges that haunts online trading firms at every step is trying to assuage their clients' mistrust that their systems may crash at critical moments--like when trading volume peaks during a market plunge.

"I think that is just the prudent behavior of active traders who learned during the market volatility to not have all their eggs in one basket," Burnham said.

The mistrust was born on a bleak day in October 1997 when the Dow registered one of the biggest single-day drops in stock market history. That day scores of investors encountered problems when they tried to log on to their online brokerage accounts to make trades. Worse still, the alternative option of calling in orders over the telephone also became troublesome as panicked investors were jamming all the available phone lines.

The incident prompted the Securities and Exchange Commission and the National Association of Securities Dealers to follow up on complaints by investors to determine the measures online brokerages were taking to handle the increased volume.

Most Web brokerages have invested heavily to strengthen their architecture to minimize the chance of a repeat of that October 1997 debacle. But with the rapid growth of online trading, executives at most these companies want their infrastructure to be able to handle today's peak trading volume, as well as meeting the challenge down the road when the ranks of Web investors has swelled.

"We've had some outages here once in a while--I don't want to hide from that," said Ameritrade's Anderson. "One challenge is to get things bulletproofed...to keep building the infrastructure so that we can handle the trade volume that we plan to handle in the near future."

Despite the system improvements, online trading firms have to contend with lost revenues as many investors continue to use multiple services. But in some cases, reliability is not the concern and many investors are still experimenting to see which services firms offer and which Web site layouts they prefer.

"I use multiple services to get the different benefits of each," Robinson said. "That's the nice thing about the Internet, you can have different browser windows open and do research at one site and execute cheaper trades at another."

Taking a position
Analysts differ on how the industry's players will position themselves in an evolving market. But they generally agree that there will be consolidation in the future.

Smaller, second-tier firms are likely takeover targets for larger financial institutions that want to get into online trading, some analysts say.

And in some cases, this has already happened. For example, Fleet Bank now owns both Quick & Reilly and Suretrade, while Waterhouse Securities is owned by The Toronto-Dominion Bank.

Second-tier online trading firms include National Discount Brokers, Web Street Securities, and Brown & Company.

But other analysts speculate that giant financial companies are unlikely to bother with the small fry, and instead will gravitate toward swallowing leaders in online trading.

"There will be nothing more valuable in cyberspace than brand recognition and we are in the winnowing process now," said Leigh. He added that, if you are a leading financial institution that is looking to enter online trading, the only quick way to gain market share is to buy somebody with a leading brand.

"You are not going to want to buy an little-known brand with no market share and try to build it up," he said.  

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