An End Run On Brokers
How Some Investment Sites Offer Direct Access To Exchanges
By Elizabeth Gardner - Internet World
Judging from ads for online brokerages, the middlemen of the equity markets have, like many other middlemen, been "disintermediated" by the Internet. Dump your traditional broker for E*Trade or Ameritrade and prepare for independent wealth! Sounds like you can just tap your own pipeline into the Nasdaq and suck out the money, doesn't it? Don't be fooled. Those middlemen are still there. At most online brokerages, it's still the brokers who receive the orders, only they get them by e-mail rather than by phone as with traditional brokerages. The orders are then routed to "market makers"--companies that either turn to the financial markets to find buyers and sellers at the desired price, or themselves become the buyers or sellers if they can't find a taker for a given order. Because market makers pay the brokers for those orders (called "payment for order flow"), and they have to make money somewhere, the prices they get for investors are not generally rock-bottom for buyers nor at the very top for sellers. They pocket the difference.
But these middlemen are about to be squeezed--if not out, then down. Brokers and full-time day traders have actually had a pipeline to the markets, bypassing market makers if they wish, through dedicated software and partially or fully dedicated networks rather than through the Web. They get faster trades, and can shop all the traditional exchanges and the newer electronic trading networks (also known as electronic communication networks, or ECNs) for the best price.
Now, companies that serve the professional and day-trader market are trying to expand to the investor who may make one trade a week instead of dozens per day. They include Tradescape.com, TradePortal, and TradeCast, which touts its new product line with the tag line, "You still trading stocks on the Web, sissy boy?" All of them offer trades executed in fractions of a second, compared with 20 to 30 seconds on average for Web-based brokers like E*Trade. They also generally come with gobs of data, including Level II Nasdaq quotes--not just the best prices for buying and selling, but all the prices that anyone is offering. The companies serve as brokers, maintaining brokerage accounts for their customers and collecting commissions on each trade, but they let their customers bypass market makers, and the orders generally zoom through their systems untouched by human hands.
"Our whole deal is about disintermediation," says TradeCast CEO Bobby Earthman, whose company received a $40 million investment last August from the Texas oil billionaires Sid and Lee Bass in exchange for 40 percent ownership. Earthman describes the company's newest product as "so easy that grandma can use it."
Last month, leading online broker Charles Schwab & Co. purchased a small but fast-growing brokerage called CyberCorp for $488 million. CyberCorp's software, like TradeCast's, offers investors direct access to the exchanges and ECNs, thereby theoretically improving both execution speed and price. At the same time, Schwab slashed its $29.95 commission for active traders. Trade more than 30 times a quarter and the commission drops to $19.95. More than 60 per quarter and it goes down to $14.95.
The CyberCorp offering is geared toward "active traders," who are much coveted by all brokerages but until now were not directly served by Schwab's product line. CyberCorp's 2,500 existing clients do an average of almost eight trades per day. Schwab's average client does eight trades a year. Even at $14.95 per trade, it's clear to see where the profit lies. The more active traders Schwab can attract, the better for its bottom line.
But even Schwab's average customer may benefit eventually. CyberCorp's software, like that of Tradescape and TradeCast, automatically picks the best price available for a given trade and routes the order to that market--a smart-shopper bot for stocks. Greg Smith, an analyst with Chase H&Q (formerly Hambrecht & Quist), thinks that's going to be the killer app for direct-access trading, and will radically change the money flow for the whole industry.
In itself, he says, the ability to access markets directly is too complicated for the average investor; day traders and brokers spend months learning how to decode and use the flood of information in "second generation" software that simply gives them prices in all the markets and leaves it up to them to choose where to send their business. But even those who do four or five trades a year can benefit from direct-access software with intelligent order routing--what Smith calls the "third generation."
"This is the future," he says. "Automating order routing is what everyone should want."
These direct-access products make the market more transparent, which should theoretically make it more efficient and therefore less expensive to operate. "Part of the promise of ECN links and real-time quotes is that the middlemen may start to slide out of the process," says Zona Research analyst Jack Staff, who recently published a book about online brokerages. "It closely approaches perfect information transfer." He predicts that all the brokerages will eventually offer direct access to the markets, either by acquiring one of the direct-access software companies or by creating their own products. "This is one of the migration paths for some of the offline brokerages who have been aced out by the upstarts online," Staff says.
Chase H&Q's Smith estimates that up to half of all trading volume could move away from market makers and into direct-access channels, but probably no more than that. The 50 or so stocks that people trade the most, such as Yahoo, Cisco, and Microsoft, have enough shares in play at any given time that buyers and sellers can easily fill their orders without a market maker. But for issues that trade more rarely, a buyer or seller might not be able to pick up a deal of any kind, much less an advantageous one. "You need a market maker when you don't have natural liquidity," Smith says.
But market makers are likely to lose their leverage with brokerage firms, and they may wind up having to give customers better prices to hang on to their business. "Now, they match the best bid," Smith says. "They could start giving an extra 16th."
Don't expect brokerages to blow trumpets about their direct-access capabilities, or at least not right away, says Zona Research's Staff. "I'm not sure that going directly to the ECNs will be understood by online investors well enough to drive them to the site in large numbers," he says, observing that customers are usually reluctant to change brokers unless they really screw up. "It might take 10 years to pay off the ad campaign."
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Date: 20000315 |
