Once viewed as spartan, amateurish services, discount brokerages have emerged as a potent and lucrative force in the U.S. securities brokerage industry, aided most recently by the popularity of Internet-based trading. Although the distinctions are increasingly blurred, discount brokerages generally charge flat-rate trading fees rather than the percentage commissions that full-service brokers levy. The tradeoff at discount houses is that investors tend to receive little or no advice, company research, or other support services to help them formulate an investment strategy.
Discount brokerages debuted in the mid-1970s, when the brokerage industry was deregulated. Until then commissions had been fixed by the stock exchanges, which specified minimum rates for their member firms. After the U.S. Securities and Exchange Commission (SEC) deregulated the industry, Charles Schwab & Co., which had been a conventional full-service firm, led the charge into reducing the cost of investing while simultaneously lowering the level of services provided.
While discount brokerages, and particularly Schwab, have made tremendous inroads in the consumer market, they continue to trail the full-service firms in terms of assets and revenues. For instance, Schwab, the largest discount broker, only had about $510 billion in assets as of early 1999, whereas Merrill Lynch & Co., Inc., the largest full-service broker, had more than three times as much, at $1.7 trillion. Likewise, Schwab's annual revenues as of 1998 weren't even one-tenth of Merrill Lynch's. The asset and revenue disparities stem largely from full-service firms' ability to allure deep-pocketed institutional investors and wealthy individuals who require more than a conduit for placing a stock order. However, the conduit Schwab has consistently reported a significantly higher profit margin. For the nine years 1990-98, Schwab's 10.2 percent average margin weighed in at nearly twice that of Merrill Lynch for the same period. This profit disparity showcases the efficiency advantage that no-frills discounters have over conventional brokers.
Ironically, some discount brokers, notably Schwab, have been offering small doses of the services they had done away with. For example, a number of discounters have begun to develop and disseminate company research reports and recommendations to aid their customers in selecting stocks. Other discounters have also tried to gain a foothold in the highly prized market for initial public offerings (IPOs), once the hallowed territory of only the most elite (i.e., wealthy) investors. These sorts of bridge services, which often gamer additional fees, are seen as yet another attack on the full-service brokers.
Although their cost structures and service offerings may differ, discount brokerages still have many similarities to conventional brokerages. First, many of the same investment vehicles, such as particular stock or mutual fund shares, may be acquired through either source. So, for example, if a company is traded on the Nasdaq market or the New York Stock Exchange, its shares are available through any broker. Availability varies more, though, with mutual funds and other kinds of investments. Second, in general the legal requirements for discounters and conventional services are identical. They must be registered with the SEC, they must be a member of the National Association of Securities Dealers (NASD), a private industry self-regulatory agency, and they must adhere to other requirements by the SEC, the NASD, and state regulatory agencies.
By far the most dramatic event for this industry since deregulation has been the development of the Internet as a medium for placing market orders and tracking investment accounts. Virtually all corners of the securities brokerage business—including the reluctant full-service houses—have been affected by groundswell of interest in Internet trading. Indeed, some were surprised to learn that Internet trading didn't appeal only to younger, less wealthy, technically savvy individuals, but also older investors and long-standing patrons of full-service brokerages.
The appeal of the Internet is simple yet powerful. With access to an abundance of real-time market information from third-party news vendors, Internet investors can rapidly obtain company and market information and use that information to make—and execute—trading decisions within minutes or even seconds. As brokerages found, such financial empowerment coupled well with relatively inexpensive transaction costs to create a remarkably strong demand for online trading services.
Not surprisingly, online trading, at least in its infancy, has been the domain of the discount broker: as of early 1999 Schwab continued to hold a commanding lead in the number of online accounts. In the first quarter of 1999, the total number of online trading accounts was estimated at 7 million, and this figure was expected to double by the end of 2000. Behind Schwab's dominant online market share as of April 1999, other leading online discounters with at least 5 percent market share included Waterhouse Securities, E*Trade, Datek, Fidelity Investments, and Ameritrade.
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