Online brokers focus on execution

Online brokers focus on execution - Internet Services - Financial - Banks - Internet - Financial Services - General - yearend: "While price cuts, consolidation and services made headlines in the online financial sector in 2005, observers are focusing on the firms' ability to deliver on promises to customers while driving asset-based earnings growth in 2006.

Sparked by over-capacity created during the go-go years of the last century and a brutal round of price cuts, several major acquisitions took place in 2005, culminating in Ameritrade's deal to buy the U.S. brokerage operations of Toronto Dominion's TD Waterhouse in June for about $3 billion.

"When I got to Ameritrade there were about 200 firms that had online brokerage operations in this country and about 15 or 16 names everybody knew. Today there are about 80 firms that have that kind of presence and probably five names that everybody knows. So consolidation certainly has taken place," Ameritrade CEO Joe Moglia said in an interview this month.

In roughly that same period, according to analysts at Merrill Lynch, trading activity in the industry has fallen about 30%, trading commissions have fallen 40% and average account assets have declined about 10%.

Faced with that reality, major industry players responded in different ways, with Ameritrade and E-Trade pursuing growth via consolidation in the struggle to maintain scale, while Charles Schwab opted for a more inward restructuring of its business driven by the return of its founder Charles Schwab to the CEO post.

Schwab redirected the firm's focus on investor services for which customers will pay. He's put muscle behind the eponymous Charles Schwab Bank, which handles deposits and loans, and has committed to restructuring the money manager US Trust, which caters to wealthy investors. Schwab is also cementing back-office support for investment advisers, one of the financial-services industry's fastest-growing areas. See full story.

Ameritrade and E-Trade are also expanding in banking and investment advisory, as retail trading has basically become commoditized.

"We will also continue to reinvest in the expansion of our regional advisor strategy, primarily through acquisition," E-Trade President and COO Jarrett Lillien said last week.

"Consolidation and price cuts were the two big themes for 2005, but from our perspective, what we chose to do was to avoid the distraction associated with consolidation and avoid such transactions that in fact increase one's reliance on more volatile trading revenue," Schwab CFO Chris Dodds said.

According to E-Trade's Lillien, an important third theme that emerged in 2005 was the industry's decision to embrace completely a new, diversified customer service offerings like banking, credit products and sophisticated cash management generally reserved for wealthier clients at more traditional firms.

"2005 ended up settling the discussion on whether you wanted to be a monoline or diversified. So that debate was a theme I think got resolved this year," Lillien said. "I think 2006 certainly consolidation is going to continue to be a theme, but I think now it's more outside of consolidation, more about functionality and service," Lillien said.

"Everybody's got to have good customer service now. It's going to be one of the areas now where people compete to differentiate themselves.," he said.

The likely most important change for the companies themselves in 2006 will be the continuing move to switch client cash deposits from brokerage accounts to FDIC-insured bank accounts.

Customer cash that comes into a broker is generally not really looking for high rate, according to E-Trade's Lillien. It's generally looking to go into the market or it's cash between trades.

While that provides cheap cash for the brokers, regulations limit where that cash can be invested, restricting it to low-return investments like overnight securities and customer-margin loans.

On a bank balance sheet, the firm can have mortgages, credit cards, and home equity lines; more choices that have higher yields. However, the downside to the bank model is that banks have to pay more for their cash,