Hardly anyone doubts any more that the Internet is an agent of revolution just beginning
to change our lives. The trouble is that, although you can see the general direction the
technology is taking us, its impact on each aspect of society and business is hard to
predict in any detail. Change of this magnitude seems imperceptible at first, and
unfathomable in the longer run.
So, in this lull before the storm, business leaders are gambling on how consumer tastes
and habits will react to what many see as baffling new choices. Some companies are moving
faster than others to take risks because they reckon the greater danger is to be left
behind. That's the case with Charles Schwab, the nation's largest discount brokerage
house, which, to general surprise, jumped successfully onto the Internet more than two
years ago and is thriving.
Schwab's bold gamble was unexpected for three reasons. First, it defied conventional
wisdom. In the sedate world of full-service brokerage houses, the Internet still is
regarded as an auxiliary service, a useful tool to enhance the productivity of brokers, to
be sure, but not the wave of the future in financial services. As Billie Collins, a
spokeswoman for Merrill Lynch, says, "On-line trading is just not a priority for us.
Our customers are not clamoring for it. The advice of Merrill Lynch brokers is what they
came here for."
Second, the competition looked intimidating. Schwab was going up against a hyperactive
crop of Internet start-ups, including E*Trade and Ameritrade, which were waging a price
war with each other and offering on-line trading at rock-bottom prices. In some cases,
investors are charged as little as $5 a trade.
Third, and perhaps most intriguing, Schwab already had a thriving brokerage business, so
why would it give customers a way to go on-line and pay about a third what they would
normally pay Schwab per trade? To many, Schwab's establishing an on-line business sounded
like cannibalism.
But Schwab correctly guessed that on-line trading might grow fast and that it could
compete with the newcomers. It also realized that, while cannibalism could be managed and
controlled, it couldn't be avoided. "What it came down to was, if you don't eat your
young, somebody else will," says William Burnham, electronic commerce analyst at
Piper Jaffray, a brokerage firm. "If Schwab didn't offer on-line trading, it would
have lost a lot of customers to on-line traders." Gideon Sasson, executive vice
president for electronic brokerage at Schwab, agrees: "You can wait for your
competitors to do it for you or you can do it yourself. We were going to do it
ourselves."
That may sound elementary, but every industry is littered with the struggling remains of
companies too inwardly focused or just too stubborn to compete with themselves. When, for
example, Encyclopedia Britannica got a call from Microsoft hoping to jointly produce a
CD-Rom version of its crown jewels, the publisher refused for fear of hurting sales of its
print edition. Britannica then lost control of the encyclopedia market when Microsoft made
Encarta on its own and undercut Britannica's price by more than 90%.
Sure enough, Schwab's on-line program initially looked painful. Of Schwab's 1.5 million
active on-line accounts, nearly half were drawn from Schwab's regular discount accounts.
Talk about cannibalism. Moreover, Schwab's average commission dropped about 25% over 12
months to $56.50 in February 1998.
In fact, Schwab came out way ahead. Over those 12 months, the average number of daily
trades for customers rose from 71,000 to 89,500. The reason is that on-line traders
execute more trades—sometimes double or triple that of regular traders—while the
number of people trading on-line continues to expand. More than half of Schwab's daily
revenue now comes from on-line trades.
By deploying its considerable marketing skills, Schwab captured a third of the market for
on-line trades and, by some estimates, as much as 50% of on-line customer
assets—this, even though Schwab charges two to three times the trading fees of its
nearest competitors. In the first two months of this year alone, the company pulled in an
impressive $22.7 billion of on-line assets, for a total of $100 billion. In the process,
Schwab has blunted the attempts by the start-ups to build big, national brands like the
one that Amazon.com developed while its giant competitors tried to figure out how to react
to the company's launch of an on-line bookstore. So, Schwab has positioned itself
masterfully for whatever the on-line future turns out to be.
And that future currently looks rosy. Today, only about 4% of all trading volume on Wall
Street goes through electronic brokerages, according to Keith Benjamin, an analyst with
Bank America Robertson Stephens. But that could rise as high as 20% within the next five
years, he said. Piper Jaffray projects that commissions from on-line trades will rise to
$2.2 billion in three years, more than eight times the commissions paid in 1996. On-line
trades will account for 60% of discount commissions in the same period, and 10% of retail
stock brokerage commissions, the brokerage firm predicts.
Not a bad market to dominate.
In retrospect, it may not be that surprising that Schwab reacted so quickly. It was
founder Charles Schwab, after all, who was among the first to jump into discount brokering
in the 1970s when the Securities and Exchange Commission ended fixed stock commissions.
And it was Mr. Schwab who saw the earliest opportunity for on-line trading back in 1985,
when the company started offering clients pre-packaged software that allowed them to
connect directly to Schwab's network.
Schwab's agility is helped because it doesn't emphasize profits by distribution channel.
That approach would have slowed any move onto the Internet, given that the move could have
hurt the traditional, office-based channel. Instead, Schwab focuses more on profit per
customer. It figures that if it can cut operating expenses while offering multiple
channels and, most importantly, gaining a greater portion of each customer's wallet, then
profits will inevitably follow.
With the Internet, Schwab began investigating the potential in 1994 and 1995, to see if it
might turn out to cause the kind of earthquake that got the firm started in the '70s.
Marching orders came directly from Mr. Schwab, who was determined to be among the first
major brokerage companies to provide Internet trading. The company handled the technology
for on-line trading smoothly enough, and saw the market developing fast enough, that it
planned a mid-1996 rollout. When the developers showed Mr. Schwab a working prototype in
December 1995, though, "Chuck saw what we had and basically said, 'You need to move
faster,'" recalls Mr. Sasson, the executive vice president. "We changed course
in midstream." What drove the decision, Mr. Sasson says, was research that showed
that huge numbers of Schwab customers used computers at home, and that, at the same time,
the Internet was ballooning. Mr. Schwab "saw urgency," Mr. Sasson says,
"and he was right."
The acceleration turned out to be especially important because start-up competitors such
as E*Trade launched their offerings in early 1996. Because Schwab had arranged to
accelerate its rollout, it didn't end up sitting idle for long, watching others build a
beachhead in the market. When Schwab did enter the market, it made a crucial decision. It
decided it didn't have to match its competitors on price, at least initially, as long as
it could beat the upstarts on brand and service. And, so far, the company has been able to
avoid fee reductions, despite tremendous pressure from competitive price cuts in the
market. Schwab executives explain that the company never has been the lowest-price
discount broker, so it wasn't about to start playing in the on-line price wars.
"Investors shopping for the lowest Web commission probably wouldn't have come to
Schwab anyway," said David Pottruck, Schwab's president and co-chief executive, along
with Mr. Schwab. "From our experience, we think the Internet is still very confusing
to a lot of people. To some, it's like giving them the Yellow pages and saying, 'Figure it
out.' So we help customers marry the capabilities and efficiency of the Internet with the
kind of hand-holding and customer service that Schwab provides." He adds that clients
of Schwab's on-line service "are not really Web-only customers but use many other
channels of access. Both our on-line and in-person businesses continue to grow."
Rather than lowering prices, Schwab has been quietly transforming its market image. Any
mention of price has disappeared from its TV advertising as the company slips away from
being the biggest discount house to a service-oriented brokerage offering "something
for everybody." In January, for instance, the company announced it was opening up
on-line trading to all customers rather than only to those who wanted Internet trading
alone. The move helped underscore the breadth of Schwab's services.
Tom Taggart, Schwab's corporate spokesman, makes no bones about the strategic shift under
way. "We're becoming full service," he says. "We want to provide multiple
channels for people to reach us and let them decide which they want to use." Instead
of becoming more of a no-frills Internet trading operation, Schwab is emphasizing its
frills. For example, the company is bringing to the Web what is considered on Wall Street
to be one of the most comprehensive financial and company information resources on the
market, called Analyst's Center.
By adding that kind of new content and other investment tools to the Schwab Web site, the
company takes on the role of an investment adviser helping customers research and manage
their own accounts. Schwab has even started teaching courses in Web trading through some
of its 270 branches. The new strategy aims to retain Schwab customers who, while enticed
by on-line trading, are not eager to give up the ability to pick up the phone or, even
more important, walk into a branch office once in a while. In this way, on-line trading
doesn't take the place of the personal service offered by local branches.
As with most Internet ventures, Schwab's on-line operation did not have all clear sailing.
No sooner had the company set its new course on-line than it suffered a setback. In
January, Schwab announced it would be beefing up its Analyst's Center with proprietary
research reports from retail brokers. This was considered a coup in the industry,
particularly among those who saw the irony in a famous discount house getting access to
the crown jewels of
the retail brokerages. The reports, to be provided by First Call, a leading financial data
distributor, were to be embargoed—that is, they would already be as much as three
weeks old by the time Schwab was permitted to post them on its Web site.
On the morning of Jan. 14, as planned, the Analyst's Center posted its first batch of
reports, prepared by Merrill Lynch analysts, among others. But, within minutes, Merrill
Lynch challenged whether First Call had the contractual right to provide the reports for
use on the Internet. Schwab's plan quickly fell apart.
Schwab now says it has another source for research, so there appears to be no lasting
damage. Schwab can even take some solace from the First Call fiasco: It shows just how
much the full-service brokerages now feel threatened by Schwab's success on the Internet.
The question is: How long can Schwab keep it up? Much of the answer depends on whether the
full-service brokers with their vast resources decide to seriously challenge Schwab in the
Internet market. So far, few of the major firms offer on-line trading, although many have
Web sites offering access to account information and research.
"They're all in a prisoners' dilemma," says James Marks, an electronic commerce
and banking analyst at Credit Suisse First Boston. "The first to step out of line is
going to be shot," meaning that the first big retail brokerage to jump on the
Internet bandwagon is going to see its best brokers abandon the company for the nearest
firm that sticks to traditional personal service.
Among the leaders, Merrill Lynch may be the first to move. Clearly worried about the havoc
that on-line trading could cause in its organization, the company is scheduled to begin
on-line trading in the third quarter. Merrill Lynch plays down the move as simply a way to
give customers more options for executing trades. In fact, the company plans to maintain
the same commission fee schedule for on-line trades and simply add on-line trading to its
existing Merrill Lynch site, which already has some 700,000 customers using it for
research and bill payments. Sticking with this strategy would leave Schwab unscathed. But,
once the service starts, Merrill Lynch may be forced to expand its effort.
Traditional brokers like Merrill Lynch don't need to worry much that their current
customers will leave. But new customers may start out with on-line services such as
Schwab's and never see any reason to even consider a Merrill Lynch. So, unless such
brokers move on-line in a big way in the coming months and years, they risk the sort of
fate that has befallen Oldsmobile, CBS, and other companies that can't seem to replace
their aging clienteles.
"I think Merrill Lynch and everybody else will have to figure out how they're going
to live in this future environment," Schwab's Mr. Sasson says. "Something is
going to happen in a relatively short amount of time. The backbone of investment will be
on-line." Certainly, many investors will always prefer to walk in and sit down with a
broker. But, given time, the Internet will likely change personal interaction in
unforeseeable ways.
Schwab, for one, is getting ready for the wild ride into the Internet's unpredictable
future, if only because the company's leadership believes it would be just too dangerous
to stay at home.
Ms. Flynn is a free-lance writer in San Rafael, Calif., and a frequent contributor to
the New York Times. She can be reached at ljflynn@aol.com.
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