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June 30, 2001

Headed for Extinction?

By Drew Sycoff

Charles Darwin would have a field day with the modern retail brokerage industry. After all, when you look at the industry's evolution over the past decade, it's a case study in natural selection. If it's true that only the most adaptive species will survive, then the role of the traditional broker in online trading is going the way of the dinosaur.

The Internet was the catalyst in a revolution in retail brokerage. Instant access to information and speed of communication combined to put more decision-making power into the hands of the retail consumer.

At the same time, Charles Schwab, a household name in financial services, began marketing low-cost brokerage services to the retail investor.

Suddenly, having a broker was no longer a privilege restricted to the "elite" -- it was now a service within reach of virtually any consumer with funds to invest.

In 1996, these trends in the Internet and brokerage business converged. That's when Schwab introduced the first online brokerage firm. Shortly thereafter, E*Trade, Ameritrade and others followed suit, introducing new levels of choice and savings.

Today, there are some 150 online brokerage firms. Forrester Research predicts that about 21 million households will be trading online by the year 2005. The question is, has the online brokerage industry provided value for the retail investor?

It's true that online brokers have introduced dramatic cost savings for self-directed retail investors. They've also given the retail community greater access to proprietary investment information. But, as they say, the more things change, the more they stay the same.

The reality is, despite claims to the contrary, it's still largely "business as usual" in the brokerage business. In most cases, today's online broker is nothing more than the old brokerage model with an electronic interface.

Brokers still charge consumers a commission for their trades. They still funnel these orders to outside market makers and pocket the payment for order flow. Everybody profits -- except the retail investor who makes it all possible.

Which brings me back to Charles Darwin. It's time for the next evolution in online trading.

Currently, online brokers use retail order flow to support two revenue streams: commission fees and payment for order flow. They act as classic "middlemen," standing in between the retail investors (who generate order flow) and market liquidity (provided by the market makers). The problem is, the role of the middleman has become irrelevant to an increasingly savvy retail investor.

The next logical step in the evolution of online brokerage is to bring the retail investor and the market maker together, cutting out the role of the traditional broker. Self-directed investors, already accustomed to doing their own research and analysis, can go straight to the markets they trade.

Liquidity for market making operations will come from retail order flow, not through relationships with outside brokers.

Most important, the retail investor will share in the cost efficiencies of this business model through no or low commissions and rebates (that is, rewards) for the payment for order flow they provide.

"Free" and "rebate" aren't new to online brokerage. Ameritrade's Freetrade, for example, offers free trading and Datek provides a rebate on the payment for order flow it receives through third-party market makers. The difference between these offerings and this next evolution is the underlying business model.

Most brokerage firms don't have significant market making operations and, therefore, are dependent on the fees generated through today's operational dinosaur -- the traditional broker. Those firms that do make markets in certain products certainly don't share the benefits with the retail investor.

This will have to change. BrokerageAmerica, for example, now connects retail investors directly with its market making operations. But it won't be easy for the established brokerage firms to adopt this new model.

In fact, it will be a very painful process. But the reality is that technology and a changing consumer will continue to transform the business.

The only way to avoid extinction is to anticipate the next evolution in online trading.

Drew Sycoff is chief executive officer of BrokerageAmerica, a unit of Andrew Garrett Inc., a New York market maker in 1,000 Nasdaq stocks.