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April 1, 2002

The Winds of Change: How internalization changed the course of history for a Midwest dealer.

By Peter Chapman

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  • The Winds of Change: How internalization changed the course of history for a Midwest dealer.
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Dempsey & Co., shaped by the convulsions in trading over the past five years, is a market making survivor.

From its roots as a tiny Chicago specialist, to its growth into one of the country's largest trading houses, to its acquisition by a national brokerage, Dempsey was whisked along by one of the hottest trends in the industry only to get sideswiped by another. It rode the surge of online orders in the 1990s, but had to run for cover in the face of the growing passion for internalization.

In July 2001, Dempsey capped a tumultuous four-year growth spurt by selling itself to E*Trade Group. The scrappy trading house was faced with a dwindling supply of order flow as major retail brokerages began to buy or build greater market making capacity so as to trade against more of their own orders.

E*Trade itself concerned about the shrinkage in its rebates, was casting around for a market maker so as to wring more profits from its orders. Dempsey could either join forces with the large online broker, or risk losing a large chunk of order flow.

"We recognized that internalization by some of the larger order-sending firms was, for us, a potential threat," said Lou Klobuchar, Dempsey's chief executive.

Internalization, or brokers filling their own orders rather than shipping them out to wholesalers such as Dempsey, is a trend that started in the last few years. The three largest retail brokerages in the country - Merrill Lynch, Salomon Smith Barney and Morgan Stanley - have each either bought or built more trading capacity.

But if internalization spells the death of the independent market maker, for Dempsey, at least, the last four years have been a good ride.

Rapid Growth

Since 1998, Dempsey has ballooned from an eight-trader, 135-stock specialist on the floor of the Chicago Stock Exchange to a 100-trader, 2,500-stock house with a presence in five market centers in the U.S. and abroad.

Its acquisition by E*Trade further pushed the firm into the big leagues as the deal locked in a large source of order flow. E*Trade is the country's third largest discount broker after Charles Schwab and Fidelity. (E*Trade had revenues of $1.2 billion last year). Dempsey's share of E*Trade's flow has jumped from over 20 percent, when E*Trade was its largest customer, to 40 percent today. That number is expected reach 50 percent, according to E*Trade executives.

In the first two months of this year, Dempsey and its GVR unit traded 1.2 billion Nasdaq shares and 375 million listed shares, according to AutEx/BlockData. Those figures give it a ranking of 22nd in the Nasdaq market and 27th in the listed market. That puts it on a par, in both cases, with Thomas Weisel and U.S. Bancorp Piper Jaffray.

Behind Dempsey's hot streak is Klobuchar. The 44-year-old became Dempsey's CEO in late 1997, following a stint as executive vice president at the Chicago Stock Exchange. Klobuchar was brought in by Jack and Jay Dempsey (kin to founder Joe Dempsey, Sr.). They recruited him after observing Klobuchar's success in aligning the CHX with the growing online brokerage industry in the mid-90s.