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April 1, 2003

Can Automation Save Schwab?

By Peter Chapman

Also in this article

The Day of the Robot Has Arrived for the Market Maker

Schwab Capital Markets, reeling from a steep drop in profits, is betting heavily on automation to keep its retail market making operation afloat.

The big wholesaler is not ready to throw in the towel as have many of its competitors. So Schwab will attempt to leverage its huge retail flow as a way of finding success on the institutional side.

In the past year, Schwab has fired about 250 traders and assistants from its retail trading operation but hired about 30 mostly sales traders for its institutional buildup.

Two key systems now handle all of Schwab's retail Nasdaq orders. SmartEx, an advanced order handling system, greets every order under 10,000 shares and decides whether to execute it internally or route it away. If a position is created, an "auto-market making" system decides when and where to offload it. Both tasks once formed the core of a market maker's job.

"The old wholesale model where you have 100 traders and 100 assistants that trade 5,000 stocks is not viable anymore," said Lon Gorman, vice chairman at Schwab Capital Markets. "It's dead. This is the only way it can work."

Buffeted by penny ticks and gun-shy retail investors, SCM's financial picture is not pretty. From a peak of $111 million in 1999, pre-tax income plummeted to $18 million in 2001. The run rate was $16 million, based on data for the first nine months of 2002.

Revenues have similarly fallen. In 2000, they hit $644 million. The following year, they were half that. The run rate was $260 million, similar to 1997 levels.

Many of the once mighty wholesalers have simply shut down. Fleet Trading is gone. NDB closed. Herzog Heine Geduld is history. Schwab, however, plans to add another 2,000 stocks to the 5,000 it already trades. Why stick with retail dealing?

Execs at Schwab cite customer service and economics. "By making all these markets we can control the quality of execution for our clients," said Larry Leibowitz, head of the equities division at Schwab. "If we send flow all over the place, it makes it much harder to guarantee our customers consistent executions. We don't control the executing venues."

Much of Schwab Capital Markets' inflow is from sister company Charles Schwab & Co., the country's largest discount broker. Schwab & Co. boasts eight million retail accounts and a stable of nearly 6,000 registered investment advisors. Nearly all Schwab & Co. order flow is routed to Schwab Capital Markets.

If SCM were to shut down, those orders would be sent to other Nasdaq/OTC desks. Those venues might not provide the best fills, say Schwab execs.

"Automation gives us consistency of quality across order flow," said Robin Jackson, a senior vice president at SCM and Leibowitz's right-hand man. Quality of execution has become a make-or-break issue under new Securities and Exchange Commission rules. Market centers -typically exchanges and dealer firms - must now publish a set of statistics every month quantifying fill quality. Those with poor numbers may be shunned by their brokerage customers. That's because they, in turn, are required to inform their customers to which venues they route.