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November 1, 2004

Why Did Schwab Sell Capital Markets?

By Gregory Bresiger

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  • Why Did Schwab Sell Capital Markets?

For Schwab, three times was not a charm. It was making its third try at institutional trading, and seemed to be doing well. It was adding professional and new firms to its operation. So the sale of the Schwab unit for $265 million in cash was a surprise, even a shock to many in the trading industry. That's because just about five months after Schwab added Soundview Technology, with its much-heralded independent research capabilities, to Capital Markets, the giant discount brokerage decided to sell the institutional trading operation.

A former Schwab official, who ran Capital Markets' Nasdaq operation until late 2002, said Schwab had intended to be a large institutional player, but was blindsided by a bear market. "They just didn't have the benefit of time. The bear market was making life impossible for everyone in our business," says Marty Cunningham, who has just founded his own firm, Hudson Securities, in Jersey City. "It gets to a point where the margins just can't support the business. The margins didn't kick in and give it the revenues it needed."

The company, at the same time it was deciding the fate of Capital Markets, has been going through its own corporate problems. Its trading revenues had recently declined for the eight consecutive month. It has had trouble meeting its earnings estimates.

At least on the surface, Schwab seemed very serious about building its Capital Markets operation over the last few years. It bought Mayer & Schweitzer, which had been cooked by the order handling rules. As a part of Schwab, it became a very profitable operation. Back in 1999, when Schwab officials were interviewed by Traders Magazine, the number of Mayer's profitless trades had risen from a reported 10 percent of all trades to 25 percent. It also invested heavily in technology. It installed SmartEx, which was a proprietary order routing technology designed to obtain the best possible price and do it at top speed. The unit also used the Schwab Liquidity Network. It offered price improvement services.

Schwab brought in a slew of trading heayweights. Possibly the most important was Lon Gorman. A former head of global equity trading at First Boston, Gorman vowed that Schwab would be in institutional trading in a big way through good times and bad. He had about 700 employees overall back in 1999, a number that subsequently dropped to some 220 today. "When the tide goes away," said Gorman just before the bull market broke, "the men get separated from the boys."

Still, Charles Schwab, founder of the discount broker, said by selling capital markets, the firm was returning to its roots. He said there was no "synergy" between capital markets and its core business.

Undoubtedly, the bear market discouraged Schwab. However, the head of a market analyst firm couldn't agree with this explanation of Schwab's quick exit. "Any reasonable strategy has to be sound enough that you can withstand a market that is going down," says Octavio Marenzi, president and chief executive of Celent Communications.