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It Used To Take Three To Tango
Saturday, January 1, 2000

The man stops you mid-step and asks for your grocery list. And he’s going to charge you an additional 1 percent or so mark up, after you’re done shopping. Get used to it — he’s going to do that every time you shop at that grocery store. Coercion? Gouging? Bribery? But hey! Hold your horses. That’s exactly how many of you may feel while trading stocks and, especially, bonds. Some brokers for no value-added service are charging you a commission, an undeserved or coercive mark-up.

Some brokerage firms and brokers add value. Some don’t. The Internet is changing the way stocks are traded and soon, how bonds may be traded. Now, online brokers process over 500,000 trades daily — that’s almost one in seven trades in the US. Online traders account for about one quarter of the total trades on the NASDAQ. Electronic accounts constitute about nine million of the 70 million brokerage accounts and this number is expected to hit 25 million by 2003. Online trading is much cheaper than traditional brokerage and trading commissions are plummeting fast. Best of all, the man outside the grocery store will soon be a memory.

Cut to the Chase

Even on the stock exchange, why do we need specialists or the “jobbers” as they are called on the other side of the Atlantic? Specialists are basically matching buy and sell orders. Sometimes, yes, they do provide “liquidity” to the market by committing their firm’s capital to facilitate a trade. Looking at the “electronic, computer screen-based systems” of the Japanese futures exchange and of some European exchanges, you don’t even need a futures pit – the carnival type gathering of traders in bright colored jackets that trade commodities and other financial instruments. The Internet is making these jobs obsolete. Obviously, a number of jobs and livelihoods are dependent on these exchanges. There is a lot at stake here. There are strong lobbies trying to plug the tides of change. This process may be slowed but it cannot be stopped. The winners are going to be the end users – farmers who hedge their crops, a mortgage banker making home loans hedging her interest rate risk, an exporter eliminating his foreign exchange risk, a stock fund manager or an investor protecting his investment. The losers — the toll collectors, the man at the grocery store. The middleman who does not add value will be adrift in Cyberspace.

Don’t Be A Buggy Whip Maker

The new economy is generating a lot of jobs. The unemployment rate in the US stands at 4.1 percent, a 30 year low. But the new economic forces are also eliminating a lot of jobs. The Internet, the Web and e-commerce are replacing a lot of middlemen. At the turn of the last century buggy whip makers vanished into oblivion when their product was replaced by another technological change — automobiles. They still surface today — in the brokerage business. They are the conduits from the firm’s research department or trading department to its clients, either individual or institutional.

But, there are a great number of value-added brokers and salesmen on Wall Street and justify that mark-up. But, if your broker just parrots the firm’s economists, stock analysts or traders, then she/he had better shape up, retrain and learn new skills or face obsolescence.

Come Clean

Tradeweb, a web site for trading government bonds, is becoming popular among institutional clients. Many Wall Street firms are paring down their government bond sales force — before the axe, many of them were making six figure incomes, for just playing gatekeeper at the grocery store. More and more sites will pop up to trade other financial instruments, threatening closed-door transactions. The new forces will demand and force transparency. And one of the first to come clean will be the bond markets where information on bond prices is held close to vest by primary dealers, a group of brokerage firms that can deal directly with the Federal Reserve Bank. They will force such companies to restructure sales functions.

The stock market is a lot more transparent. Stock prices are broadcast instantaneously after a trade on the exchange. But there’s a daisy chain of middlemen in the stock market – the specialist on the floor of an exchange, the trader at a Wall Street firm and then a salesman who would call on a client to execute a trade. The Web is forcing how this information is disseminated and how a transaction is executed. Conceivably, the specialists and salespeople and perhaps traders will be made extinct if the end investors are allowed direct access.

This is not arguing against the functions of a stock exchange. To be fair, an exchange validates a public company’s financial credibility. It referees transactions by ensuring that the trades – exchange of shares for actual cash – go smoothly and that there is little “counterparty” credit risk of a trade “failing” and that pricing information is disseminated quickly. The member firms that are allowed to be a part of the exchange also make sure that there is enough capital to back a trade. But as Wall Street firms are becoming less and less risk averse by eliminating trading for their own accounts or reducing capital allocated to that part of the business, they are becoming, in a way, “middlemen” too.

Ditch the Ride, Save the Fare

For equity underwriting, that is, the IPO process, the company issuing stock pays 7 percent of the capital raised to the Wall Street firms for taking them “public”. According to the Wall Street Journal (12/08/99) over $100 billion in IPOs were issued in 1999. Many Wall Street investment-banking firms do add a lot of value and deserve a fee for their services. Tapping this lucrative IPO market, three online brokers, Schwab, TDWaterhouse and Ameritrade announced plans to form an online investment bank. Scott Ryles, former head of Merrill Lynch’s technology banking group will be the head of this Web investment bank.

Many of the recent IPOs have run up in price. Institutional clients of the traditional investment banks get a majority of the shares in the IPO. Most individual investors get less than 1% and then have to buy the newly public shares in the IPO aftermath, after they have run up in price. But, in the first half of 1999, individual shareholders got a chance to stick their tongues out at institutional clients when they held more of the recently IPOed shares than the institutional clients combined. Traditional banks will be forced to sit up and address the IPO allocation process.

For starters, a company could sell its shares directly to the public or institutional clients through an auctioning mechanism that can be managed on the Web. As long as the company’s been given a clear bill of health and the credit risk of a transaction is addressed, the Web can be used to facilitate the IPO process at much lower costs to the issuing company and to the end investor. Again, the losers are the middlemen that do not add value.

Swim With the Tide

GM and Ford are bringing together their suppliers through the Web. It makes for sound business strategy. Soon, someone will bring together the end investor and the issuer/portfolio manager/individual investor. The man outside the grocery store, the many middlemen and women will have to look at better ways to contributing to the New Economy or be put out to pasture. Any radical change that shakes up an existing system and threatens people’s livelihood will be slowed down by the people who have most to lose. The brokers, Wall Street firms and exchanges will slow this process. But the change is inevitable in the end. You either crest the wave or you drown.

Shirish Malekar is founder and CEO, SMYLE Ventures. He is formerly head of Global Fixed Income Investments, and partner and portfolio manager at a leading US Asset management company.

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