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CASE STUDY E*TRADE SECURITIES, INC.
This case was prepared by Chuck Glew, Mark Lotke, Mario Palumbo, and Marc Schwartz, under the supervision of Rajiv Lal, Professor of Marketing and Management Science, Stanford University Graduate School of Business, as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted with permission of Stanford University, Graduate School of Business, Copyright q 1996 by the Board of Trustees of the Leland Stanford Junior University.
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INTRODUCTION E*Trade pioneered the electronic deep-discount brokerage business in the late 1980s and has experienced phenomenal growth since 1992. Electronic brokerage firms make extensive use of technology in most customer interactions and, as a result, can achieve significant cost advantages over traditional brokerage firms. E*Trade’s strategy until now has been to continually pass these cost savings from automation on to its customers as they amortized their fixed costs over a greater number of accounts. The company charges a fixed commission rate on trade executions up to 5,000 shares ($14.95 NYSE, $19.95 NASDAQ), a 75% savings compared to the traditional discount brokers. As of the spring of 1996, E*Trade is at a critical juncture in its development and faces many challenges. A flood of new competitors are establishing internet sites and for the first time in its history, E*Trade has been dethroned as the price leader. In April 1996, a new entrant, eBroker, has introduced ‘‘no frills’’ trading through the Internet at a flat $12 per trade. In addition, Charles Schwab, the leading discount brokerage firm, is preparing itself for entry directly into E*Trade’s domain. E*Trade is being forced to reexamine its business model and choose a strategy with which to
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address the changing environment. While some executives within E*Trade believe they should continue to lower price and go head-to-head with eBroker, others believe the company faces a larger challenge from Charles Schwab’s entry into the market. Defending against Schwab would require focusing resources on enhancing its product/service offering, which might jeopardize E*Trade’s low-cost position.
General Atlantic Partners, a New York-based private investment firm focused on investing in high-growth information technology companies, made a significant minority equity investment in E*Trade. These funds are being used to accelerate E*Trade’s transition to self-clearing (presently provided by Herzog, Heine, and Geduld), bolster E*Trade’s customer support infrastructure (systems, personnel), and launch an aggressive marketing campaign (print, TV, radio). In May 1996 the company filed with the SEC for an initial public offering scheduled for that summer.
THE COMPANY History Trade*Plus, the parent company of E*Trade, was founded in 1982 as a PC financial management service bureau by Bill Porter. In 1992, the visionary Porter launched E*Trade Securities, a pioneering on-line brokerage services provider based in Palo Alto, California. Initially, E*Trade generated most of its revenues by providing back-office on-line processing services to discount brokerage firms (Fidelity, Schwab, and Quick & Reilly). Although E*Trade continues to service Quick & Reilly, the company has moved away from a ‘‘private label’’ strategy to aggressively pursue a direct-to-consumer business model. In 1995, over 80% of revenues were derived from trading commissions by E*Trade customers. Additional revenues are generated from interest on customer cash balances and margin accounts, connect-time revenue sharing with on-line service providers, and third-party processing services. As a result of the shift from full-service to discount brokerage, increased PC penetration in the home, and the explosion of the Internet, the company has experienced dramatic revenue growth ($2 million in 1993, $10 million in 1994, $22 million in 1995, and budgeting in excess of $50 million for 1996). The company’s stated internal strategy is to become America’s dominant deep-discount brokerage firm by fully automating the front and back-office trade processing function and maintaining its position as the low-cost provider. The company has made significant information technology investments in automating order entry, customer support, trade execution, and post-trade clearing and confirmation. In September 1995,
Product E*Trade provides its 50,000 customers with trade execution on stocks and options, and by year end, is likely to offer mutual funds. In addition to trade execution, the company provides stock quotes (real-time or delayed), news services, consolidated monthly statements, and limited portfolio analytics. Customers can access E*Trade through various low-cost channels including touch-tone telephone (TeleMasters), on-line service providers (CompuServe, America Online, BOA HomeBanking), direct modem link, and most recently, the Internet. E*Trade launched its Internet home page in January 1996 and as of May 1996 over 35% of all trading is done over the Internet. Pricing E*Trade’s brokerage services appeal to active, independent investors who routinely make their own investment decisions and do not want to pay full-service commissions. E*Trade offers this growing customer segment a compelling value proposition: a flat $14.95 commission rate on all NYSE trades up to 5,000 shares and $19.95 for all OTC trades. As seen in the Table 1, E*Trade’s commissions are typically 50% to 75% less expensive than traditional discount brokerage firms such as Schwab or Fidelity, particularly for larger trades. By leveraging information technology and passing savings on to consumers, E*Trade has steadily lowered its commission rates from $24.95 to $14.95 over the past two years. The company consistently offered the industry’s low-
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TABLE 1
Comparison of Commissions 100 Shares @ $40
5,000 Shares @ $20
Fixed Component
Variable Component
Fixed Component
Variable Component
E*Trade Listed
$14.95
—
$14.95
—
E*Trade OTC
$19.95
—
$19.95
—
Lombard Listed
$34
—
—
$100
Lombard OTC
$34
—
—
$75
e.Schwab
$39
—
$39
$120
PCFN
$60
—
$100
$100
NDB Listed*
$33
—
$33
—
NDB OTC*
$28
—
$28
—
Ceres
$18
—
$18
—
Schwab/Fidelity
$56
$26.40
$155
$110
* Includes $3 postage fee per order.
est commissions until April 1996 when a new entrant, eBroker, began offering $12 trade execution under a ‘‘no frills/no service’’ market positioning.
vidual Investor, Smart Money, Forbes) campaign. These ads focused on E*Trade’s low commission rates (with accompanying comparison tables) and featured bold tag lines such as:
Advertising-Marketing Advertising plays a significant role in the brokerage business not only because it creates brand awareness, but also because it is the first step in the customer acquisition process. Brand awareness is critical in the nascent electronic brokerage business because most of the competing firms are new to the business and because many customers have an aversion to depositing their money with a firm they have never heard of. These issues are especially important on the Internet, which has the perception of being unsecured. In addition to creating brand awareness, most advertising in this industry also compares the advertising firm’s product-service offering to competitors. In January 1996, E*Trade aggressively increased its advertising budget to raise awareness, generate new account inquiries, and unveil its new Internet site. The company placed weekly full-page ads in the Wall Street Journal, complementing its continued television (CNBC business channel), local radio, and magazines (Indi-
E*Trade is leading the electronic trading revolution. In fact, we started it. How else could we charge just $14.95 per trade? Your broker is obsolete . . . (above a picture of a young boy sitting next to his computer sticking his tongue out at a tired, paper-inundated broker). In February 1996, E*Trade altered its advertising campaign to emphasize product/service enhancements. The new ad states ‘‘E*Trade saves you up to 78% on brokerage commissions (bells and whistles included)’’ and lists 24-hour access, free quotes, on-line portfolio management, free checking, and margin and IRA accounts. These successful campaigns have positioned E*Trade as the electronic brokerage leader in the eyes of investors and generated significant new account inquiries. Unfortunately, the company was not adequately prepared for the re-
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sponse as wait times for customer service surged. This upset both current customers who had questions concerning their trades as well as new customers who were less than impressed with their first interaction with the company. In addition, competitors have begun to locate and publicize holes in the E*Trade service offering. For instance, Lombard, an electronic brokerage competitor, includes a column in its advertisement comparing the minimum check amount that can be written from the account. Lombard has no minimum while E*Trade will only honor checks written on the account in excess of $500. As E*Trade and its competitors continue to advertise nationally in an attempt to build brand awareness, customer acquisition costs are rising. In addition to the advertising component, customer acquisition is generally a several-step process consisting of an initial inquiry, often by email or telephone, and often a follow-up conversation, either to answer specific questions or to check on the status of the application. These customer service-intensive interactions are quite costly for E*Trade. With low margins per trade, E*Trade’s new customers must trade frequently to recoup total customer acquisition costs.
brokerage houses is their participation in all aspects of the investment process, from initial decision through execution and follow-up. These services may include the following: suggesting investment opportunities, providing research reports, executing the trade, offering customerservice support, and issuing monthly reporting statements. Brokers tend to be proactive, making suggestions to their clients and trying to influence their investment choices, as well as increasing their investment and trading activity. The brokerage could be a stand-alone institution or a separate department or trust division of a larger entity. Typically, these services are used by households with more than $100,000 in assets. Brokers are paid a significant percentage of their compensation through commissions (typically $150 to $300 per trade), thus they are rewarded for spurring this activity, and potentially are able to collect additional fees depending on the extent of their financial-planning advice. The broker-client relationship is often a long-standing one-on-one relationship in which word-of-mouth referral plays a large role in new-client development. Full-service brokers tend to offer their own line of products, and when they go outside of their family of products, they will usually only sell ‘‘load’’ funds which generate additional commissions. Products offered include retirement accounts, credit products, insurance, and portfolio planning. Full-service brokers provide newsletters and industry-specific and companyspecific research reports written by a team of inhouse analysts. Full-service brokers sometimes provide access to initial public offerings (IPOs) of stock and secondary offerings that are being underwritten by the investment banking arm of the firms. Examples of full-service brokers are Merrill Lynch and Smith Barney Shearson.
THE MARKET Segmentation The market for trading and brokerage services is divided between three primary segments: fullservice brokers, discount brokers, and deep-discount brokers. The increasing presence and use of technology as the primary vehicle of trade execution has led to the creation of a fourth segment, the electronic deep-discount broker. This distinction is not entirely clean as a number of firms including large discount brokers like Schwab and Fidelity have introduced on-line offerings alongside and in conjunction with their traditional products and services.
Discount Brokers. Discount brokers, such as Charles Schwab and Fidelity Investments, offer limited services for investors who do not need specialized product offerings and who do their own research. These institutions make their revenues primarily on the number of trades they execute and on margin account charges. The financial profile of a discount brokerage client
Full-Service Brokers. A full-service brokerage provides a broad range of services, from helping to develop an investment strategy through performance measurement of the executed strategy. The important distinction of this class of
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is broader, ranging from minimal assets to about $250,000 in assets on average. Clients typically tend to be more active traders who do not require specialized and personalized service and are willing to make this trade-off for lower commissions (typically $80 to $100 per trade). Customers in this segment make their own trading decisions without the support and advice of the broker. Recently, discount brokers have become closer in service to full-service institutions, with the exception of the personalized service and investment advice. They have been moving more and more to differentiating themselves through increased service offerings to the point where 800 telephone numbers, monthly account summaries, quotes, and general investment advice are the norm and not points of differentiation. However, information tends to be general in nature and is not geared toward specific investments, industries, or portfolios. In fact, even when asked directly, representatives will not lend their advice with respect to specific trades. Examples of discount brokers are Charles Schwab and Fidelity.
ment was conducted through the telephone or in PC-based on-line environments such as America Online (AOL) or CompuServe. Much of the current trading volume and expected growth, however, is coming through the internet. Current commission levels range from EBroker’s $12 and E-Trade’s $14.99/$19.99 pertrade offering to the $40 range with very minimal customer-service levels. This might result in a limited number of quotes, shorter hours of operation, longer waits for making contact, potentially less advantageous trade execution, less detailed account correspondence, restrictions on margin account trading, and fewer product offerings (mutual funds, bonds, 401(k) accounts). Many deep-discount brokers conduct a large percentage of their business through means that minimize the labor component, including electronic on-line services or through automated telephone lines. Examples of electronic deep-discount brokers are Lombard, National Discount Brokers, and e.Schwab.
Value Chain The value chain for investment services from the customer’s perspective includes the following activities: investment strategy, investment decisions, trade execution, portfolio servicing, and performance measurement. As one would expect, the different brokerage firm types span various sections of this chain. The full-service broker participates in investment decisions and is more likely to offer a higher level of service at other points in the process, as well as more detailed statements. Discount brokers, on the other hand, operate in a more focused area of the chain, primarily providing trade execution with limited support, customer service, and performance measurement. The value chain as it relates to the brokerage firms includes the following areas: marketing, research provision, investment advice, trade input, trade execution, and account servicing (see Exhibit 1). There are two ways in which these activities differ by firm category. First, it is possible that one aspect of the value chain is missing entirely for a particular type of firm. As mentioned earlier, this is the case with investment advice as it relates to the discount brokerage
Deep-Discount Brokers. Deep-discount brokers take the discount concept one step further and provide even fewer service offerings and less flexibility in trading, but for a measurably lower price (typically $40 to $60 per trade). Historically, price has been the primary means of differentiation in this segment, but there is some indication that the minimum threshold level of service has been increasing lately. Original deep-discount outlets were cheap alternatives set up in the midwest, where low-cost labor allowed even further price declines. Examples of deep-discount brokers are Quick & Reilly, Waterhouse, and Olde. Electronic Deep-Discount Brokers. Electronic deep-discount firms include companies that were founded as electronic-only trading outfits (PC Financial Network, E*Trade), as well as discount and deep-discount brokerage firms that offered a portion of their services through the electronic medium. Initially, trading in this seg-
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firm—it simply does not exist. The other point of differentiation is the degree to which the particular part of the chain is emphasized. For instance, full-brokerage firms are likely to spend more absolute dollars on account servicing than deep-discount brokers, although this relationship may not hold as a percentage of the trading commission.
ing an alternative to customers who did not require the level of service offered by a full-service brokerage house, and hence, did not want to pay for services that were not being utilized. Discount brokers could employ less labor (and less skilled labor) because a variety of services and hand holding was not required of them. Although a number of players entered the market with this strategy, it was Charles Schwab that gave wide-scale credibility to the approach and institutionalized the discount broker concept. At a time when firms were offering low prices but skimping on service, Schwab’s strategy and eventual scale allowed it to ‘‘gentrify’’ the market by providing a truly professional approach to what at one time was a ‘‘bucket shop’’ mentality. Its approach was to remain neutral in the investment decision and simply execute trades. Over time it sought to decrease its dependency on trading volume by offering more products and services to enable it to generate charges for ‘‘assets under management.’’ The increasing use of technology is rapidly transforming the security brokerage business, which was once a sleepy, relationship-based, primarily local industry. Technology has helped to increase economies of scale and to permit rationalization in the industry. Increasingly, discounters such as Fidelity and Charles Schwab have leveraged technology to substantially reduce the cost of executing a trade and performing account-related servicing. A major component of this cost-reduction strategy has been the severing of the personal relationship between a particular broker and a particular client. Customers of these two discounters use national toll-free numbers as their primary interface with the firm. They speak to a different representative each call. This aggregation of customer inquiries helps to reduce total variability in demand patterns, allowing far fewer customer-service representatives and brokers to be employed. However, through sophisticated uses of technology, these firms are able to maintain high customer-service levels because each representative has access to the customer’s entire account history. In addition, significant economies are realized by aggregating the functions
Market Size Brokerage firms generate their revenue from commissions, margin accounts, and auxiliary services. A significant portion is generated from commissions, and in 1991 total industry commissions were estimated to be in the neighborhood of $12 billion. Although this figure is not expected to change significantly through 1998 (slight increase in volume, slight decrease in average commission), the distribution between segments is projected to change. Full-service brokers’ commissions are estimated to decline from $10 billion in 1991 to $8 billion in 1998, while discount brokers’ share is expected to increase from $2 billion to roughly $4 billion over the same time period. On-line discount commissions are expected to comprise almost 10% or $400 million of the discount brokers share by 1998. From 1994 to 1998 the number of trades conducted is estimated to increase from 100 million to 144 million. Full-service brokers will see their trading volume hover around the 65 million mark over this period, while discount brokers volume will increase from 30 million to 65 million, and on-line services will account from 13 million trades in 1998 up from 5 million in 1994. According to Forrester Research, growth in online brokerage accounts is anticipated to increase at 30%, from 550,000 in 1995 to 1.3 million in 1998. The two largest players, Schwab and PCFN, account for about 60% of the market (or 150,000 accounts each) with Fidelity controlling 13% and E*Trade with 6%. The remaining 20% of the market is divided up among a number of the smaller players. Market Evolution The market has evolved in a fairly straightforward manner, with the discount brokers provid-
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dealing with the collection and manipulation of account data. Although Schwab and Fidelity served a specific market need, its relatively high level of customer service created the potential for another layer of firms beneath it. Because the discounters’ increasing scale enabled them to substantially enhance customer service without increasing price, the remaining firms were left with price competition as the only viable strategic alternative. As they began to compete on price, they created a third-tier price umbrella. This third tier was initially satisfied by deep-discount brokers and is increasingly served by electronic deep-discount brokerage firms. E*Trade, and the new breed of electronic brokerage firms, have been able to dramatically reduce costs beyond the discounters by leveraging technology not only in the back office but also in the customer interface. To reduce costs, E*Trade’s relies upon pure electronic order intake, which results in lower compensation costs per trade. However, to make the model work, E*Trade must also attract high-volume traders who can generate high profits per account, even with low per-trade margins.
TABLE 2
Revenues by Cost Type*
Compensation per Trade
$39.61
$8.22
$8.57
$2.83
Occupancy & Equipment per Trade
$7.40
$1.52
$3.53
$4.10
$11.46
$6.63
Operating Income per Trade Average Number of Trades per Account
4.41
18.18
Operating Income per Account
$50.60
$120.00
* Estimates from Industry Experts and Company Records.
traders. Second, E*Trade has a substantially lower cost structure, primarily because of lower compensation costs and greater use of technology. Because a lower level of support is provided, E*Trade needs far fewer employees per trade, increasing productivity. Finally, E*Trade is much more profitable on average, with twice the profitability per account of Schwab.
CUSTOMERS Segmentation Customers can be segmented based on a number of different characteristics, each of which affects how a particular company should address the market. The following are potential criteria with which to analyze the customer pool: frequency of trading, size of trades, wealth, technology usage, time/knowledge constraints and information/service needs (hand holding). An investor can be judged more or less likely to utilize the services of a particular type of firm based on the degree to which he or she fits these criteria. One would suspect the full-service broker client to have low to moderate frequency of trades, a higher-than-average size of trade, significant wealth, less comfort with technology, and less available time or business knowledge. These investors are not impacted by the higher cost of the trade because they value the addi-
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Communications/DP per Trade
Marketing & Selling per Trade
Cost Structure The importance of leveraging technology to reduce costs cannot be overstated. The primary benefit comes in the form of labor cost savings. The average spent on employee compensation per trade executed is $40 for Schwab, and $8 for E*Trade. These dramatic cost reductions, in conjunction with a much lower commission schedule, produce an average operating income per trade of only $6.63 for E*Trade versus $11.46 for Schwab. However, in terms of operating income per account, E*Trade’s more frequent traders generate an average income of $120, versus only $50 for Schwab’s (Table 2). E*Trade has much lower commissions and costs that are counterbalanced by the frequency with which its customer base executes trades. In summary, there are major differences between the economic models employed by the various brokerage firm segments. First, E*Trade has much lower commissions that tend to attract more frequent (and, hence, more profitable)
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tional service they are receiving and because the commission will comprise a lower percentage of the actual dollars traded. Additionally, their greater wealth is likely to make it difficult for them to rely on themselves to ‘‘put their money to work.’’ At the other end of the spectrum, one would expect the electronic deep-discount broker client to have a higher frequency of trades, a moderate average size of trade, moderate wealth, comfort with technology, and more time and business knowledge. Although at the outset these are likely to be the pools they will attract, the challenge for each of the market segments is how to attract those customers who fit several of the categories but not all of them. For instance, how can a firm like E*Trade appeal to a customer who, based on his/her trading size and volume, will benefit from E*Trade’s service offering, but may not have much comfort with technology? The issue of customer segmentation is especially important for the trends associated with the increasing penetration of electronic trading. As more firms vie to gain share as well as capture new growth, it will be important for firms to identify which customer-segments are most valuable to them and then develop a strategy to ensure that they will gain a disproportionate share of their business. There are certain obstacles to Internet trading that will permanently discourage a large set of potential customers (those who might otherwise be inclined to select E*Trade’s price/service offering). First, there are concerns about the security of the Internet. More technicallysavvy customers know that it is much easier for a thief to steal a carbon copy of a credit-card receipt than it is to intercept and decode an encrypted message on the Internet. However, the popular press has made much of the potential for hackers to intercept credit-card numbers, and by logical extension, brokerage account information, on the Internet. The electronic brokerage firms must continually fight this misperception, which will likely be fueled by mass publicity, should a break-in ever occur. Second, because the Internet is a shared net-
work, E*Trade has no control over its speed. Often the Internet is quite slow, or demand peaks in such a way that customers get locked out of E*Trade’s web site. This can create an enormous amount of frustration for investors, especially if they are intra-day traders. Finally, the least tangible of these factors is the perception that electronic deep-discount brokerages provide less advantageous trade execution for customers. Discounters such as Schwab and Fidelity have been emphasizing their better trade execution through superior position, volume, and more personal approach. There is no empirical data to support the claims by the discount brokers; however, in focus groups and in Internet chat areas, customers have mentioned trade execution as a concern.
E*Trade’s Customers E*Trade customers are active, independent, empowered investors who are comfortable in the on-line services world. They are attracted to E*Trade’s low commission rate for two primary reasons: these investors make their own investment decisions and resent paying high brokerage fees, and they trade frequently (five to six executions per month) so that the commission savings quickly become significant. E*Trade’s high-volume customers trade in excess of 10 times a month and hold 75% of their disposable investment assets in individual equities and 25% in mutual funds, whereas E*Trade’s lower-volume customers trade 3 to 4 times a month (still above average for the industry) and hold 25% of their assets in individual equities and 75% in longer-term-oriented mutual funds. E*Trade’s demographic analysis shows their typical customer household to have dual annual incomes above $75,000, professional/technical occupation(s), graduate school education(s), children, a single-family home worth in excess of $200,000, and over-represented interests including stocks/bonds, PCs, investing, science/ technology, and real estate investments. Over 75% of E*Trade’s customers have been discount and deep-discount brokerage customers, and the majority of them still maintain accounts at their other brokerage firm (primarily with Schwab and Fidelity). Customers have several
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reasons for maintaining multiple accounts, including easy access to mutual fund investing, existing 401(k) plans established by their employers, and prior relationships (applies to fullservice brokers only). Many customers establish an E*Trade account on a trial basis with the intent of gradually transferring their higher turnover stocks into the account over time. E*Trade’s customer base has roughly doubled each year over the past four years. The company expects future growth in new accounts to come from active investors who are becoming increasingly comfortable with technology, and to a lesser degree, younger technology enthusiasts who begin to fit the demographic profile of an individual investor. Because the annual commission savings increase with trading activity, it is no surprise that E*Trade’s core, earlyadopter customers were high-volume traders. Over time, E*Trade has established a brand image as the leader in the electronic trading segment, and once customers make the decision to switch, E*Trade appears to be one of the most respectable, reliable options. This has helped them attract medium to low volume customers who might not benefit as greatly as the high-volume traders. It is the company’s belief that as more services become available and customer service improves, price will become less of a reason for switching. Customers have, for the most part, been satisfied with their E*Trade experience. Recently, however, the flurry of new accounts generated by the national advertising campaign has created some severe customer-service problems, including excessive telephone wait times (often greater than 20 minutes per call), difficulty logging onto the web site, and sign-up delays. Customers typically keep their old account (usually with Fidelity or Schwab) open, and any major problem is likely to cause them to return to their old brokerage firm. In this sense, the electronic discount brokerage firms, as a group, get only one shot every few years at each of the discount brokerage customers. A single service gaffe can drive that customer away from the electronic brokerage sector for years. Although it may seem that there are few
switching costs in this business, barriers can actually be quite high, and E*Trade is working hard to increase them. First, reputation is critical in this business. Because most investors are quite careful with their money, they are no more likely to place their account in a fly-by-night brokerage firm than they are to buy a risky penny stock. A brokerage firm must carefully cultivate its reputation. Established firms have a major advantage in the process of attracting new customers. Second, many of the electronic deepdiscount firms, including E*Trade, are trying to follow the discounters’ lead of building an investment ‘‘home’’ for its customers. The more hooks a firm gets into a customer’s wallet, the more likely he is to stay. Fidelity and Schwab provide a wide enough range of services to serve as a customer’s only financial-services vendor. Many customers are reluctant to leave Fidelity or Schwab because the firms provide everything from checking to tax planning. Also, the consolidation of financial information on a single statement is very important to most customers. They value the simplicity of receiving all financial information from one company. Third, switching assets in and out of a brokerage firm can be quite difficult. Some firms charge fees or otherwise try to prevent transfers out. In many cases, however, the actual barriers are much smaller than either the psychological or perceived barriers. Third, because there are significant differences between the customer bases of the firms, there are some services that are easy for one firm to provide but difficult for others to duplicate. For instance, most of E*Trade’s customer base is on-line, allowing for fast and customized electronic communication. For Schwab or Fidelity to communicate with their customers in the same way requires significant manpower in the customer-service centers. Finally, because tracking customer activity is relatively easy in this business, there is also the possibility of creating loyalty-incentive programs, modeled on the airlines’ frequent-flier programs. Such programs might reward frequent traders with enhanced customer service, free investment products (such as free investment research reports or a subscription to the Wall Street Journal) or free real-time quotes.
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Potential Future E*Trade Customers Because many high-volume traders have already joined an electronic deep-discount brokerage firm and because of national, mainstream advertising, the next wave of customers who join E*Trade are likely to have a profile very different from current customers. First of all, they are more likely to be lower-volume traders, who do not receive as large a cost savings from trading electronically. Therefore, they are probably less price sensitive. In addition, because of the proliferation of firms offering fixed commissions between $12 and $34, having the lowest commissions might not be as important as it used to be when they lowest competitive firms were priced in the high $30s or low $40s. They also tend to be less technologically savvy and feel that Internet security is not at a level sufficient for them to feel comfortable. This group of customers also tends to need more handholding, and values greatly the ability to speak to a live person when they have a question or want to get more information. So the next wave of customers may be less profitable (because they trade less frequently) but may be more costly to serve because of the high advertising costs needed to attract them and the higher service levels required throughout the relationship.
COMPETITION
With the explosion of the World Wide Web (Web), the graphical portion of the Internet, and easy-to-navigate web browsers, barriers to access were virtually eliminated. Brokerage firms were no longer required to establish relationships with on-line service providers, as they could reach customers directly over the Internet. The deep-discount brokers embraced this paradigm shift more rapidly than the discount brokers, who were hesitant to cannibalize sales from their installed base. Drawn by the opportunity to regain their price-leadership position and lower their cost structure, deep-discount brokers established their own home pages (Aufhauser), whereas other less technologically savvy brokers (National Discount Brokers, Jack White) relied upon Security APL’s Internet brokerage electronic storefront. The discount brokers entered the electronic brokerage market gradually because they had to consider the effect of lending credibility to the emerging market, thus accelerating customer migration. Schwab and Fidelity first experimented with touch-tone trading, offering a 10% discount on commissions. This discount was then expanded to include trades that were entered via branded front-end trading software that accessed the brokerage firm by modem. Both Schwab and Fidelity have yet to offer trading over the Internet, citing security reasons. A brief description of E*Trade leading competitors are provided below:
E*Trade faces significant competition from a growing set of competitors, which come in three varieties: (1) electronic pure plays, (2) deepdiscount migrators, and (3) discount migrators. The electronic pure plays (PC Financial Network and E*Trade) pioneered the industry, as these firms were incorporated as technology-focused, electronic-only brokerage firms. During the early 1990s, E*Trade and PCFN competed primarily on access through the on-line service providers. PCFN was the first to establish a presence on Prodigy, and as a result, signed up many of Prodigy’s customers. Likewise, E*Trade dominated on CompuServe. E*Trade and PCFN established relationships with America Online about the same time and basically split AOL’s customers 50/50.
PC Financial Network Founded as an electronic brokerage firm in 1988, PC Financial Network (PCFN) is jointly owned by an investment bank, Donaldson, Lufkin & Jenrette (DLJ), and Pershing & Company, a leading clearinghouse and market-maker. An on-line trading pioneer PCFN claims to have the largest number of on-line brokerage accounts (over 300,000); however, industry insiders estimate the number of active accounts to be closer to 150,000. The company currently limits its online trading services to America Online and Prodigy. PCFN’s commissions are toward the high end for on-line brokers. PCFN currently charges a minimum of $40 per trade up to $2,500 in principal value, with commissions ris-
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ing to $100 plus 0.1% of the principal value for trades in excess of $40,000. In addition, PCFN provides its customers with 100 free real-time stock quotes for every trade execution. Initially a technological leader, the company has recently become more of a follower. PCFN’s lack of internet presence, coupled with the decline of Prodigy, has significantly reduced the company’s growth rate.
savings vs. traditional discount brokers, Lombard’s advertisement also emphasize its investment information, charts and graphs, and accessible customer service. In April 1996, Lombard announced its intent to spin off its Advanced Technology Group (ATG) as an independent company focused on providing turnkey Internet software/transaction processing systems. These third-party solutions are designed to enable banks and brokerage firms to more easily enter the on-line brokerage business. Lombard’s 1995 revenues are estimated at $24 million. The firm is privately-held and is considering an IPO in early 1997.
National Discount Brokers Founded as a traditional deep-discount brokerage firm, National Discount Brokers (NDB) is a wholly owned subsidiary of The Sherwood Group (NYSE: SHD). In October 1995, NDB launched its on-line services on the Web through the PAWWS Financial Network, a financial web site established in March 1994 by Security APL, a Chicago-based portfolio accounting software and service-bureau vendor. The PAWWS home page serves as a single integrated site for financial information, real-time quotes, portfolio accounting, securities and market research tools, and on-line trading. Customers can chose among several brokerage firm besides NDB including Jack White & Company’s Path On-line and Howe Barnes’ The Net Investor. NDB is among the more aggressive on-line brokers with respect to low price. NDB currently charges $20 per trade for OTC stocks or up to 5,000 shares of any listed stock for $25 plus $3 postage and handling.
TransTerra TransTerra, an Omaha-based financial-services corporation, has four separate subsidiaries which target distinct price points in the on-line brokerage market, three of which offer trading services over the Internet. Only its highest-end offering, AccuTrade, is not available over the Internet. AccuTrade charges $48 per transaction, is available over AOL and Windows direct modem link, and offers ‘‘power tools for the active investor.’’ In September 1995, TransTerra acquired Aufhauser, the first brokerage firm to launch a stand-alone web site (February 1995). TransTerra charges $34 per trade through Aufhauser’s WealthWEB site; however, recently the company has started experimenting with a combination $800-per-year unlimited trading commission and $20-per-month for realtime quotes in targeting active traders. In February 1996, TransTerra launched Ceres Securities On-line with the help of NetBroker’s Broker On-line, an electronic toolkit for the construction of full-featured electronic brokerage services. Ceres charges $18 per trade. Finally, in April 1996, with substantial advertising in financial publications, TransTerra launched its cheapest on-line trading subsidiary, eBroker. Designed to capture the rock bottom price segment of the market, eBroker offers the lowest commission per trade of any on-line broker (including E*Trade) at $12 per trade. Advertisements feature the $12 commission and tell investors, ‘‘Don’t call. Don’t write,’’ implying there is absolutely no customer service pro-
Lombard Institutional Brokerage Founded as a traditional deep-discount brokerage firm in 1992, Lombard Institutional Brokerage aggressively embraced on-line brokerage services. In October 1995, Lombard began offering its customers the option of placing orders over the Internet through its own designed and managed web site. By March 1996, on-line trades accounted for about 15% of total transaction activity. The company estimates that by 1998, 50% of Lombard’s trades will be executed on-line. Lombard positions itself as a premium service provider at $34 per trade (whether placed on-line or with a live broker over the telephone). In addition to promoting its cost
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vided. Using a scaled-back version of Aufhauser’s trading engine, eBroker is attempting to skim away the most valuable high-volume traders and also test the elasticity of demand for possible market expansion.
reputation for customer support, and breadth of products and services. Its full-page ads in the Wall Street Journal declared the ‘‘end of the commission compromise.’’ Presently, e.Schwab is only available by direct modem link, but the internet product is operational in beta release (80% of the modem functionality has been ported) with a full-scale internet rollout scheduled for July.
Charles Schwab Charles Schwab, a NYSE listed company, is the market leader in traditional, nonelectronic discount brokerage services, serving slightly more than 50% of the total discount brokerage market. Schwab is known for its high levels of customer service and its reasonable prices. Schwab began testing more limited service offerings at lower prices with its touch-tone telephone trading system, TeleBroker, in 1994 and with its direct modem, on-line interface, StreetSmart, in 1995. Customers trading through either of these less-labor-intensive options received a 10% discount off Schwab’s typical $60 to $80 commission rate. However, customers always had the fall-back option of speaking to the highlytrained customer-service representatives. In 1996, Schwab crossed over the threshold into electronic brokerage with the launch of its e.Schwab, a premium-priced ($39 per trade) online brokerage option. E.Schwab advertising emphasizes the Schwab name, well-established
DECISION E*Trade must decide how to react to the growing competitive pressure from e.Schwab on the high-end and eBroker on the low end. With several competitors offering commissions below $20, E*Trade has lost its historic point of differentiation. Some executives within the senior management team argue that E*Trade should quickly and decisively regain its price-leadership position. Other managers believe that price differences at this level are indistinguishable to the customer and that E*Trade should increase its value proposition by enhancing its product and service offering while maintaining its current commission structure. The company must decide where it can create a profitable and sustainable position along the price/quality (service) trade-off.
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This case was prepared by Chuck Glew, Mark Lotke, Mario Palumbo, and Marc Schwartz, under the supervision of Rajiv Lal, Professor of Marketing and Management Science, Stanford University Graduate School of Business, as a basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Reprinted with permission of Stanford University, Graduate School of Business, Copyright q 1996 by the Board of Trustees of the Leland Stanford Junior University.
j
INTRODUCTION E*Trade pioneered the electronic deep-discount brokerage business in the late 1980s and has experienced phenomenal growth since 1992. Electronic brokerage firms make extensive use of technology in most customer interactions and, as a result, can achieve significant cost advantages over traditional brokerage firms. E*Trade’s strategy until now has been to continually pass these cost savings from automation on to its customers as they amortized their fixed costs over a greater number of accounts. The company charges a fixed commission rate on trade executions up to 5,000 shares ($14.95 NYSE, $19.95 NASDAQ), a 75% savings compared to the traditional discount brokers. As of the spring of 1996, E*Trade is at a critical juncture in its development and faces many challenges. A flood of new competitors are establishing internet sites and for the first time in its history, E*Trade has been dethroned as the price leader. In April 1996, a new entrant, eBroker, has introduced ‘‘no frills’’ trading through the Internet at a flat $12 per trade. In addition, Charles Schwab, the leading discount brokerage firm, is preparing itself for entry directly into E*Trade’s domain. E*Trade is being forced to reexamine its business model and choose a strategy with which to
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address the changing environment. While some executives within E*Trade believe they should continue to lower price and go head-to-head with eBroker, others believe the company faces a larger challenge from Charles Schwab’s entry into the market. Defending against Schwab would require focusing resources on enhancing its product/service offering, which might jeopardize E*Trade’s low-cost position.
General Atlantic Partners, a New York-based private investment firm focused on investing in high-growth information technology companies, made a significant minority equity investment in E*Trade. These funds are being used to accelerate E*Trade’s transition to self-clearing (presently provided by Herzog, Heine, and Geduld), bolster E*Trade’s customer support infrastructure (systems, personnel), and launch an aggressive marketing campaign (print, TV, radio). In May 1996 the company filed with the SEC for an initial public offering scheduled for that summer.
THE COMPANY History Trade*Plus, the parent company of E*Trade, was founded in 1982 as a PC financial management service bureau by Bill Porter. In 1992, the visionary Porter launched E*Trade Securities, a pioneering on-line brokerage services provider based in Palo Alto, California. Initially, E*Trade generated most of its revenues by providing back-office on-line processing services to discount brokerage firms (Fidelity, Schwab, and Quick & Reilly). Although E*Trade continues to service Quick & Reilly, the company has moved away from a ‘‘private label’’ strategy to aggressively pursue a direct-to-consumer business model. In 1995, over 80% of revenues were derived from trading commissions by E*Trade customers. Additional revenues are generated from interest on customer cash balances and margin accounts, connect-time revenue sharing with on-line service providers, and third-party processing services. As a result of the shift from full-service to discount brokerage, increased PC penetration in the home, and the explosion of the Internet, the company has experienced dramatic revenue growth ($2 million in 1993, $10 million in 1994, $22 million in 1995, and budgeting in excess of $50 million for 1996). The company’s stated internal strategy is to become America’s dominant deep-discount brokerage firm by fully automating the front and back-office trade processing function and maintaining its position as the low-cost provider. The company has made significant information technology investments in automating order entry, customer support, trade execution, and post-trade clearing and confirmation. In September 1995,
Product E*Trade provides its 50,000 customers with trade execution on stocks and options, and by year end, is likely to offer mutual funds. In addition to trade execution, the company provides stock quotes (real-time or delayed), news services, consolidated monthly statements, and limited portfolio analytics. Customers can access E*Trade through various low-cost channels including touch-tone telephone (TeleMasters), on-line service providers (CompuServe, America Online, BOA HomeBanking), direct modem link, and most recently, the Internet. E*Trade launched its Internet home page in January 1996 and as of May 1996 over 35% of all trading is done over the Internet. Pricing E*Trade’s brokerage services appeal to active, independent investors who routinely make their own investment decisions and do not want to pay full-service commissions. E*Trade offers this growing customer segment a compelling value proposition: a flat $14.95 commission rate on all NYSE trades up to 5,000 shares and $19.95 for all OTC trades. As seen in the Table 1, E*Trade’s commissions are typically 50% to 75% less expensive than traditional discount brokerage firms such as Schwab or Fidelity, particularly for larger trades. By leveraging information technology and passing savings on to consumers, E*Trade has steadily lowered its commission rates from $24.95 to $14.95 over the past two years. The company consistently offered the industry’s low-
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TABLE 1
Comparison of Commissions 100 Shares @ $40
5,000 Shares @ $20
Fixed Component
Variable Component
Fixed Component
Variable Component
E*Trade Listed
$14.95
—
$14.95
—
E*Trade OTC
$19.95
—
$19.95
—
Lombard Listed
$34
—
—
$100
Lombard OTC
$34
—
—
$75
e.Schwab
$39
—
$39
$120
PCFN
$60
—
$100
$100
NDB Listed*
$33
—
$33
—
NDB OTC*
$28
—
$28
—
Ceres
$18
—
$18
—
Schwab/Fidelity
$56
$26.40
$155
$110
* Includes $3 postage fee per order.
est commissions until April 1996 when a new entrant, eBroker, began offering $12 trade execution under a ‘‘no frills/no service’’ market positioning.
vidual Investor, Smart Money, Forbes) campaign. These ads focused on E*Trade’s low commission rates (with accompanying comparison tables) and featured bold tag lines such as:
Advertising-Marketing Advertising plays a significant role in the brokerage business not only because it creates brand awareness, but also because it is the first step in the customer acquisition process. Brand awareness is critical in the nascent electronic brokerage business because most of the competing firms are new to the business and because many customers have an aversion to depositing their money with a firm they have never heard of. These issues are especially important on the Internet, which has the perception of being unsecured. In addition to creating brand awareness, most advertising in this industry also compares the advertising firm’s product-service offering to competitors. In January 1996, E*Trade aggressively increased its advertising budget to raise awareness, generate new account inquiries, and unveil its new Internet site. The company placed weekly full-page ads in the Wall Street Journal, complementing its continued television (CNBC business channel), local radio, and magazines (Indi-
E*Trade is leading the electronic trading revolution. In fact, we started it. How else could we charge just $14.95 per trade? Your broker is obsolete . . . (above a picture of a young boy sitting next to his computer sticking his tongue out at a tired, paper-inundated broker). In February 1996, E*Trade altered its advertising campaign to emphasize product/service enhancements. The new ad states ‘‘E*Trade saves you up to 78% on brokerage commissions (bells and whistles included)’’ and lists 24-hour access, free quotes, on-line portfolio management, free checking, and margin and IRA accounts. These successful campaigns have positioned E*Trade as the electronic brokerage leader in the eyes of investors and generated significant new account inquiries. Unfortunately, the company was not adequately prepared for the re-
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sponse as wait times for customer service surged. This upset both current customers who had questions concerning their trades as well as new customers who were less than impressed with their first interaction with the company. In addition, competitors have begun to locate and publicize holes in the E*Trade service offering. For instance, Lombard, an electronic brokerage competitor, includes a column in its advertisement comparing the minimum check amount that can be written from the account. Lombard has no minimum while E*Trade will only honor checks written on the account in excess of $500. As E*Trade and its competitors continue to advertise nationally in an attempt to build brand awareness, customer acquisition costs are rising. In addition to the advertising component, customer acquisition is generally a several-step process consisting of an initial inquiry, often by email or telephone, and often a follow-up conversation, either to answer specific questions or to check on the status of the application. These customer service-intensive interactions are quite costly for E*Trade. With low margins per trade, E*Trade’s new customers must trade frequently to recoup total customer acquisition costs.
brokerage houses is their participation in all aspects of the investment process, from initial decision through execution and follow-up. These services may include the following: suggesting investment opportunities, providing research reports, executing the trade, offering customerservice support, and issuing monthly reporting statements. Brokers tend to be proactive, making suggestions to their clients and trying to influence their investment choices, as well as increasing their investment and trading activity. The brokerage could be a stand-alone institution or a separate department or trust division of a larger entity. Typically, these services are used by households with more than $100,000 in assets. Brokers are paid a significant percentage of their compensation through commissions (typically $150 to $300 per trade), thus they are rewarded for spurring this activity, and potentially are able to collect additional fees depending on the extent of their financial-planning advice. The broker-client relationship is often a long-standing one-on-one relationship in which word-of-mouth referral plays a large role in new-client development. Full-service brokers tend to offer their own line of products, and when they go outside of their family of products, they will usually only sell ‘‘load’’ funds which generate additional commissions. Products offered include retirement accounts, credit products, insurance, and portfolio planning. Full-service brokers provide newsletters and industry-specific and companyspecific research reports written by a team of inhouse analysts. Full-service brokers sometimes provide access to initial public offerings (IPOs) of stock and secondary offerings that are being underwritten by the investment banking arm of the firms. Examples of full-service brokers are Merrill Lynch and Smith Barney Shearson.
THE MARKET Segmentation The market for trading and brokerage services is divided between three primary segments: fullservice brokers, discount brokers, and deep-discount brokers. The increasing presence and use of technology as the primary vehicle of trade execution has led to the creation of a fourth segment, the electronic deep-discount broker. This distinction is not entirely clean as a number of firms including large discount brokers like Schwab and Fidelity have introduced on-line offerings alongside and in conjunction with their traditional products and services.
Discount Brokers. Discount brokers, such as Charles Schwab and Fidelity Investments, offer limited services for investors who do not need specialized product offerings and who do their own research. These institutions make their revenues primarily on the number of trades they execute and on margin account charges. The financial profile of a discount brokerage client
Full-Service Brokers. A full-service brokerage provides a broad range of services, from helping to develop an investment strategy through performance measurement of the executed strategy. The important distinction of this class of
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is broader, ranging from minimal assets to about $250,000 in assets on average. Clients typically tend to be more active traders who do not require specialized and personalized service and are willing to make this trade-off for lower commissions (typically $80 to $100 per trade). Customers in this segment make their own trading decisions without the support and advice of the broker. Recently, discount brokers have become closer in service to full-service institutions, with the exception of the personalized service and investment advice. They have been moving more and more to differentiating themselves through increased service offerings to the point where 800 telephone numbers, monthly account summaries, quotes, and general investment advice are the norm and not points of differentiation. However, information tends to be general in nature and is not geared toward specific investments, industries, or portfolios. In fact, even when asked directly, representatives will not lend their advice with respect to specific trades. Examples of discount brokers are Charles Schwab and Fidelity.
ment was conducted through the telephone or in PC-based on-line environments such as America Online (AOL) or CompuServe. Much of the current trading volume and expected growth, however, is coming through the internet. Current commission levels range from EBroker’s $12 and E-Trade’s $14.99/$19.99 pertrade offering to the $40 range with very minimal customer-service levels. This might result in a limited number of quotes, shorter hours of operation, longer waits for making contact, potentially less advantageous trade execution, less detailed account correspondence, restrictions on margin account trading, and fewer product offerings (mutual funds, bonds, 401(k) accounts). Many deep-discount brokers conduct a large percentage of their business through means that minimize the labor component, including electronic on-line services or through automated telephone lines. Examples of electronic deep-discount brokers are Lombard, National Discount Brokers, and e.Schwab.
Value Chain The value chain for investment services from the customer’s perspective includes the following activities: investment strategy, investment decisions, trade execution, portfolio servicing, and performance measurement. As one would expect, the different brokerage firm types span various sections of this chain. The full-service broker participates in investment decisions and is more likely to offer a higher level of service at other points in the process, as well as more detailed statements. Discount brokers, on the other hand, operate in a more focused area of the chain, primarily providing trade execution with limited support, customer service, and performance measurement. The value chain as it relates to the brokerage firms includes the following areas: marketing, research provision, investment advice, trade input, trade execution, and account servicing (see Exhibit 1). There are two ways in which these activities differ by firm category. First, it is possible that one aspect of the value chain is missing entirely for a particular type of firm. As mentioned earlier, this is the case with investment advice as it relates to the discount brokerage
Deep-Discount Brokers. Deep-discount brokers take the discount concept one step further and provide even fewer service offerings and less flexibility in trading, but for a measurably lower price (typically $40 to $60 per trade). Historically, price has been the primary means of differentiation in this segment, but there is some indication that the minimum threshold level of service has been increasing lately. Original deep-discount outlets were cheap alternatives set up in the midwest, where low-cost labor allowed even further price declines. Examples of deep-discount brokers are Quick & Reilly, Waterhouse, and Olde. Electronic Deep-Discount Brokers. Electronic deep-discount firms include companies that were founded as electronic-only trading outfits (PC Financial Network, E*Trade), as well as discount and deep-discount brokerage firms that offered a portion of their services through the electronic medium. Initially, trading in this seg-
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firm—it simply does not exist. The other point of differentiation is the degree to which the particular part of the chain is emphasized. For instance, full-brokerage firms are likely to spend more absolute dollars on account servicing than deep-discount brokers, although this relationship may not hold as a percentage of the trading commission.
ing an alternative to customers who did not require the level of service offered by a full-service brokerage house, and hence, did not want to pay for services that were not being utilized. Discount brokers could employ less labor (and less skilled labor) because a variety of services and hand holding was not required of them. Although a number of players entered the market with this strategy, it was Charles Schwab that gave wide-scale credibility to the approach and institutionalized the discount broker concept. At a time when firms were offering low prices but skimping on service, Schwab’s strategy and eventual scale allowed it to ‘‘gentrify’’ the market by providing a truly professional approach to what at one time was a ‘‘bucket shop’’ mentality. Its approach was to remain neutral in the investment decision and simply execute trades. Over time it sought to decrease its dependency on trading volume by offering more products and services to enable it to generate charges for ‘‘assets under management.’’ The increasing use of technology is rapidly transforming the security brokerage business, which was once a sleepy, relationship-based, primarily local industry. Technology has helped to increase economies of scale and to permit rationalization in the industry. Increasingly, discounters such as Fidelity and Charles Schwab have leveraged technology to substantially reduce the cost of executing a trade and performing account-related servicing. A major component of this cost-reduction strategy has been the severing of the personal relationship between a particular broker and a particular client. Customers of these two discounters use national toll-free numbers as their primary interface with the firm. They speak to a different representative each call. This aggregation of customer inquiries helps to reduce total variability in demand patterns, allowing far fewer customer-service representatives and brokers to be employed. However, through sophisticated uses of technology, these firms are able to maintain high customer-service levels because each representative has access to the customer’s entire account history. In addition, significant economies are realized by aggregating the functions
Market Size Brokerage firms generate their revenue from commissions, margin accounts, and auxiliary services. A significant portion is generated from commissions, and in 1991 total industry commissions were estimated to be in the neighborhood of $12 billion. Although this figure is not expected to change significantly through 1998 (slight increase in volume, slight decrease in average commission), the distribution between segments is projected to change. Full-service brokers’ commissions are estimated to decline from $10 billion in 1991 to $8 billion in 1998, while discount brokers’ share is expected to increase from $2 billion to roughly $4 billion over the same time period. On-line discount commissions are expected to comprise almost 10% or $400 million of the discount brokers share by 1998. From 1994 to 1998 the number of trades conducted is estimated to increase from 100 million to 144 million. Full-service brokers will see their trading volume hover around the 65 million mark over this period, while discount brokers volume will increase from 30 million to 65 million, and on-line services will account from 13 million trades in 1998 up from 5 million in 1994. According to Forrester Research, growth in online brokerage accounts is anticipated to increase at 30%, from 550,000 in 1995 to 1.3 million in 1998. The two largest players, Schwab and PCFN, account for about 60% of the market (or 150,000 accounts each) with Fidelity controlling 13% and E*Trade with 6%. The remaining 20% of the market is divided up among a number of the smaller players. Market Evolution The market has evolved in a fairly straightforward manner, with the discount brokers provid-
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dealing with the collection and manipulation of account data. Although Schwab and Fidelity served a specific market need, its relatively high level of customer service created the potential for another layer of firms beneath it. Because the discounters’ increasing scale enabled them to substantially enhance customer service without increasing price, the remaining firms were left with price competition as the only viable strategic alternative. As they began to compete on price, they created a third-tier price umbrella. This third tier was initially satisfied by deep-discount brokers and is increasingly served by electronic deep-discount brokerage firms. E*Trade, and the new breed of electronic brokerage firms, have been able to dramatically reduce costs beyond the discounters by leveraging technology not only in the back office but also in the customer interface. To reduce costs, E*Trade’s relies upon pure electronic order intake, which results in lower compensation costs per trade. However, to make the model work, E*Trade must also attract high-volume traders who can generate high profits per account, even with low per-trade margins.
TABLE 2
Revenues by Cost Type*
Compensation per Trade
$39.61
$8.22
$8.57
$2.83
Occupancy & Equipment per Trade
$7.40
$1.52
$3.53
$4.10
$11.46
$6.63
Operating Income per Trade Average Number of Trades per Account
4.41
18.18
Operating Income per Account
$50.60
$120.00
* Estimates from Industry Experts and Company Records.
traders. Second, E*Trade has a substantially lower cost structure, primarily because of lower compensation costs and greater use of technology. Because a lower level of support is provided, E*Trade needs far fewer employees per trade, increasing productivity. Finally, E*Trade is much more profitable on average, with twice the profitability per account of Schwab.
CUSTOMERS Segmentation Customers can be segmented based on a number of different characteristics, each of which affects how a particular company should address the market. The following are potential criteria with which to analyze the customer pool: frequency of trading, size of trades, wealth, technology usage, time/knowledge constraints and information/service needs (hand holding). An investor can be judged more or less likely to utilize the services of a particular type of firm based on the degree to which he or she fits these criteria. One would suspect the full-service broker client to have low to moderate frequency of trades, a higher-than-average size of trade, significant wealth, less comfort with technology, and less available time or business knowledge. These investors are not impacted by the higher cost of the trade because they value the addi-
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Communications/DP per Trade
Marketing & Selling per Trade
Cost Structure The importance of leveraging technology to reduce costs cannot be overstated. The primary benefit comes in the form of labor cost savings. The average spent on employee compensation per trade executed is $40 for Schwab, and $8 for E*Trade. These dramatic cost reductions, in conjunction with a much lower commission schedule, produce an average operating income per trade of only $6.63 for E*Trade versus $11.46 for Schwab. However, in terms of operating income per account, E*Trade’s more frequent traders generate an average income of $120, versus only $50 for Schwab’s (Table 2). E*Trade has much lower commissions and costs that are counterbalanced by the frequency with which its customer base executes trades. In summary, there are major differences between the economic models employed by the various brokerage firm segments. First, E*Trade has much lower commissions that tend to attract more frequent (and, hence, more profitable)
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tional service they are receiving and because the commission will comprise a lower percentage of the actual dollars traded. Additionally, their greater wealth is likely to make it difficult for them to rely on themselves to ‘‘put their money to work.’’ At the other end of the spectrum, one would expect the electronic deep-discount broker client to have a higher frequency of trades, a moderate average size of trade, moderate wealth, comfort with technology, and more time and business knowledge. Although at the outset these are likely to be the pools they will attract, the challenge for each of the market segments is how to attract those customers who fit several of the categories but not all of them. For instance, how can a firm like E*Trade appeal to a customer who, based on his/her trading size and volume, will benefit from E*Trade’s service offering, but may not have much comfort with technology? The issue of customer segmentation is especially important for the trends associated with the increasing penetration of electronic trading. As more firms vie to gain share as well as capture new growth, it will be important for firms to identify which customer-segments are most valuable to them and then develop a strategy to ensure that they will gain a disproportionate share of their business. There are certain obstacles to Internet trading that will permanently discourage a large set of potential customers (those who might otherwise be inclined to select E*Trade’s price/service offering). First, there are concerns about the security of the Internet. More technicallysavvy customers know that it is much easier for a thief to steal a carbon copy of a credit-card receipt than it is to intercept and decode an encrypted message on the Internet. However, the popular press has made much of the potential for hackers to intercept credit-card numbers, and by logical extension, brokerage account information, on the Internet. The electronic brokerage firms must continually fight this misperception, which will likely be fueled by mass publicity, should a break-in ever occur. Second, because the Internet is a shared net-
work, E*Trade has no control over its speed. Often the Internet is quite slow, or demand peaks in such a way that customers get locked out of E*Trade’s web site. This can create an enormous amount of frustration for investors, especially if they are intra-day traders. Finally, the least tangible of these factors is the perception that electronic deep-discount brokerages provide less advantageous trade execution for customers. Discounters such as Schwab and Fidelity have been emphasizing their better trade execution through superior position, volume, and more personal approach. There is no empirical data to support the claims by the discount brokers; however, in focus groups and in Internet chat areas, customers have mentioned trade execution as a concern.
E*Trade’s Customers E*Trade customers are active, independent, empowered investors who are comfortable in the on-line services world. They are attracted to E*Trade’s low commission rate for two primary reasons: these investors make their own investment decisions and resent paying high brokerage fees, and they trade frequently (five to six executions per month) so that the commission savings quickly become significant. E*Trade’s high-volume customers trade in excess of 10 times a month and hold 75% of their disposable investment assets in individual equities and 25% in mutual funds, whereas E*Trade’s lower-volume customers trade 3 to 4 times a month (still above average for the industry) and hold 25% of their assets in individual equities and 75% in longer-term-oriented mutual funds. E*Trade’s demographic analysis shows their typical customer household to have dual annual incomes above $75,000, professional/technical occupation(s), graduate school education(s), children, a single-family home worth in excess of $200,000, and over-represented interests including stocks/bonds, PCs, investing, science/ technology, and real estate investments. Over 75% of E*Trade’s customers have been discount and deep-discount brokerage customers, and the majority of them still maintain accounts at their other brokerage firm (primarily with Schwab and Fidelity). Customers have several
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reasons for maintaining multiple accounts, including easy access to mutual fund investing, existing 401(k) plans established by their employers, and prior relationships (applies to fullservice brokers only). Many customers establish an E*Trade account on a trial basis with the intent of gradually transferring their higher turnover stocks into the account over time. E*Trade’s customer base has roughly doubled each year over the past four years. The company expects future growth in new accounts to come from active investors who are becoming increasingly comfortable with technology, and to a lesser degree, younger technology enthusiasts who begin to fit the demographic profile of an individual investor. Because the annual commission savings increase with trading activity, it is no surprise that E*Trade’s core, earlyadopter customers were high-volume traders. Over time, E*Trade has established a brand image as the leader in the electronic trading segment, and once customers make the decision to switch, E*Trade appears to be one of the most respectable, reliable options. This has helped them attract medium to low volume customers who might not benefit as greatly as the high-volume traders. It is the company’s belief that as more services become available and customer service improves, price will become less of a reason for switching. Customers have, for the most part, been satisfied with their E*Trade experience. Recently, however, the flurry of new accounts generated by the national advertising campaign has created some severe customer-service problems, including excessive telephone wait times (often greater than 20 minutes per call), difficulty logging onto the web site, and sign-up delays. Customers typically keep their old account (usually with Fidelity or Schwab) open, and any major problem is likely to cause them to return to their old brokerage firm. In this sense, the electronic discount brokerage firms, as a group, get only one shot every few years at each of the discount brokerage customers. A single service gaffe can drive that customer away from the electronic brokerage sector for years. Although it may seem that there are few
switching costs in this business, barriers can actually be quite high, and E*Trade is working hard to increase them. First, reputation is critical in this business. Because most investors are quite careful with their money, they are no more likely to place their account in a fly-by-night brokerage firm than they are to buy a risky penny stock. A brokerage firm must carefully cultivate its reputation. Established firms have a major advantage in the process of attracting new customers. Second, many of the electronic deepdiscount firms, including E*Trade, are trying to follow the discounters’ lead of building an investment ‘‘home’’ for its customers. The more hooks a firm gets into a customer’s wallet, the more likely he is to stay. Fidelity and Schwab provide a wide enough range of services to serve as a customer’s only financial-services vendor. Many customers are reluctant to leave Fidelity or Schwab because the firms provide everything from checking to tax planning. Also, the consolidation of financial information on a single statement is very important to most customers. They value the simplicity of receiving all financial information from one company. Third, switching assets in and out of a brokerage firm can be quite difficult. Some firms charge fees or otherwise try to prevent transfers out. In many cases, however, the actual barriers are much smaller than either the psychological or perceived barriers. Third, because there are significant differences between the customer bases of the firms, there are some services that are easy for one firm to provide but difficult for others to duplicate. For instance, most of E*Trade’s customer base is on-line, allowing for fast and customized electronic communication. For Schwab or Fidelity to communicate with their customers in the same way requires significant manpower in the customer-service centers. Finally, because tracking customer activity is relatively easy in this business, there is also the possibility of creating loyalty-incentive programs, modeled on the airlines’ frequent-flier programs. Such programs might reward frequent traders with enhanced customer service, free investment products (such as free investment research reports or a subscription to the Wall Street Journal) or free real-time quotes.
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Potential Future E*Trade Customers Because many high-volume traders have already joined an electronic deep-discount brokerage firm and because of national, mainstream advertising, the next wave of customers who join E*Trade are likely to have a profile very different from current customers. First of all, they are more likely to be lower-volume traders, who do not receive as large a cost savings from trading electronically. Therefore, they are probably less price sensitive. In addition, because of the proliferation of firms offering fixed commissions between $12 and $34, having the lowest commissions might not be as important as it used to be when they lowest competitive firms were priced in the high $30s or low $40s. They also tend to be less technologically savvy and feel that Internet security is not at a level sufficient for them to feel comfortable. This group of customers also tends to need more handholding, and values greatly the ability to speak to a live person when they have a question or want to get more information. So the next wave of customers may be less profitable (because they trade less frequently) but may be more costly to serve because of the high advertising costs needed to attract them and the higher service levels required throughout the relationship.
COMPETITION
With the explosion of the World Wide Web (Web), the graphical portion of the Internet, and easy-to-navigate web browsers, barriers to access were virtually eliminated. Brokerage firms were no longer required to establish relationships with on-line service providers, as they could reach customers directly over the Internet. The deep-discount brokers embraced this paradigm shift more rapidly than the discount brokers, who were hesitant to cannibalize sales from their installed base. Drawn by the opportunity to regain their price-leadership position and lower their cost structure, deep-discount brokers established their own home pages (Aufhauser), whereas other less technologically savvy brokers (National Discount Brokers, Jack White) relied upon Security APL’s Internet brokerage electronic storefront. The discount brokers entered the electronic brokerage market gradually because they had to consider the effect of lending credibility to the emerging market, thus accelerating customer migration. Schwab and Fidelity first experimented with touch-tone trading, offering a 10% discount on commissions. This discount was then expanded to include trades that were entered via branded front-end trading software that accessed the brokerage firm by modem. Both Schwab and Fidelity have yet to offer trading over the Internet, citing security reasons. A brief description of E*Trade leading competitors are provided below:
E*Trade faces significant competition from a growing set of competitors, which come in three varieties: (1) electronic pure plays, (2) deepdiscount migrators, and (3) discount migrators. The electronic pure plays (PC Financial Network and E*Trade) pioneered the industry, as these firms were incorporated as technology-focused, electronic-only brokerage firms. During the early 1990s, E*Trade and PCFN competed primarily on access through the on-line service providers. PCFN was the first to establish a presence on Prodigy, and as a result, signed up many of Prodigy’s customers. Likewise, E*Trade dominated on CompuServe. E*Trade and PCFN established relationships with America Online about the same time and basically split AOL’s customers 50/50.
PC Financial Network Founded as an electronic brokerage firm in 1988, PC Financial Network (PCFN) is jointly owned by an investment bank, Donaldson, Lufkin & Jenrette (DLJ), and Pershing & Company, a leading clearinghouse and market-maker. An on-line trading pioneer PCFN claims to have the largest number of on-line brokerage accounts (over 300,000); however, industry insiders estimate the number of active accounts to be closer to 150,000. The company currently limits its online trading services to America Online and Prodigy. PCFN’s commissions are toward the high end for on-line brokers. PCFN currently charges a minimum of $40 per trade up to $2,500 in principal value, with commissions ris-
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ing to $100 plus 0.1% of the principal value for trades in excess of $40,000. In addition, PCFN provides its customers with 100 free real-time stock quotes for every trade execution. Initially a technological leader, the company has recently become more of a follower. PCFN’s lack of internet presence, coupled with the decline of Prodigy, has significantly reduced the company’s growth rate.
savings vs. traditional discount brokers, Lombard’s advertisement also emphasize its investment information, charts and graphs, and accessible customer service. In April 1996, Lombard announced its intent to spin off its Advanced Technology Group (ATG) as an independent company focused on providing turnkey Internet software/transaction processing systems. These third-party solutions are designed to enable banks and brokerage firms to more easily enter the on-line brokerage business. Lombard’s 1995 revenues are estimated at $24 million. The firm is privately-held and is considering an IPO in early 1997.
National Discount Brokers Founded as a traditional deep-discount brokerage firm, National Discount Brokers (NDB) is a wholly owned subsidiary of The Sherwood Group (NYSE: SHD). In October 1995, NDB launched its on-line services on the Web through the PAWWS Financial Network, a financial web site established in March 1994 by Security APL, a Chicago-based portfolio accounting software and service-bureau vendor. The PAWWS home page serves as a single integrated site for financial information, real-time quotes, portfolio accounting, securities and market research tools, and on-line trading. Customers can chose among several brokerage firm besides NDB including Jack White & Company’s Path On-line and Howe Barnes’ The Net Investor. NDB is among the more aggressive on-line brokers with respect to low price. NDB currently charges $20 per trade for OTC stocks or up to 5,000 shares of any listed stock for $25 plus $3 postage and handling.
TransTerra TransTerra, an Omaha-based financial-services corporation, has four separate subsidiaries which target distinct price points in the on-line brokerage market, three of which offer trading services over the Internet. Only its highest-end offering, AccuTrade, is not available over the Internet. AccuTrade charges $48 per transaction, is available over AOL and Windows direct modem link, and offers ‘‘power tools for the active investor.’’ In September 1995, TransTerra acquired Aufhauser, the first brokerage firm to launch a stand-alone web site (February 1995). TransTerra charges $34 per trade through Aufhauser’s WealthWEB site; however, recently the company has started experimenting with a combination $800-per-year unlimited trading commission and $20-per-month for realtime quotes in targeting active traders. In February 1996, TransTerra launched Ceres Securities On-line with the help of NetBroker’s Broker On-line, an electronic toolkit for the construction of full-featured electronic brokerage services. Ceres charges $18 per trade. Finally, in April 1996, with substantial advertising in financial publications, TransTerra launched its cheapest on-line trading subsidiary, eBroker. Designed to capture the rock bottom price segment of the market, eBroker offers the lowest commission per trade of any on-line broker (including E*Trade) at $12 per trade. Advertisements feature the $12 commission and tell investors, ‘‘Don’t call. Don’t write,’’ implying there is absolutely no customer service pro-
Lombard Institutional Brokerage Founded as a traditional deep-discount brokerage firm in 1992, Lombard Institutional Brokerage aggressively embraced on-line brokerage services. In October 1995, Lombard began offering its customers the option of placing orders over the Internet through its own designed and managed web site. By March 1996, on-line trades accounted for about 15% of total transaction activity. The company estimates that by 1998, 50% of Lombard’s trades will be executed on-line. Lombard positions itself as a premium service provider at $34 per trade (whether placed on-line or with a live broker over the telephone). In addition to promoting its cost
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vided. Using a scaled-back version of Aufhauser’s trading engine, eBroker is attempting to skim away the most valuable high-volume traders and also test the elasticity of demand for possible market expansion.
reputation for customer support, and breadth of products and services. Its full-page ads in the Wall Street Journal declared the ‘‘end of the commission compromise.’’ Presently, e.Schwab is only available by direct modem link, but the internet product is operational in beta release (80% of the modem functionality has been ported) with a full-scale internet rollout scheduled for July.
Charles Schwab Charles Schwab, a NYSE listed company, is the market leader in traditional, nonelectronic discount brokerage services, serving slightly more than 50% of the total discount brokerage market. Schwab is known for its high levels of customer service and its reasonable prices. Schwab began testing more limited service offerings at lower prices with its touch-tone telephone trading system, TeleBroker, in 1994 and with its direct modem, on-line interface, StreetSmart, in 1995. Customers trading through either of these less-labor-intensive options received a 10% discount off Schwab’s typical $60 to $80 commission rate. However, customers always had the fall-back option of speaking to the highlytrained customer-service representatives. In 1996, Schwab crossed over the threshold into electronic brokerage with the launch of its e.Schwab, a premium-priced ($39 per trade) online brokerage option. E.Schwab advertising emphasizes the Schwab name, well-established
DECISION E*Trade must decide how to react to the growing competitive pressure from e.Schwab on the high-end and eBroker on the low end. With several competitors offering commissions below $20, E*Trade has lost its historic point of differentiation. Some executives within the senior management team argue that E*Trade should quickly and decisively regain its price-leadership position. Other managers believe that price differences at this level are indistinguishable to the customer and that E*Trade should increase its value proposition by enhancing its product and service offering while maintaining its current commission structure. The company must decide where it can create a profitable and sustainable position along the price/quality (service) trade-off.
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