Online Discount Brokers: Disintermediation Won't Strike Evenly

A good deal has been said in the past few weeks about the disintermediation of the online discount brokerage industry. Bank of America (BAC) and Zecco.com roiled the market with the introduction of the "free trade era," leaving some concerned about their investments in Ameritrade (AMTD), E*Trade (ET) and Charles Schwab (SCHW).

The market probably overreacted to the news and now those stock have seemed to recover, but there is still a lot of uncertainty on the future of the industry.

Few have recently mentioned OptionsXpress (OXPS), yet this is in all likelihood one of the stocks that will be more affected by the disintermediation process, since among the online brokers, OptionsXpress has the highest percentage of revenues derived from trading commissions (more than 70%). In addition, a significant proportion of OXPS' pretax earnings (more than 25% of the total in 2006) derives from payments for order flow [PFOF]. These are payments received from brokers that execute OptionsXpress trading volume. These payments will gradually decline over time as a result of the expected switch to a min. $0.01 bid/ask spread in option trading. If history repeats itself, option trading will experience a dramatic decline in PFOF, as stock trading experienced in the past.

Regarding other online discount brokers, I would feel more safe for at least a couple of reasons:

• Low cost providers have been around for a while: think of Interactive Brokers, whose commission on US stocks is $0.005 per share. The company has been offering for years a low cost / technology based service addressed mainly at high volume traders. An important lesson: the market is not a homogeneous entity but it is fairly segmented. There are option traders (they are more likely to use OptionsXpress or Thinkorswim), there are heavy traders (those who use Interactive Brokers or Zecco) and investors looking for a broad range of services who are probably less price sensitive. Ameritrade, E*Trade and Charles Schwab are more likely to attract this type of clientele and therefore are less affected by this free trade revolution.

• The percentage of revenues derived from trading commissions has declined over time as a result of the increased offering to clients. Based on last quarter’s data, trading commissions now represent slightly more than 30% of revenues at AMTD, 23% at ET and only 13% at SCHW. Two implications: 1) if they want, they can reduce commissions without hurting too much the P&L; and 2) apparently their customers are interested in other services (those that make up the bulk of revenues) and therefore will be less likely to change provider.