Testimony from June 14, 1999
Prepared Testimony from Edward Nicoll, President and COO, Datek Online
Testimony from June 14, 1999
Prepared Testimony from Edward Nicoll, President and COO, Datek Online
Mr. Chairman,
Thank you for your gracious invitation to speak before the National
Summit on High Technology. The
Joint Economic Committee deserves considerable praise for its willingness
to take on such a broad topic
that is of immense importance to American citizens and to the economy
as whole.
At first glance, it might seem as if there was nothing more to be said
about the role of technology at the
end of twentieth century'. The modem era has been defined by technology.
It has shaped the way we
live, the way we work, the way we communicate and the way we view the
world and ourselves. No
industry has been immune from its benefits. From health care to homebuilding,
from transportation to
television, every industry we know of has seen its basic business model
undergo a radical transformation
in the last few decades as a result of the immense leaps we have taken
in technology. I am not a scientist
nor would I describe myself as a technologist. But I have been fortunate
enough to be "present at the
creation" of an industry that owes its existence to technology: online
investing. Today I am the President
of Datek Online, the nation's fourth largest online brokerage company.
Eleven years ago, I helped to
launch Waterhouse Securities, one of the earliest innovators in automating
transactions for buyers and
sellers of securities.
In the decade since then, technology has not only changed the brokerage
industry, it has created an
entirely new relationship between citizens and the securities market.
As I will explain today, this
watershed change has had an unprecedented and positive impact on the
ability of individual consumers to
manage their own finances and invest in our economy. The growth of
the online brokerage industry has
also propelled the financial services industry into the next century,
breaking down the barriers and rigid
trading rituals that had existed since the earliest days of the first
stock market in this country. I am
convinced that both consumers and the brokerage industry are far better
off.
Having said that, I believe what I am discussing today is still an industry
in its infancy. It should be
apparent to anyone familiar with online investing that three years
ago, I could not have testified on this
subject. Until 1995, there were no online brokerages of any significance.
Today, of course, online investing has emerged as one of the most dynamic
and creative sectors of the
economy. While I am very confident about its future, I must confess
that I cannot predict with any
certainty what its future shape will be. This is an industry that has
thrived precisely because of the
tremendous advances in technology, and I fully expect those advances
to continue -- perhaps at an even
more breathtaking pace.
In my testimony before this committee, I would like to describe the
dramatic changes we have already
seen in the way securities are traded due to Internet-related technology;
the rapid growth of the online
brokerage industry: the impact this industry has had on consumers,
on the economics of buying and
selling securities, and on the economy as a whole. I will also briefly
describe some of the technological
advances that have already taken place in this new financial services
arena. I will then touch on a subject
that I know is of keen interest to this committee: consumer education
and the question of whether online
investing is for everyone. Finally, I wills
share with you my thoughts about the proper role of Congress in helping
this industry continue to thrive
while protecting the interests of consumers.
The Evolution of Trading
When I think about the many, many changes that have occurred in the
world of securities transactions
over the last 25 years, one date in particular stands out. May 1, 1975.
Though barely discussed today, this
was truly a watershed date in the securities industry. On that date,
the Securities and Exchange
Commission forced the securities industry to end the practice of fixed
prices on commission rates for all
securities that were bought and sold. Its impact was not immediate,
but it set in motion a series of gradual
changes that made the world of online investing possible.
The real effect of the end of fixed commissions is that the charges
for services provided by traditional
brokerage firms could now be unbundled. The fee for advice could be
separated from the fee for
transactions. Brokers could offer lower prices for fewer services or
higher prices for more comprehensive
services. Indeed, lower prices were only a secondary consideration
of the SEC. It understood that
because there could be a range of prices reflecting a range of services,
the notion that the full-service
broker was the only option for consumers really ended on that day.
It took a while, however, for both the
industry and the public to appreciate the impact of this development.
At first, just a small handful of firms
took advantage of this new environment: Charles Schwab, Quick and Reilly,
and Source Securities were
really the industry leaders when it came to the rise of the discount
broker. But again, the full effect of the
SEC decision was more than lower commission rates. By unbundling all
the services a traditional
brokerage house provided to its clients, the industry was forced to
consider the real cost of each of the
services offered. That set the stage for a whole new relationship between
broker and client once
technology advanced.That technology arrived in the form of the Internet.
So much has been said and
written about the rapid spread of the Internet that I will only mention
a few statistics that capture the
scope of the changes it triggered. In 1994, according to a research
report by Morgan Stanley, three million
people, most of them in the U.S., used the Internet. Last year, 100
million people used it. Some experts,
such as Nicholas Negroponte, the founder and director of the Media
Lab at the Massachusetts Institute of
Technology, predict that some 1 billion people will be connected to
the Internet by 2005.
The very fact that the Internet has rapidly become a popular medium,
not just a tool used by engineers or
computer experts, is the source for the truly revolutionary character
of online investing. The Internet has
made it possible for anyone with a computer and a modem to interact
with our equity markets in a way
that was inconceivable 10 years ago. It has made it possible for the
average citizen to take control of his
or her investments and it has leveled the playing field between individual
investors and professional
investors.
It is worth remembering how different things were a decade or two ago.
Buying or selling stock was not
something that was easily done by a person without any links to the
financial markets. To begin with, one
had to establish a relationship with a brokerage house or investment
bank. For better or worse, this
relationship was often established by a commissioned broker "cold calling"
a prospective investor. Orders
were place in person or over the phone with a licensed broker. That
broker in turn would write the order
up and pass it to a specially trained order clerk who translated the
buy or sell order into a code that could
then, through the use of a teletype, transfer it to the floor of the
Exchange. On the Exchange floor, the
newly received order would be walked around until the trade was executed.
The confirmation would then
require walking back through all those steps.
Automation helped increase the speed of buying and selling stock, but
it was the Internet and the
technology it has spawned that fundamentally changed the role of the
consumer. Today many trades are
made online without a commissioned broker's involvement. They are routed
automatically to the
appropriate exchange or other execution venue. A buyer's ability to
make the purchase is verified
automatically by computer. The trade is then executed and the buyer
receives an immediate confirmation
while he or she is still online. All of this happens in under 10 seconds
and -- here is the critical point -- it
often occurs with no human intervention. Technology and the Internet
have allowed every stage of the
transaction to be automated so that for most transactions a human is
needed only in unusual
circumstances.
The Empowered Consumer
For the typical consumer, the ability to buy and sell stocks instantaneously
over the Internet without the
intermediaries is obviously a quantum leap in efficiency. But the more
striking aspect of this technological
change is the way in which it has placed the consumer at the very center,
rather than the periphery, of the
world of investing. The Internet has not only brought a mechanism to
execute trades within the reach of
ordinary consumers, it has brought a new sense of democracy and liberation
to securities transactions.
Once knowledge about stocks was limited to an elite circle of experts
concentrated on Wall Street.
Without maintaining an account at one of these firms, it was extraordinarily
difficult for the average
consumer to learn about investment opportunities, or even to keep track
of investments they would like to
make. For the more experienced investors, the pre-Internet system wasn't
any friendlier. To gain
knowledge about the state of the market or the current performance
of one's account, one had to rely on
a call to a brokerage house during market hours. The financial section
of the morning newspaper was one
of few sources of information about how a particular stock performed
on a given day.Today, the
accessibility to financial information has empowered the consumer.
Technology now puts in the hand of
anyone interested in investing much of the same information that was
once only available to large financial
institutions. Technology has given us real time quotes, online research
reports, and enormous historical
databases. With a simple computer and access to the Internet, someone
with no training in finance or
securities can, in a matter of seconds, look at a three-month performance
record of a stock, compare it is
to its three-year performance, compare it again to the performance
of competing companies, and then
create a graph comparing all those companies to the Dow-Jones Industrial
average over the same period.
It is not exaggeration to say that no long ago these were pieces of
information available only to preferred
clients of large brokerage houses -- and even then, generating and
communicating such data could take
several hours to several days.
From a financial perspective, the spread of online trading has caused
a revolution in traditional
commission costs. In the past, the high cost of transaction fees effectively
served as a barrier to most
ordinary investors. It was simply too expensive to buy and sell stocks.
Today, the average cost of a trade
is below twenty dollars -- a fraction of what the large investment
houses have traditionally charged their
clients.
Lower commission fees mean that individuals have greater financial freedom
to invest as they see fit. It
has also allowed a very small subsection of investors with more experience
to trade as frequently as
professional traders. These are active investors who no longer need
the cumbersome and costly
relationship with a Wall Street financial house to pursue the investment
style of their choice. They serve
the same function that previously was exclusively reserved for privileged
members of the Wall Street
community: providing needed liquidity to securities markets. That liquidity
improves securities markets by
promoting efficient price discovery and reduces trading costs by narrowing
spreads between bids and
offers.
The Growth of the Online Brokerage Industry
Lower costs, greater access, the democratization of financial knowledge,
and the efficiency of Internet
trading have helped spawn an industry that has soared in just a few
years. The first online broker
appeared in 1995. Today, Datek is one of more than 100 online brokers
competing in a dynamic market.
I have every reason to believe that competition will intensify. Just
this month we have had an
announcement from Merrill Lynch, which has the country's largest physical
retail brokerage network, that
it, too, is launching an online trading service for its clients at
competitive prices.
A brief glance at the most recent statistics for the online brokerage
industry amply illustrates the sheer
demand for its services. According to Credit Suisse, First Boston,
online trading grew at a remarkable 47
percent during the first quarter of 1999. This expansion follows an
equally impressive 34 percent growth
rate during the final quarter of 1998. This growth has not been concentrated
in just one or two industry
giants. Every major online trading firm experienced growth rates of
between 23 and 63 percent in the first
quarter of this year.
To understand the practical meaning of these growth rates, it is worth
considering that during the first
quarter of 1997, there were fewer than 100,000 online trades executed
in the United States. Today there
are nearly 500,000 trades executed each business day. More remarkable
is that this growth has occurred
while the overall market values were more modest. Credit Suisse First
Boston reports that during the first
quarter of this year, market values on the New York Stock Exchange
grew 4.4 percent. This suggests that
the large number of consumers making online trades are not being driven
by a short-term market frenzy.
Rather, they are attracted by both the ease and low-cost that online
investing offers.It is also safe to
assume that much of the growth in online trading comes from a migration
of traders from traditional,
full-service brokerages. During the first quarter of this year, nearly
16 percent of all equity trades occurred
online -- almost one in six trades. That, too, is an increase over
the fourth quarter of 1998 when 13.8
percent of trades were conducted online. Some have predicted that by
next year, one in every four trades
will be conducted over the Internet.
It is worth stressing that individuals, not institutions, largely fuel
this growth. This has been a consumer
revolution. According to the U.S. Department of Commerce, online trading
is the fastest growing
consumer use of the Internet after email. Americans are investing from
their home computers or their
offices. Most online investment firms deliberately tailor their services
to meet the demands of individuals,
not businesses. The growth in the number of households with online
trading accounts attests to the
success of this strategy. According to the New York Times (April 17,
1999), the number of households
with online trading accounts has risen from 2.2 million in December
1997 to 6.3 million in April 1999.
Forrester Research, a high-tech research firm, estimates that the number
of online accounts will grow to
20.3 million by 2003.
The Importance of Technology
This astonishing level of growth is a product of the finest technology
available. Online trading owes its
existence to technological developments and has itself become a driver
of technological innovation.
If we have learned anything in the past three years, it is that this
is not a static industry. My company,
Datek, has gained 10 percent of the market of online trading after
just two years in operation. With the
kind of growth we have experienced, we simply could not afford to rest
on the technology that we started
with. Over the last year we have implemented system-wide upgrades that
have increased processing speed
and capacity by more than 500 percent. I know that our competitors
are faced with the need to make
similar technological improvements. The nature of the business, and
the demand from our clients, leaves
us no other option.
The push for better, faster, more secure data transfer systems to be
used for online trading has also
brought considerable benefits to customers. In an effort to provide
our clients with more real-time
information, we developed what is known as a streaming quote applet,
which we have named "Streamer."
Streamer allows dynamically updating real-time quotes that work through
almost all firewalls. Customers
on our system not only see the most recent price of a stock, they see
the dynamic fluctuations of the
stock play out before them in real time. This type of information was
once reserved for only the most
experienced traders working inside a large brokerage firm or on the
floor of the stock exchange.
I believe this is just scratching the surface of what online trading
has to offer. As sophisticated as we now
seem, the industry has not even begun to explore the capacity of an
interactive website and more
advanced automation of every aspect of a transaction.
Individual investors are also just beginning to benefit from the increased
efficiencies and open access of
Alternative Trading Systems (ATS), which now compete with some of the
traditional trading venues. For
Nasdaq stocks we helped to create a separate company, The Island ECN,
which electronically matches
orders without the intervention of a market maker.
Today, Island is the single largest ECN in the world, and the second
largest ATS. I fully expect this aspect
of online trading to continue to develop. The enhanced technology that
we see today has forced us to
rethink the way our markets operate. And I believe that consumers are
the ultimate beneficiaries of this
process.
The Impact on the Securities Industry
Technology, in short, has revolutionized an industry that for decades
had been conducted by a small
number of specialized firms concentrated in one part of the country.
I can confidently predict that online
investing will have a permanent impact on virtually every aspect of
the securities industry: from the
pricing of services, to the structure of companies, to the type of
employee who is attracted to the industry.
In truth, online investing gave the securities industry a much-needed
push into the modem era. It has
forced a rethinking of the basic business model. It has introduced
new players in an industry long
dominated by established financial giants. Above all, it has fostered
remarkable gains in productivity.
When I left Waterhouse Securities in 1995, the firm was executing approximately
10,000 transactions a
day for its customers, charging on average $50 per transaction. To
run this business, we needed about
1,200 employees. When I arrived at Datek last year, the firm was executing
nearly 50,000 trades a day at
$10 a trade. Note that this produces the same $500,000 a day in revenue
at Datek as Waterhouse
generated when I left. But at Datek, we employed less than 400 employees
at the time: an increase in
productivity per employee of 300 percent. And note that the investing
public was the real beneficiary of
this increased productivity, since their average commission charge
decrease by a whopping 80 percent
from 1995 to the present!
The greatest savings for the industry have obviously come from the high
cost of maintaining an army of
brokers who charge clients high commission fees. This has been not
only a high cost for the traditional
brokerage firms but it also was once a considerable barrier to entry
for new competitors. The Internet
changed that by eliminating the need for brokers for those investors
confident of making their own
decisions and seeking their own investment advice and research.
I think the decline of the traditional, commission-based broker has
actually been an improvement for
consumers. The old model that operated at most brokerage houses was
filled with mixed incentives. A
good broker established relationships with clients and worked honestly
to give them the best advice. But
his or her commissions were driven by the amount of buying and selling
a client did, especially in products
that carried the highest commission payout to the broker. Sometimes
the best advice a client could get
was to neither buy nor sell, but to simply do nothing. Unfortunately,
the broker was paid nothing to
proffer such advice. Therefore good brokers needed to resist the temptation
to make recommendations
based on their own interests rather than those of their customer. Often,
full-service brokers found it
difficult to resist that temptation.
By removing the commission-based broker from the equation, a new relationship
has been established
between an online brokerage house and its customers. At Datek, our
goal is not to offer advice on
investments or to encourage or discourage individual trading. Our service
is designed for the self-directed
investor who wants to make his or her own decision. Twenty years ago,
there were relatively few of
those types of consumers simply because there was little investment
information available and no
mechanism to service the consumer. Online investing has effectively
created a market of informed,
confident investors.
Online Investing is Not For Everyone
Mr. Chairman, I've spoken enthusiastically about the benefits of online
investing because I believe those
benefits are significant, both for consumers and for the economy. But
I also want to emphasize that online
investing is not for everyone.While many investors enjoy the freedom
that comes with online investing,
others will continue to demand a higher level of personal attention
that can only come from a traditional
broker. While investors who make their own investment decisions can
and should execute trades swiftly
and efficiently using online brokerage, those investors who need advice
and have been served well by an
investment advisor should stick with that advisor.
On the other side of the coin, Mr. Chairman, there is a myth developing
that online accounts are only for
day-traders, latched onto their computer keyboards, monitoring every
financial channel, ready to take
immediate advantage of any shift in a stock's price. The truth is,
all self-directed investors can benefit
from online trading -- whether they trade once a day, or once a year.
But that begs the question for many investors entering the market: how
does one become such a
self-directed investor? I believe there is now a gap that needs to
be filled between the amount of
information that is available to the public and some of the public's
ability to make use of that information.
I am convinced that more and more Americans would like to be confident,
self-directed investors. But to
get there -- to have a sufficient amount of knowledge to do research
on line and make trades with
confidence -- requires both self-discipline and education. I believe
there is a healthy market out there for
companies that want to help investors win that confidence. For our
part, Datek Online is undertaking a
number of steps to improve consumer education about online investing
and to promote more knowledge
about stock markets in general. For example, in conjunction with Smart
Money magazine, we are helping
to launch SmartMoney University, a highly interactive website that
will promote financial literacy and a
broader understanding of online investing. We will also act as a sponsor
of LearnTolnvest.org, a
not-for-profit program for high school investment clubs, especially
in underserved inner cityschools. We
will provide participating schools with the tools they need to invest
(at no charge) and work with other
sponsors to mentor students about the business of buying and selling
stocks.
A Role for Congress?
I know that the Joint Economic Committee is watching this industry
with great interest. Congress has a
critical role to play, both in protecting consumers and in creating
an environment where legitimate
businesses can innovate and grow.
I said that is a critical role, Mr. Chairman, but also a difficult one.
Congress has the power to act as a
partner with an evolving industry that will face exciting opportunities,
but also unknown challenges in the
years ahead.
No one would be foolish enough to predict exactly where this industry
is going. But if Congress and the
Administration continue to allow this industry to evolve, unhindered
by heavy regulation ... if you
continue to allow the entrepreneurs to create new ways of serving consumers
... if you continue to allow
technology to make our equity markets more accessible -- then I am
confident in predicting three things:
First, more Americans than ever before will own equities, allowing millions
of additional Americans to
share in the prosperity of our country.
Second, investors will become more educated about the advantages and
dangers of investing, allowing
them to make better decisions about how to invest their assets.
Third, our industry will continue to innovate, providing more choices
for consumers at more competitive
prices.
Please remember that online trading is an industry that has flourished
within a highly regulated financial
services industry, but without much specific additional government
regulation. We have provided our
customers with security arrangements and privacy that they can count
on. We have lowered their costs.
We have provided tools and information to them never previously available.
I would urge you and your colleagues to see these successes as only
the first stage. As an active
participant in the industry, I share your concern for maintaining an
industry that is free from fraud and
protects our customers. But I am heartened by the way the market has
worked to address these concerns
without the need for legislation or government intervention. It would
be a grave error to consider heavily
regulating an industry that is still evolving and continually providing
benefits to ordinary consumers.
In closing, I would like to thank you again, Mr. Chairman and all the
members of the Committee for your
leadership and foresight in sponsoring this first annual National Summit
on High Technology. I look
forward to working with you in the years to come and to answering any
additional question