For Online Brokers, the End of the Order-Flow Gravy Train

Nothing's sacred on Wall Street anymore. Merrill Lynch (MER) is going online, Schwab (SCH) is dabbling in investment banking and even the mighty New York Stock Exchange is working on electronic trading.

Going with the flow
How Order-Flow Payments Work

At the same time, the Street is trying to quit another stubborn and much-derided habit: payment for order flow, the rebates that brokerage firms take for sending orders to a certain firm to execute. Critics, including academics, liken the practice to bribery, though it isn't illegal.

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Among those most affected will be online brokers, which are preparing to bid farewell to the juicy payments as the twin glaciers of regulation and marketplace change steadily grind the practice into oblivion. As a result, the online brokers' already highly visible diversification efforts are taking on even greater significance.

Going for Broke

Observers say that after it made inroads on Wall Street for a decade, payment for order flow began retreating around two years ago as a result of new order-handling rules set in 1997 by the National Association of Securities Dealers. That and other market reforms reduced spreads, cutting market-makers' profits and their incentive to pay off brokers.

Online Brokers' Rebate Revenues Rise... Annual order flow payments

...But Per Trade Payments Are Falling Rebate per trade

*Estimates. DLJdirect revenue based on calendar years. E*Trade and Ameritrade on fiscal years ending Sept. 30. Source: Salomon Smith Barney.

"When you have an artificially wide noncompetitive spread, it makes sense to pay a bribe to your broker," Columbia University law professor John Coffee says.

Now Coffee and other observers say that switching stock quotes from fractions to decimals in mid-2000 should deal the final blow to payment for order flow. They say "decimalization" will make it harder for market makers to profit on spreads, once again reducing market-makers' inclination to share the wealth with brokers.

What's Lost

Payment for order flow isn't an insignificant part of many online brokers' revenue base. In 1999, for instance, E*Trade (EGRP) took in $39.2 million in payments for order flow, which amounts to some 6% of its 1999 revenue of $621.4 million. Proportionally, Ameritrade (AMTD) has an even bigger hand in the cookie jar, grabbing $22.1 million in 1999 order-flow payments, or about 8% of its $268.4 million in total revenue, according to analysts and company reports.

And smaller players may be even more exposed. At Web Street (WEBS), a small brokerage that went public Nov. 17, payment for order flow in 1997 amounted to $121,971, nearly as much as commission income of $168,728, according to a filing with the SEC. In 1998, payment-for-order-flow revenue amounted to $3.2 million, while commission income was $4.1 million.

But knowing that order-flow payments won't continue indefinitely, online brokers are making plans. For example, Amar Mehta, an analyst at CIBC Oppenheimer, estimates that E*Trade will sharply reduce its dependence on order-flow payments over the next year by 30 to 40 cents per trade in each quarter -- that's 39 to 79 cents a trade by the end of fiscal 2000, from $1.99 during the fourth quarter of 1999. In the long term, Mehta says, he isn't expecting any payment-for-order-flow revenue. (CIBC hasn't underwritten for E*Trade or Ameritrade, and rates both stocks hold.)

New Direction

So now the big online brokers are adding new business lines such as mutual funds and banking products to make up for any lost revenue. E*Trade, for instance, recently launched a mutual fund family and set plans to buy Internet bank TeleBanc (TBFC). Ameritrade is among several brokerages launching an investment bank with Schwab and TD Waterhouse (TWE) in an alliance announced earlier this week.

"If they get enough volume, down the road they can cross-sell products and leverage the account base," Mehta says. A decline in payments for order flow "can easily be offset by other products."

Indeed, three sector analysts say their long-term estimates don't include payment for order flow, but they aren't counting on a revenue decline because of diversification plans.

Online brokerages that have close ties to the traditional market-making system are clearly gearing up for this change in other ways. For example, Ameritrade, E*Trade, TD Waterhouse and others pumped money into a market-making consortium that became Knight/Trimark (NITE). They are the firm's largest customers and have seen their investment in Knight stock skyrocket, providing revenue that funds the major marketing campaigns to attract new clients.

But now, most online brokerages have made similar investments in electronic communication networks such as Archipelago or Redibook that compete with these market makers. This change means the online brokerages will be less dependent on the market maker's model, and actually have an incentive to send their orders to ECNs instead.

But it also shows that they are diversifying into the electronic trading arena that even traditional Wall Street has gotten behind as the way of the future. After all, even NYSE Chairman Dick Grasso is building an ECN.

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