10 Things You Need to Know: Declining Profit Margins Will Span Old Wall Street and New

This story is part of a weeklong series that looks at the top 10 trends to help you invest in the coming year. Click on the tile at left to see other stories.

Old Wall Street and New Wall Street have something in common beyond trading stocks after all -- declining profit margins could threaten both this year.

Technology has created this situation. Old-line Wall Street firms such as Merrill Lynch (MER Quote) and Morgan Stanley Dean Witter (MWD Quote) are ratcheting up lower-cost electronic services, which will soon cut into their commissions.

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New Wall Street stars such as Schwab (SCH Quote) and E*Trade (EGRP Quote) must give clients more services, which cost more to offer than discount trading.

For now, the bull market, which produces fat profits for plenty of brokers, is delaying this erosion. But it's clear that the rapid technological changes behind this are becoming more prevalent. With time, they'll catch up to Wall Street and could eat into earnings.

"The upcoming year may be one of functional change. The big firms have realized the necessity to change their paradigm over the past two years. Now there's a big question of what happens to revenue," says James Freeman, a New York-based securities industry consultant.

There are examples of the change all over the Street. Goldman Sachs (GS Quote) is considering partnering with the Chicago Stock Exchange to launch an options exchange to get more trading income; Merrill is moving its institutional business online; Morgan Stanley has placed its e-brokerage brand under the Morgan Stanley banner; and Schwab seems to be taking on the analysis and product line of a full-service firm.

All this concern may seem strange, especially in the wake of a glorious 1999. Goldman Sachs, for instance, posted blowout fourth-quarter earnings. So did Morgan Stanley, helped by commission income up 36% from a year earlier. And Schwab recently said fourth-quarter results would exceed analysts' expectations, a signal that sparked a mini-rally among e-brokers.

Despite this, the proliferation of these lower-cost businesses is causing plenty of changes.

For one thing, volume is becoming all the more important. Order flow, once just a nickel-and-dime byproduct of the big houses, has become something big firms use as leverage when dealing with exchanges and competitors. For instance, alternative trading platforms are willing to sell parts of their franchise to firms such as Schwab and Merrill to get volume, while other firms demand payments and rebates from market makers for both equity and options order flow.

"I don't think it is more important [to revenue] than [in] the past, when volume was growing gradually and [commission] prices were falling moderately," says Jerome Kenney, a Merrill Lynch executive vice president. "Today, as prices plunge more rapidly, people are reaching for volume, and order flow has become an important relative measure" of firms' strength.

Meanwhile, "the new Wall Street is building up all the structure of old Wall Street," says Freeman, the consultant, pointing to recent plans by TD Waterhouse (TWE Quote), Ameritrade (AMTD Quote) and Schwab to launch an investment bank, and Wit Capital's (WITC Quote) acquisition of traditional research shop Soundview Capital.

"As long as full-service firms held up the price umbrella, [the e-brokers] could win on price," Kenney says. "Now that's not the case. The distinguishing factor is no longer price. It's getting pretty crowded."

It's not just the securities firms that are feeling the pinch. Exchanges -- especially the options players, the New York Stock Exchange and the Nasdaq -- see shrinkage every day in what customers are willing to pay. But they can take solace in the fact that electronic communications networks -- the upstarts that have challenged them and pushed down prices -- will also get squeezed on another front in the war between old and new.

The nine ECNs, which match buy and sell orders, charge a transaction fee to their broker-dealer or institutional customers. And these mostly electronic systems employ only a fraction of the number of employees at traditional exchanges. But with competition increasing, there's little more to shave off of per-execution costs.

"On a singular transaction basis, there's not much you can do to change the price structure," explains John Schaible, president of Clearwater, Fla.-based ECN Nextrade.

Instead, Schaible says, the ECNs are trying to create technology that will enable them to increase volume without adding hefty costs. (This is often called scalability.)

The result of all this: consolidation. Says Merrill's Kenney, "I expect there should be further consolidation of dealers and discount firms, just like there was in the computer and semiconductor markets."

Read them all 10 Things You Need to Know to Profit in 2000 Monday, Jan. 3 For Wide Spreads and Cheap Stocks, Investors Can Join the Latin Club Wireless Internet Stocks -- Understanding the Monster Tuesday, Jan. 4 Intel Hopes the Itanium Will Be a Chip Off the Old Block Exchange-Traded Indices Pose Threat to Mutual Funds Wednesday, Jan. 5 Technology Buildout Goes Global B2B Becomes the BFD Thursday, Jan. 6 PC, R.I.P.: The New Kids Are in Town Broadband's Benefits Cut Wide Swath for Net Outfits Friday, Jan. 7 Declining Profit Margins Will Span Old Wall Street and New Weighing and Measuring the Contenders to Be the Next Microsoft