Schwab Bid for CyberCorp a Sign of Things to Come

Black sheep, welcome to the flock.

When Schwab (SCH Quote) this morning announced plans to acquire CyberCorp, a renegade software firm-turned-trading shop, it was the most clear sign yet that direct-access systems pioneered by daytraders have gone mainstream.

It's a strange sort of road that brought Schwab, which went up-market with its acquisition of blue-blood U.S. Trust three weeks ago, to the doorstep of tiny CyberCorp with $488 million of flowers and candy. But it's one that's likely to be traveled by many established brokers -- online and otherwise -- that need connections to firms that will allow them to cut commissions for active traders by offering direct-access trading without market makers.

Instinet has already arrived there, with plans to launch direct-access trading in April. Firms such as Schwab are tired of losing their most active, profit-generating investors, exactly the ilk that will jump into direct trading, says Bill Burnham, a general partner at Softbank Capital Partners and a former online brokerage analyst.

CyberCorp fashioned itself into exactly the kind of "direct access" trading firm Wall Street sees as part of the evolution of electronic trading. It was pushed on to the must-buy list by aggressive chief executive Philip Berber, whose experience at the Irish defense ministry, Avon (AVP Quote) and Ford (F Quote) lacks even a trace of a Wall Street pedigree. He'll now be chairman of the Schwab unit, CyberCorp.

"They came on the radar screen about this time a year ago," Burnham says. "They were very aggressive in telling me how many trades they were doing and how big they were getting. They wanted to be part of the quarterly survey." CyberCorp never made it into that survey, but its persistence -- and growth -- paid off. It's now on the list of top 10 online brokerages compiled by two other big Wall Street firms, an important measure of the credibility afforded it by major players.

Going Mainstream Schwab's acquisition of CyberCorp shows a shift in the future of electronic brokerages.

Online Trading

Direct-Access Trading

In addition to Schwab, CyberCorp's Berber says management had talked to Lehman Brothers(LEH Quote), Merrill Lynch (MER Quote) and Instinet. Lehman and Merrill declined to comment.

And CyberCorp wasn't the only belle at the direct-access ball. Momentum/Tradescape, a daytrading firm with similar technology, also says that it has alliance discussions underway. And A.B. Watley(ABWG Quote), a small New York firm of the same genre, last week said it was looking around, too.

Like CyberCorp, Tradescape is being represented by investment bankers from Morgan Stanley Dean Witter(MWD Quote), while A.B. Watley has Wasserstein Perella pitching it to suitors. Not exactly the grunge typically associated with daytrading companies.

Still, CyberCorp's path from obscurity wasn't all Berber bluster -- there was good reason for Schwab to make the move.

Adding CyberCorp should keep Schwab's active investors -- about 1% of the company's more than 6 million accounts -- from wandering, co-chief executive David Pottruck said during a conference call. By discounting prices for clients who make more than 30 trades per quarter to $19.95, and to $14.95 for those who make 60 trades per quarter from $29.95, Schwab instantly becomes a player in a direct-access world.

According to US Bancorp Piper Jaffray's fourth-quarter research released today, Schwab's market share fell by 0.60 percentage points during the quarter to 22% and was down 5.5 percentage points in 1999.

Direct-access opportunities may help that situation. For one, Schwab is following a typical securities industry trend -- growing retail access to what was once the domain of professionals, like investment-grade research and initial public offers. Here they'll have some of the trading tools of professional investors.

Then there's the stock market itself. Electronic order-matching systems are attracting more equity volume -- making trading cheaper and easier and leaving the Nasdaq, the New York Stock Exchange and their member firms in a race to catch up.

Now Berber, whose early CyberCorp development was done on his son's home computer, and CyberCorp have gotten the entire cottage industry about a half-billion worth of validation from traditional Wall Street. Momentum/Tradescape President James Lee, who is shopping around his own firm and technology to similar players, remembers when big equity traders wouldn't even consider taking order flow. "We couldn't get the relationships with the major wholesalers in years past," he said.

Modern direct-access trading (the kinder, gentler way to describe daytrading systems) came about in 1997 as changes in the Nasdaq's order-handling rules created an opening for a slew of Instinet knock-offs -- cheap, fast electronic trading systems. From these systems emerged an army of semiprofessional traders who, from their homes or small trading firms, could send buy and sell orders at a speed J.P. Morgan himself could never have imagined.

In 1998, CyberCorp stopped selling its software to daytrading firms and opened an online brokerage of its own, seeking to establish itself as a virtual player and distancing itself from an industry under intensifying regulatory scrutiny

Berber made the rounds with analysts and the press in 1999. That summer, about six offers floated into CyberCorp. Things looked good. Strangely enough, even the shooting rampage in July 1999 by former daytrader Mark O. Barton did little to slow daytrading's popularity. Meanwhile, that spring, Schwab and others had started working on whether to build or buy a trading system for active investors.

Now that Schwab has made that decision and chose to look beyond daytrading's image problem, other brokerages won't be far behind.