Big Brokerages Following Online Tactic of Lower Commissions - TheStreet

After nearly five years of watching low-cost online brokers such as

Datek Online

steal retail customers, the Wall Street establishment has grasped the fact that retail investors aren't going to pay a few hundred bucks to trade 1,000 shares of

Cisco

(CSCO) - Get Report

anymore.

With this epiphany, the firms have begun to take the drastic steps to make sure the pursuit of lower commissions is a fruitful one, going well beyond simply slicing commissions to levels closer to

Charles Schwab

(SCH)

, or even Datek's $10-a-trade deal. Wall Street's strongest firms are in hot pursuit of transaction-driven revenue as a means to make up in volume what they've lost on profit margins.

For example, last week, Charles Schwab -- the granddaddy of modern discount trading -- cut its lowest commission at its

CyberCorp

active trading unit to $10. The move came a week after

Merrill Lynch

(MER)

said it would buy

Nasdaq

market maker

Herzog Heine Geduld

, a purchase that will help it make more money off Nasdaq trading, now heavily influenced by individual investors.

Knight Trading Group

(NITE)

, the Jersey City-based Nasdaq market maker, has driven this movement, using massive volume and modern technology to keep its execution costs low and maintain juicy rebates for the online brokers who send it their trades.

"There's been a paradigm shift. I think today the volume and power in many stocks are driven by individual investors," says Knight Chief Executive Officer Kenneth Pasternak.

Unfortunately for Knight, Pasternak isn't the only one realizing that the individual investor -- and his or her beloved, yet unprofitable, low commission -- is here to stay. Large brokerages such as

Morgan Stanley Dean Witter

(MWD)

,

Salomon Smith Barney

(a unit of

Citigroup

(C) - Get Report

), Merrill and

Goldman Sachs

(GS) - Get Report

have gradually increased their market shares. In May, Morgan and Merrill moved up in the rankings among the top 10 market makers in terms of shares, according to

Autex/BlockData

.

Merrill's purchase of Herzog will make it the second-largest Nasdaq market-making firm, just behind Knight and ahead of Schwab.

Internal Affairs

Schwab, of course, has been in the business of trading Nasdaq stocks for nearly a decade, through its

Mayer & Schweitzer

unit, now known as

Schwab Capital Markets

. Despite regulatory changes in the late 90s, Schwab figured out it could make money trading Nasdaq stocks under the new rules by executing orders in-house, thus cutting out other middlemen.

This is called "internalization," and its advantage is that it enables a brokerage to trade against its order flow, says Greg Smith, an analyst for

Chase H&Q

. Broadly speaking, he says, the revenue on an internalized trade might bring in about $8 compared with the $2 that a market maker would typically rebate to an online broker, putting the benefit of internalization at $6 per trade.

Merrill's Herzog purchase shows that for Merrill to price like a discount broker with $29.95 online trades, there has to be a tradeoff, according to a top Schwab executive. "The only way to deliver that value down to the customer is to internalize," says Lon Gorman, head of Schwab Capital Markets. (

TheStreet.com

looked at

internalization in a December story.)

Keeping a tight line on profits is all the more important, given the recent drop in retail trading volumes related to the market's decline. For instance, on Wednesday, Schwab said that its daily average revenue trades in May fell 37% from April. At the same time, assets under management slipped 3% to $865.3 billion.

Market-making on this action, even at the clipped levels of spring, has continued to dominate an area that Gorman once thought might lose some volume to electronic trading systems. Last year, Schwab bought a piece of the

Redibook

ECN, he says, to meet potential customer demand to execute trades through ECNs (electronic communications networks). That demand hasn't materialized.

"The profit model of ECNs just has not come to fruition. It may, and we'll have to see how that plays out, but aside from Instinet and maybe even Island, this is not one of those businesses that's going to have super margins," Gorman says.

Still, ECNs have had their effect on market makers in the form of consolidation, says Jaime Punishill, an analyst at Cambridge, Mass.-based

Forrester Research

. "You've got to believe that market makers will remain and that ECNs are going to push margins for market makers and that market makers are going to need size," says Punishill.

And as brokerages are finding out, size, whether it's the number of stocks a broker trades or the retail investor's 1,000 shares of Cisco, matters.