, which has railed against online trading, has agreed to buy an online trading technology firm, consolidation in the industry may really begin to pick up.
Friday, Merrill announced its agreement to buy
D.E. Shaw Financial Technology
, a unit of
that develops Internet technology services for brokerages and other financial firms. Terms weren't disclosed.
Online trading and Internet technology in general has presented a conundrum for full-service brokers, with their broker-entrenched business models and established technology systems. As the biggest online brokers increase their share of the equity trading market, financial services firms and traditional brokers feel pressure to prowl for online brokers that can offer technology, expertise or just accounts. In addition, online brokers increasingly view size as a way to shore up their defenses in the face of fierce competition in their own industry.
, a consulting firm best known for its online broker rankings, has stepped in to help potential buyers and sellers find suitable mates -- as sort of a matchmaker for online brokers. "It's clear there are many potential acquirers out there and they don't know how to identify potential acquirees," says Alex Stein, a principal at Gomez Advisors.
Prime targets for both traditional and online brokers are the dozens of smaller shops with Internet trading expertise. Smaller brokers that are considered potential targets include
, a discount broker with branches that offer online trading under the name
National Discount Brokers
, whose online trading unit recently cracked the top 10 in trading market share, according to
. (Neither returned a call seeking comment.)
Smaller firms are vulnerable because during 1998, the top nine online brokers increased their share of online trades to about 90% of trades, with only one name change in the bunch. And those top brokers have quickly raised the standards for marketing, technology spending and Internet services.
Online brokers up for the challenge could buy other brokers for accounts or technology, says Stein at Gomez. And full-service brokerages or financial firms could buy online brokers, particularly inexpensive small ones, for the technology, expertise or to bypass regulatory barriers.
On the Outside Looking In
Traditional firms still are still puzzled about how to handle the Net and self-directed trading.
"The big bricks-and-mortar firms are staring like deer in the headlights and wondering how they are going to deal with this online brokerage thing that could end up eating into their market," says Frank Quattrone, a top technology investment banker at
Credit Suisse First Boston
It makes sense for traditional brokerages to buy smaller online brokerages instead of buying a system from a vendor or trying to develop the technology in-house, says Hal Schroeder, a senior equity analyst at
Keefe Bruyette & Woods
. For example,
in December said it would acquire tiny online broker
Bull & Bear Securities
Bull & Bear Group
. The move offered Royal Bank a quick and easy entree to the U.S. discount and online brokerage market. Purchases, such as Merrill's agreement with D.E. Shaw, can deliver instant technology and Internet expertise.
"Full-service brokers are seriously considering buying an Internet discount broker to learn about the market," says Stein at Gomez. But buying an online brokerage firm doesn't necessarily mean entering the online discount brokerage war.
"Merrill will just use the technology for their own customer base," says analyst Scott Appleby at
, which hasn't participated in any underwriting for Merrill. In a Friday research note, investment banking analyst Dean Eberling at
Putnam Lovell de Gradual & Thornton
says Merrill could just integrate the technology into its existing retail strategy -- which would have little impact on the business -- instead of developing a separate online trading subsidiary.
Merrill says it plans to combine its Private Client Technology group with D.E. Shaw Financial Technology's Internet and software development group. As
previously planned, it expects to roll out online trading for selected fee-based clients in the next several weeks. Merrill had been developing its own Internet services and painfully inching closer to offering Internet trading. But the firm has been schizophrenic about online trading, denouncing it on the one hand and pledging to eventually offer it on the other.
Brokers Buying Brokers
Potential mergers or acquisitions aren't limited to full-service firms and banks playing catch-up.
In the online brokerage sector, the top three firms --
-- accounted for more than half of fourth-quarter online trades, according to Piper Jaffray.
At the same time, customer and regulatory standards about technology are rising. Volume is exploding. Customers want more services and more sophisticated Web sites, and brokers want to build out services so they aren't as dependent on low commission equity trades. The spending of the top players has capped out the smaller guys, says Appleby at ABN Amro.
Costs of the necessary hardware and software are high and will remain high. E*Trade, for example, spends tens of millions and still suffers technology problems. A small broker or one with low commissions might not be able to keep up with technological demands.
"The stakes are going up, and the price to play is getting higher. The little guys are going to be squeezed and they are going to have to sell," says one industry insider.
If smaller brokers are struggling with rising costs, they may be willing to sell to another broker interested in getting more accounts or expertise in a particular technology area at a reasonable price. Waterhouse, for example, bought online discount broker
in 1998 for about $100 million, increased its account base by 15% and pushed itself into the No. 2 spot in terms of market share.
While publicly traded online brokers are valued at Internet stock levels, pushing up the value of other brokers and therefore the acquisition price, there are strong reasons for buyers to act soon. Barriers to competition, already high, can only increase.
Among the online brokers, E*Trade has made it clear it is acquisition-minded and has more than $500 million in cash to back up its intentions.
says it is willing to buy if the price is right. During the past few months, it has become clearer what stakes are needed to stay in the game. The time for action may have arrived.
-- Staff Reporter
Gregg Wirth contributed to this article.