Charles Schwab Case

Charles Schwab, a Stanford MBA, founded Charles Schwab & Company in 1971 in California. The company quickly established itself as an innovator. A defining moment came with the 1975 "May Day," when Schwab took advantage of the new opportunities deregulation offered. Schwab would not provide advice on which securities to buy and when to sell as the full-service brokerage firms did. Instead, it gave self-directed investors low-cost access to securities transactions. From the late 80s to the early 90s, before the commercial use of the Internet, Schwab used technology to increase efficiency and quality and expand its services. Schwab's innovations harnessed technology to the solution of business problem. As Schwab's President and co-CEO David Pottruck put it, "we are a technology company in the brokerage business."

Schwab introduced TeleBroker, a fully automated telephone system that allowed customers to retrieve real-time stock quotes and place orders. Schwab also leveraged its back-office operations with SchwabLink, a service to provide fee-based financial advisors with back-office custodial services and the capability for RIAs to plug into Schwab's computers to trade. The RIA market became an important source of revenue for Schwab. By 2000, Schwab had 5,900 affiliated RIAs, who controlled about 30% of Schwab's assets, up from zero in 1987. Merrill Lynch viewed these RIA's as a "virtual sales force" for Schwab: "We don't compete with the discounters. We do compete with Schwab. They have essentially built a Merrill Lynch by proxy." Schwab introduced the Mutual Fund OneSource program in 1992, enabling customers to purchase no-load mutual funds without paying commissions. The vast majority of OneSource assets were in non-Schwab funds, except the SchwabFunds money market, the only money market fund offered to OneSource customers. Funds were ranked and presented to Schwab customers based on objective characteristics (e.g., sector, investment style, or management fees) and performance. Customers could use their Schwab account to buy or sell more than 1,100 mutual funds from about 200 third-party fund families without paying any fees, and the transactions were integrated into their Schwab account statements and reports. Schwab serviced these accounts, aggregating all OneSource trades into a single daily transaction that was communicated electronically to the participating funds. Schwab charged fund providers a 25-35 basis point fee for listing the fund in OneSource and providing shareholder services.

Schwab impacted the industry in various ways. However, we need to first define the various types of firms that existed. The industry consists of three distinct types of firms: traditional full service brokers, limited-service discount brokers and

Internet brokers. The market share for these three types of firms was as following: Full

service brokers - 74%, Discount Brokers - 20%, and Internet brokers 4%. Traditionally, full-service brokers have aided investors in making investment decisions through expert advice and guidance. They guide investors through the purchase and/or sale of stocks, bonds, mutual funds, options, and other financial securities. Their services are delivered through a network of local offices and are they highly compensated through their firms' individual commission structure. Leading full-service brokerage firms include Merrill Lynch, Paine Webber, Dean Witter, Smith Barney, and Prudential Securities. Limited service brokers surfaced in the mid-1980's to challenge the traditional full service brokers. They became increasingly popular in the late 1980's and early 1990's with knowledgeable investors who take an active role in managing their portfolios, trade frequently and want to minimize trading costs. The discount broker's, such as Schwab, main advantage is that they offer investors discounted commissions. They are able to charge these reduced fees since they don't employ brokers or investment researchers. Customer service representatives, who are not authorized to give investment advice, handle purchases and/or sales primarily over the phone and investors are provided with little to no investment information and market or company updates. Notable limited-service discount brokers include Charles Schwab, Quick & Reilly, and Fidelity Investments.

In the mid-1990s, the growing use of the Internet induced online brokers to launch Internet trading. In the years since, several discount brokers, as well as pure electronic brokers, entered the new business segment and fought aggressively for market share.

The Internet offered such firms essentially two technological advantages.

First, online brokers can provide less expensive trade execution than their offline counterparts. Placing orders online allows investors to circumvent personal brokers, reducing transaction costs. As a large number of investors established Internet connections, the web became a ubiquitous network that can be used as a communication channel between a brokerage firm and its customers. Online trading also lets brokerage firms automate their order placement process, thereby economizing on personnel time and effort.

Secondly, the Internet contributed to the emergence of online trading by becoming a medium for the transmission of information. Large groups of consumers became increasingly sophisticated and more able to direct their own financial affairs without the help of a personal broker. The Internet facilitates the diffusion of information, eroding one of the main advantages of professional brokers: their access to superior information.

The use of the Internet has led to a sharp drop in trading costs. the average commission charged by the top-10 online trading firms fell from $52.89 at the beginning of 1996 to $15.75 in 1999 - a 70% reduction. The attractive pricing has stimulated great growth. Economic theory points out that in building a network, firms often tend to establish the most valuable connections first. In this respect, online firms initially focused on attracting the busiest traders. However, as new accounts start contributing less trading activity than existing ones, online brokers may find expansion an increasingly costly task. It is easier to attract a small number of large customers than a large number of small customers. Furthermore, the explosive growth of online trading has attracted many entrants to the industry, leading to intense competition. In addition to discounters and pure electronic firms, traditional full-service brokers like Merrill Lynch and USB Paine Webber offer online services. The proliferation of online firms may thus lead to even deeper price discounts and tighter profit margins.

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