Charles Schwab Vs Merrill Lynch

CREATION OF ONLINE DISCOUNT BROKERAGE HOUSES AND THE THREAT CAUSED TO GIANT CORPORATIONS BY A SMALL COMPANIES:

CHARLES SCHWAB VS. MERILL LYNCH.

BY:

MBA STUDENT

ABSTRACT

Technological innovations and development of high speed internet in late 1980s created opportunity for many businesses playing in financial markets to change their strategy and find new ways of fighting against competition and apply competitive advantage tools in succeeding in their business. On the other side, investors benefited from this as well. Now, they had new ways of investing their capital and spare resources with little cost and more opportunities to invest. This led to the creation of Electronic Communication Networks (ECN) in financial markets, which caused dramatic impact on how financial markets operate and on how stocks are traded. As a result, firms with strong leadership and management took some risk, changed strategies in conducting part of their business and entered financial markets through the Internet. They started to provide online services. Now, small companies like Charles Schwab could easily compete with companies like Merrill Lynch, who was giant Investment Banking firm. In traditional financial markets Investment Bankers played the role of intermediary for firms and companies to issue stocks and bonds with the purpose of raising capital. The internet was going to destroy their business and push them out of the business. At the same time, these virtual financial markets created strong financial risks to those companies involved with online IPOs and they had an option to choose between traditional approach and online IPOs. This paper analyses how Charles Schwab was successful in putting Merrill Lynch business in danger by providing almost the same type of services online.

INTRODUCTION

In the past few years there has been a growth in Internet markets where companies and investors can get advice on buying and selling corporate stock online. This was mainly due to the network called Electronic Communication Networks. ECNs were created out of the Nasdaq Market Makers Antitrust Litigation led by William Lerach. The litigation alleged collusion among Wall Street traders, and was proven in 1998, leading to a $1 billion settlement from major Wall Street firms. At the time of the settlement, the SEC also put in a new regulation, the Limit Order Display Rule (rule 11Ac1-4), which authorized "electronic communication networks", or ECNs. Since then firms and investors found it very easy way of raising capital and investing at a relatively low cost, without incurring any trading costs. This led to the creation of online brokerage houses who facilitated transactions on behalf companies who wanted to go to public for the first time. These companies were reluctant to give much of their money to traditional Investment Bankers because of the cost of their services. In fact, by early 1999, the mechanics of Internet IPOs had quickly progressed from the first phase, a partial distribution of IPO shares directly to investors via the Internet, to the actual determination of the offer price and the allocation of shares through an online auction process. Internet-based investment banks provide companies with a choice of whether to use a traditional investment bank, or one that provides the new online services to distribute some portion of their IPO. When companies are considering an IPO they must identify which channel(s) they wish to use to distribute the IPO. This is an important decision because it potentially affects all public companies, or companies considering going public, the investment banking industry, and all stock investors. The importance is also indicated by the fact that in 1999 a record $74 billion was raised through 511 initial public stock offerings with new issues posting an average first-day gain of 68.3 percent. The traditional IPO process involves the issuing firm, an investment bank that acts as an intermediary between the seller and buyers, and a select group of typically larger investors. The investment bank provides services such as pricing the stock, forming syndicates of investment banks and their brokerage arms to distribute shares, providing access to a select group of large investors to facilitate distribution and, if need be, supporting prices in the IPO after-market by placing its own buy orders for the stock. Prior to the offer, the investment bank contacts its buying clientele and explains the details of the offer and the selling company. During this time the investment bank assesses interest in the IPO and takes preliminary subscriptions for shares. The bank then uses this information to determine the price and the number of shares to sell. Because many IPOs are over-subscribed, the bank pro-rates the shares during the final distribution based on the original subscriptions. This service comes at a price, however, as the investment bank receives a commission -- typically based on the amount of money raised in the IPO. The stock price run-up of the average IPO on the first day of trading is so great, that it appears that investment banks are often setting the offer price too low. Theories have emerged to explain the existence and magnitude of underpricing and defend it as an efficient way to clear the IPO market. However, there is still a real possibility that many companies are being sold too cheap. Consider the case of Theglobe.com, a Website builder that debuted in February 1999. Theglobe's bankers, Bear Stearns and Volpe Brown Whelan, underwrote its shares for $9, raising $27.9 million in capital. On the first day of trading, the price rose to $63.50. Had Theglobe sold the IPO for $63.50, rather than $9, the company would have collected not $27.9 million but $197 million - seven times the money to build the brand and develop new products [Tully 1999]. Given these transaction costs and a less than open IPO market, a new information technology enabled IPO offered a solution.

THE ROLE OF ECNS

ECNs provide investors with enhanced flexibility and reduced trading costs, also enhances competition in the established securities exchanges and Stock Markets. In simplest terms, ECNs bring buyers and sellers together for electronic execution of trades. An ECN is defined as any electronic system that widely disseminates to third parties orders entered into it by an exchange market maker or over-the-counter market maker, and permits such orders to be executed in whole or in part.. There currently are many ECNs operating in securities markets like; Instinet, Island, Bloomberg Tradebook, Archipelago, REDIBook, Strike, Attain, NexTrade, Market XT, and GFI Securities.