Andy Klein 
Bob Lessin 
Philip Cooper 
Jeff Max 
Christopher Lynch 
Chris Surr 
Michael Paull |
Investment banks are scared. They may well play it down but the fear is palpable. It’s caused by e-commerce, a catch-all phrase for the many advances in technology centred on the phenomenon that is the internet.
The big players will try to convince you that what they are doing is keeping pace with, if not driving the pace of, the benefits that technology can bring. And there may be some truth in that. But we are now at a stage where the previous wholesale financial markets structures are beginning to break down as the internet spreads through them.
Exchanges and their members no longer try to work in harmony, battling instead against each other’s rival systems. Retail investors, empowered by the web, are fast becoming much more proactive and influential, at least in US equities. And across the board investment banks face the prospect of traditional revenue streams contracting or disappearing altogether as the internet brings transparency and efficiency to once-closed areas.
Investment banks usually have been the ones having to respond, rather than initiate. Take research as an example. In 1996 Fidelity asked its main brokers to start sending earnings models via e-mail so that its own analysts could manipulate the data as they saw fit. From there it was a short step to send more general research in the same way. Suddenly, once-restricted research is widely and often freely available.
The rapid developments that e-commerce has instigated in retail business during the past three years have stripped bankers of their arrogance. Merrill Lynch bowing to the pressure of cheap on-line retail broking in June – less than a year after senior executives were proclaiming that it wouldn’t affect them – has been an eye-opener for investment banking.
Established leaders in the financial industry face an ever-growing army of new competitors. Charles Schwab may still dominate US on-line retail investing with just over a quarter of the market share but of the other top 10, three did not exist in the early 1990s (although two were born out of other technology companies): E*Trade started in 1992 and is now the second-largest on-line broker with 13.5% of the market; Datek Securities is three years old and has a 10.1% share and Ameritrade dates from 1997 and has captured an 8.5% market share, according to data from Standard & Poor’s.
Could the revolution in retail stock dealing spread into core investment banking? There are potential threats and some new companies have been set up. At present these are focused mainly on offering investment-banking-style services to the retail investor but the knock-on effect could be severe, as the Securities and Investment Authority in the US estimates that the retail market is set to account for 50% of all equity trading volumes in the US by 2002.
Pricing and research, formerly the domain of investment banks, are the primary targets. WR Hambrecht, a new venture set up by Bill Hambrecht, co-founder and former CEO of Hambrecht & Quist, plans to make the pricing of IPOs – raising $100 million or so – more of a science by using algorithms to find the optimal price based on orders received. It charges less than the famous 7% that all smaller IPOs seem to warrant, taking instead between 5% and 6%. If that catches on, the more established investment banks will have no choice but to follow, and so see a long-standing revenue stream reduced.
The new banks are also offering retail investors free investment-banking-style research over the internet. Wit Capital, a New York-based venture that seeks co-lead manager mandates on IPOs to sell to retail and is 20%-owned by Goldman Sachs, appointed former Merrill Lynch internet analyst Jonathan Cohen to head its research. He had been sacked by Merrill late last year following a wrong call on AOL. He said they were overpriced, and were worth $17 a share. They went up to as high as $150 a share, and now trade at $100.
The banks will tell you, with some pride, of the electronic broking systems they are starting up, either alone or in a consortium with other banks, in debt or equity, as proof of their commitment to technology and to obtaining for customers the best price for a transaction. What they mention with rather less glee is the effect this will have on their business. It’s not the costs – if anything they will make more money from having commoditized products with minuscule spreads traded electronically. The big fear is the loss of privileged access to information, which many banks use for their own purposes – fund managers so often complain that their bank appears to be using the information it has provided to them to trade against them.
E-commerce will strip that advantage from the banks. Given the anonymity that the trading systems usually provide, allowing all-comers to access liquidity, what does it mean for another service that investment banks have traditionally provided, that of awarding portions of equity and debt deals according to who their most valued clients are? Anonymity means that even the largest fund paying the most commission will have to pitch in with other funds, the Belgian dentist, mama and papa in Italy and whoever else is on the system.
If that weren’t enough, most bankers envisage having only a short space of time in which to transform their traditional models into fluent e-commerce businesses. “My task is to make the role of head of e-commerce an irrelevance within two to three years,” says Thorkild Juncker, managing director and head of the US bank’s financial markets e-commerce effort. In other words, if e-commerce is not a seamless, integral part of your business plan by that time, you’re probably out of the running.
“I’m reminded of something Andy Grove [chairman of Intel Corporation] said: ‘If you’re not scared to death every day, you’re doomed’,” recounts a senior executive in sales and trading at Morgan Stanley Dean Witter. “Am I scared every day? Sure. Do I fear being amazoned? Of course I do,” he confesses, referring to the astounding success of amazon.com. in challenging the franchise of the US bookstore chain Barnes & Noble.
These are bankers’ worst fears and perhaps will prove to be nothing more than that. After all, it’s rather more difficult to break into the investment banking business than it is to sell books – or music, videos, toys and games, as amazon.com is now doing. “Clients use us for a variety of complex transactions where advice is needed,” says one investment banker. “And that’s something that’s very difficult to provide over the internet.”
Nevertheless, e-commerce has the power – as it is already proving – radically to shake up the world of investment banking. Forget about the introduction of the euro; forget about the Y2K problem. These are no more than exercises in crisis management. E-commerce heralds fundamental change. From providing research to pricing trades, from handling client relationships to devising compensation structures, all are potential traps for the established investment banks.
And it all revolves around one issue: as e-commerce strips away all of the inefficiencies that were previously integral to the financial system, which the banks would exploit to the fullest advantage, what exactly do they do next? “What technology is doing is allowing the clients of investment banks to access massive amounts of information for themselves, rather than going through their brokers,” says Phillip Cooper, director of the e-financial services team at London-based e-business services group Momentus. “That has huge implications. It reveals more clearly what the investment banks are good or bad at and forces the bankers to find new ways of adding value to the clients.” It might also force banks to radically transform themselves.
At JP Morgan’s London office, Juncker is wrestling with exactly that issue. “Banks used to be defined by their physical presence. But now connectivity allows the clients to ignore the walls, to pull apart firms’ capabilities and rebuild in a way which suits them best.”
That would shatter the traditional structure of investment banking: a blinkered approach to individual products, long kept in their own silos, each controlled by a different ignition key, will no longer work. “Product alignment can be so strong in this business that, for example, five different salesmen from the same institution might be selling two or three different short-term interest-rate products to the same person on the buy side,” says Juncker. “That’s not a sustainable model.”
And that has a direct impact on the way relationships are handled. Traditionally, an individual salesperson has been responsible for his or her own accounts and defends them vigorously as they form an integral part of both the job description and the way salaries are calculated. “As e-commerce makes overall client focus more important than product focus it also takes the relationship with the client away from the individual and places it in the hands of the bank itself,” says Cooper. “That in turn changes the role of the banker from being a silo manager to an account manager.”
That’s just the internal conflict. The external battlefield is not as straightforward as it once was, either. It is no longer just for the investment banks to slug it out between themselves, weaker competitors being either assimilated or annihilated. Joining the fray are not only asset managers – American Century being one of the most proactive – but non-financial institutions. Microsoft, for example, has a joint venture with Itochu in Japan to develop an online share-dealing platform there. The Sydney Futures Exchange chose to be bought by Computershare, a computer services and share registry company in Australia, rather than link up with what once would have been its only natural partner, the Australian Stock Exchange. And AOL has teamed with upstart retail investment bank Wit Capital in the US, adding 17 million potential accounts to the bank’s client base, which previously stood at just 68,800 after three years in business. “This business used to be a pitched gun-battle,” says one senior investment banker in New York. “It could get messy but you knew who the opponents were. Not any more. Now it feels as if we’re being shot at from every direction.”
Investment bankers don’t tend to sit around waiting for help, though. That much is obvious from the rampant activity of the last few months, in which an e-commerce spending frenzy on the part of the institutional financial market has supplanted merger mania as the craze for the summer. In the past, an investment bank might enter into a strategic alliance but few worked well because the infrastructures at the separate institutions, not to mention the egos, usually got in the way.
But this year has been awash with joint ventures, consortia-based projects, investments, acquisitions and mergers, all traceable in part or in full to the e-commerce phenomenon. It’s a remarkable whirl of activity, partly driven by firms’ desires to demonstrate that they are on top of the internet challenge. Rather, it betrays how many firms are confused and defensive. Those who run investment banks have never been renowned for their ability to manage multiple channels, being more focused on particular products and, of course, compensation issues.
So why, suddenly, overload themselves with a series of new challenges that they know they might not be best equipped to handle? Answer: they fear that they can’t afford not to.
A fitting example is provided by a London-based investment banker talking to Euromoney on the last day of July, a Friday. In the paper that morning is the announcement that investment banks Goldman Sachs and Morgan Stanley Dean Witter and several other institutions are investing in Easdaq, the troubled, three-year-old pan-European stock exchange. “I really can’t understand the point of it,” says the investment banker. And then, after a pause, he continues, suddenly sounding less dismissive and more worried: “That said, there might be something we’ve missed. Maybe we ought to take a closer look at it.” The total new money being invested in Easdaq was just €22.8 million ($24 million).
Yet these investments – whether in Easdaq or Tradepoint, another stock exchange, in Europe, or in electronic commission networks [ECNs] in the US – are just the opening skirmishes in a battle to establish a viable, flexible, e-commerce strategy. No-one knows the outcome, of course, but one thing is certain: a coherent strategy no longer entails simply having a website detailing the products and services the institution offers.
Consider what investment banking has become over the past 15 to 20 years: a vast industry of brokers, traders, salespeople, corporate financiers, researchers in all the major products, siloed into manageable chunks: equities, government bonds, corporate bonds; short-term interest rate products; derivatives; products delineated by geography, by currency, by sector. More recently, the larger investment banks have put themselves forward as one-stop shops for all of a client’s financial needs.
But if all the baggage and spin are stripped away, investment banking at its core is about controlling the flow of just two things: money and information. On top of that, relationships are built and business won or lost. The quicker and more efficiently and accurately that can be done using these two commodities, the better.
And that is how investment banking has managed to thrive: as intermediaries in the financial marketplace, the banks were able to collate disparate pieces of information and arrange the transfer of monies more readily than either the buy or the sell side could. In equities and derivatives this was easy enough – issuers and investors cannot become members of exchanges. In the more complex debt markets it was even easier, as the banks and brokers acted as quasi-exchanges in the absence of an official one.
The majority of the investments and joint ventures of recent months have been prompted by the desire, or need, to take this process further. Investments in Easdaq and Tradepoint, and Optimark and the ECNs in the US are, in part, ways of trying to secure a degree of influence over the systems that either do, or will, offer better pricing and execution than traditional methods. The same is true of inter-dealer bond-broking systems such as EuroMTS and Brokertec. They are also meant as a warning to the traditional systems, such as the major equities and derivatives exchanges, that they have to shape up or face being swept aside.
So they can be characterized to a degree as defensive moves, designed to protect the position and franchise of the incumbents. An alternative way of putting it is that the banks are adopting “sustaining technologies”. This is a term in The Innovator’s Dilemma, a 1997 book by Harvard Business School associate professor Clayton Christensen. The book analyses what makes companies succeed or fail when new technologies appear by investigating the effect of technology on the hard-disk-drive industry and the mechanical-excavator industry. Depending on your standpoint, his theories are either a revelation or a cause for nightmares.
The book has become a pseudo-bible and Christensen a pseudo-prophet for investment banks in the US. Several have talked to him at length. Kevin McGilloway, chairman of Lehman Brothers’ e-commerce committee, says he bought 25 copies and gave one to each member of the committee to read. At least one bank has even appointed him as an external e-commerce adviser.
The opposite of sustaining technologies are called disruptive technologies by Christensen. So in the disk-drive world, the continual innovations that allowed disks to be reduced in size can be classed as a disruptive technological development for which the makers of larger disks were not prepared. Furthermore, contends Christensen, the most disruptive developments were always relatively simple ones. The internet, and its application to e-commerce, is just that – a cheap, simple-to-use tool that is managing to turn so many industries inside out.
To the investment banks, the combination of technology, connectivity, availability and affordability is fundamentally shifting the balance of power: investment banks no longer have near-exclusive control over the flow of money and information.
Learning from retail
Some find it curious that only now, after two years or more of retail developments taking the lead in e-commerce, is the investment-banking and asset-management world starting to take e-commerce seriously. After all, haven’t the Wall Street firms been the biggest enthusiasts for the power of the internet, taking dozens of internet companies public and publishing voluminous research on them?
Well, in this instance, retail had to come first. For technology will usually hit hardest areas that are inefficient or inaccessible. It is a lot easier to set up amazon.com to cater for those who get exasperated at trying to locate books in impersonal bookstores than it is for a start-up on-line bond underwriter to poach a large corporate away from his relationship banks because a bond deal didn’t go as well as planned.
It is a similar argument for on-line retail investing with firms such as Schwab, TD Waterhouse, DLJdirect or E*Trade, regardless of whether you’re a day trader or not. It’s cheaper and more convenient than the telephone or a branch visit if all you want to do is trade in and out of stocks. For a fund manager with hundreds of millions or billions to invest you need a more comprehensive service pre- and post-trade, as well as during trading.
What the retail world has proved is that properly utilized, e-commerce makes business more convenient, more speedy, more transparent, and ultimately less costly. In both examples above, the requirements of the retail customer are much less complicated and demanding. But it is unavoidable that what attracts the retail client to such products will ultimately appeal also to the big institutions.
Where does this leave investment banks?
Let’s start with the good news. “E-commerce is a significant development for investment banking but it won’t change everything. There’s no point in completely transforming the investment-banking model. Just keep up the arms race by applying technology where appropriate and staying efficient.” So says Bill Burnham, formerly the e-commerce analyst at CSFB before being lured away to a new e-commerce-focused venture-capital fund set up by the investor of investors in e-commerce companies, Japan’s Softbank.
Not everyone would agree, but a quick comparison with the retail market lends it some credence. Think of the internet in that sphere and it won’t be long before you start thinking of the 20-something college graduates becoming multi-millionaires by listing their companies, .com this or .com that, on a stock exchange. Look around the investment banking world and you’ll see little, if any, of that. The reason is fairly simple. Money and information may provide the skeleton to investment banking but the ability to flesh that out into a profitable business depends on the ability to form relationships with the (potential) clients.
Second, investment banking is a highly regulated industry. It is not one into which any Tom, Dick or Harry can suddenly jump. Third, the amount of capital needed to be able to conduct business in the capital markets can be prohibitive. So it is unlikely that one or more techno geeks is going to be able to disenfranchise the investment banks just yet.
Now the bad news. Good ideas often find capital; sound ideas with adequate financial backing are liable to push for regulatory approval. And three of the biggest on-line retail brokers in the US, with a combined market share of 32%, didn’t exist until the mid-1990s.
That market is set to grow, so blurring the traditional divide between retail and institutional. A recent report by the Securities and Investment Authority predicted that the direct investing public (as opposed to those investing indirectly in mutual funds), spurred by on-line trading, will account for 50% of trading volumes in the US by 2002. Already, all the main on-line brokers offer research from investment banks, usually for free; this may appear a few days after institutional accounts receive it but undoubtedly that will change as the retail market becomes a larger and more powerful sector.
Indeed, retail-oriented investment banks are already being set up, their expressed intent being to attack the inconsistencies between the institutional and retail investing universes. Wit Capital, WR Hambrecht and E*Offering are the three major examples so far. E*Offering is a spin-off of E*Trade, which owns 25%, and has the support of the co-founder of Robertson Stephens, Sandy Robertson. At present Robertson’s involvement is as an investor, just as he also is in the corporate bond electronic trading tool LIMITrade – he was locked into a one-year no-competition clause on leaving Robertson Stephens at the end of last year.
Wit Capital, set up by a corporate lawyer in 1996, has lured former Morgan Stanley and Salomon Brothers banker Bob Lessin to run it. Its aim is to provide research of investment-banking quality, for free, and to be co-lead manager in IPOs and act as the main retail distributor.
Bill Hambrecht left the investment bank he co-founded, Hambrecht and Quist, after a disagreement over future strategy and set up a new outfit. Its major offering is OpenIPO, which is designed to provide universal access to IPOs, charge the issuer lower fees and offer better valuation and less volatility. Essentially, OpenIPO is a Dutch auction, attempting to foster price discovery through a blind-auction process, the offering being set at the lowest bid accepted by the company. Instinet and Fidelity have invested in the firm – Instinet will list Hambrecht’s IPOs on its broker system and Fidelity will offer them to its customers over the internet.
Two recent transactions show the potential effect of the firm’s activities. (The comparison is somewhat artificial as it does not account for market conditions.) WR Hambrecht, along with Daiwa Securities America, underwrote a $26 million IPO for salon.com, an online magazine. The two underwriters charged 5% in fees, priced the deal at $10.50 a share and these closed at $10.07 on the first day. A similar deal, for theglobe.com, another online magazine, was brought by Bear Stearns and Volpe Brown Whelan. They charged $2 million – 7.1% – for the $28 million IPO, priced the shares at $4.50 and saw them rise to $31.75 by the end of the day.
Which is the more successful? It depends on your point of view. Most day traders and institutional investors would love to make a 600% return that quickly. But such huge first-day leaps in the stock price deprive the selling company of proceeds.
What are the investment banks doing?
The established investment banks may have the flow and the relationships at present but they also have a lot of infrastructural baggage and legacy systems. And they know the costs of inaction, indeed have been some of the most vicious critics of those in their industry that have resisted the changes technology can bring, and the first to exploit them. Witness their scathing attacks on the Chicago Board of Trade last year for failing to move to electronic trading, discussed later in the profile of Brokertec – an inter-dealer bond and derivatives broking system that was set up by a consortium of seven investment banks arguably as a direct consequence of the exasperation they felt towards the CBOT.
Most of the leading US investment banks have set up e-commerce steering committees headed by senior executives. All seem to be following the same broad agenda. First, to consolidate any e-commerce-related initiatives into one coordinated effort – providing a single front end with one password, for example. Second, to drive forward all proprietary developments, whether purely technological or using technology to expand into new products. Third, to evaluate all approaches made to the bank seeking partnership, funding, or both. Fourth, to examine any consortium-based initiatives that the firm should be involved in – for example, Tradeweb or Brokertec.
How they approach this on a day-to-day basis is another matter, and at this early stage there is only one definite statement to make. Bill Johnson, chair of Warburg Dillon Read’s e-commerce committee, as well as being global head of treasury products, sums it up: “One of the core principles we are all working around is flexibility. No-one knows exactly or how quickly these new technologies will change the business landscape.”
Merrill Lynch’s approach to e-commerce is one of the more interesting of the major banks’ in that, although not completely divorced from the day-to-day businesses, it’s e-commerce unit, Direct Markets, is a separate entity with its own P&L.
The only other bank to do something similar is CSFB, which has created a separate P&L unit for its debt and derivatives group, run by Ben Cohen. “We’re making it into a distribution channel for the benefit of the whole division,” says Richard Thornburgh, vice-chairman of CSFB’s executive board and the man in charge of the bank’s e-commerce drive. “E-commerce is bundling together the businesses we’re involved in, particularly debt and derivatives. So we decided the best way to proceed was to create a separate unit.”
It is something, Christensen says in his book, that is potentially the only way in which an established business can hope to cope with disruptive technology successfully. “With few exceptions the only instance in which mainstream firms have successfully established a timely position in a disruptive technology were those in which the firms’ managers set up an autonomous organization charged with building a new and independent business around the disruptive technology.”
It is a model that others have put to use in the retail banking sector: e-Citi, for example, the unit that houses Citigroup’s electronic services development efforts, run by Ed Horowitz; or, more obviously, Banc One’s internet bank, Wingspanbank.com.
That Merrill has in part adopted this model is no surprise: Michael Packer, managing director and the man in charge of direct markets, has two copies of Christensen’s book on his office shelf. Competitors wonder aloud whether Merrill chose this route because it realized that to adapt wholly from within the established businesses would have been too difficult a task. It was just this model of separation that was proposed, and rejected, for developing an on-line capability for Merrill’s retail broking clients. Its traditional full-service broking operation was under a great deal of pressure from on-line retail trading operations but in the event its head, John Steffens, was given control over internet strategy. The resulting tension may have contributed to the resignation of president and COO Herb Allison, who apparently had suggested keeping the two separate.
Packer was not a Merrill man, however, which would point to the bank’s executive board deciding that fresh blood was needed to tackle e-commerce. Packer had previously directed Simon & Schuster’s e-commerce strategy. His career before that included teaching at MIT and leading the technology groups supporting the trading and structuring businesses at Bankers Trust.
The problem of legacy infrastructure is not something that many of the smaller or specialist firms have to worry about; their concern is in combining new technology with services that had limited reach beforehand to win more clients. Barclays Capital provides an example of how technology is helping a smaller investment bank access new clients. Earlier this year the UK investment bank, which specializes in credit products, joined Tradeweb, an electronic government bond trading vehicle initially set up by Lehman, CSFB, Goldman Sachs and Salomon Brothers two years ago. There are now seven banks involved, Merrill Lynch and JP Morgan being the other two.
Tradeweb is an internet-based system designed for trading US treasury products; it lists the brokers’ prices side by side. John Roberts, a managing director in Barclays Capital’s New York office, regards participating in Tradeweb as presenting the firm with a great opportunity. “A client looks at Tradeweb and sees quotes from, let’s say, five different houses. Effectively it’s eroding the advantages the US banks have had by allowing us to compete on a level playing field for the first time. As a European bank used to having to be aggressive in the US market it offers us a lot of opportunities. I get to see more information and I get more hits. Many of the enquiries I get each day are from accounts I’d never have seen before.”
DLJ has found itself in a similar position: it has spent the past two years breaking into the high-grade corporate bond market and has put the emphasis on providing prospective clients with direct access to a well-structured research tool (see page 75).
Not that many are expecting a complete level playing field: e-commerce will not reverse the trend towards globalization. If anything, it will speed the process up as e-commerce lays bare an institution’s weaknesses. It certainly doesn’t cover them up.
This puts a spotlight on the bulge-bracket wannabes. Salomon Smith Barney, CSFB, Warburg Dillon Read and JP Morgan all fall into this category and all smell an opportunity to advance. But does the advantage lie with those banks more used to reinvention? “We think we’re well placed because we’re used to change,” says Scott Moeller, director in corporate development and planning at Deutsche Bank. “We’ve been in a constant state of flux while building our investment banking franchise over the last four years. We don’t have the mindsets which might afflict some of the more entrenched institutions.”
Lehman Brothers would put itself in a similar category. Says chief information officer Kevin McGilloway, now also chairman of the bank’s e-commerce steering group: “We had to rebuild our front and middle offices entirely after we split from American Express in 1994. And we have a good straight-through processing system, too. We think we’re well positioned for developing with e-commerce.”
Such institutions face a different problem, that of growth fatigue. Will you be able to persuade the board and shareholders that the money they have allowed you to invest in state-of-the-art systems over recent years has effectively been wasted? And will your bankers be willing to give up the great new system they’ve just got which you’d been promising them for ages? It is a situation of which the managers are well aware. “E-commerce cannibalizes existing businesses, but it can also serve to expand markets for us,” says Moeller. “There are people who are not happy at having to scrap relatively new systems. I’ve said to a few people that if they don’t cannibalize their existing businesses themselves with an e-commerce solution, then someone outside the company, or even outside the banking industry, will probably do it for them.”
This is especially true in the highly liquid and more commoditized businesses, continues Moeller. Additionally, it is now possible in some areas of the business for new entrants from outside the industry to set up competing systems. “But it is also important to note that e-business opens up new client groups and new markets that may not have previously been economic for us to serve,” he says. “E-commerce is just a very new and potent force for us in the financial services industry where change – and therefore cannibalization of existing systems – has always been necessary to survive.”
At this early stage, the message from virtually all the banks on e-commerce is: be prepared. “I prefer not to call it a strategy,” says Juncker at JP Morgan. “You can’t work this out in terms of ‘first we do this and then this’. It’s much more of a process, making sure that you have a framework in place so that you can respond to opportunities and act swiftly in the face of changes. In that way, when something comes along, you’re in a position to decide whether it makes a good fit with your business or not.”
Already banks are taking flexibility of approach to mean different things. Warburg Dillon Read would appear to be waiting for what looks like the best opportunity. For aside from Tradepoint it has made no visible investment. That is not wholly representative of the Swiss bank’s efforts, says Johnson. “A lot of the deals out there have been financial investments but that is not the only option. Alternatively one can invest in intellectual capital. At times we feel this is the better approach, as it creates an active dialogue for ideas.” A venture the firm has looked closely at, says Johnson, is one of the ECNs in the US.
Almost the direct opposite of this approach has been taken by Goldman Sachs. The US bank is by far the largest visible investor in e-commerce-related ventures. It has stakes in three ECNs; in Easdaq; in Optimark, an alternative trading system in the US; has set up another alternative trading system, Primex, with Merrill Lynch and Madoff Securities; is involved in the three major consortia of electronic bond trading systems, Tradeweb, EuroMTS and Brokertec; has a minority stake in on-line investment bank Wit Capital; and bought options-trading firm Hull Group outright.
Its competitors ponder what the strategy might be. Is it just promoting an image of being the e-commerce-friendly investment bank? Is it a massive hedging strategy to make sure it’s in the endgame somehow? Is it an elaborate way of pitching for IPO business? Or is it just venture capitalism dressed up as a strategy?
This is hotly rebutted by Duncan Niederauer, managing director and head of electronic trading for equities. “We’re not investing in alternative trading technologies to win IPO mandates and we’re not endeavouring to be a venture capital fund. We’re attempting to actively participate in their development in an effort to influence their collective impact on the markets and our business model.” He wonders whether some confusion over Goldman’s strategy derives from the fact that this is not the traditional Goldman Sachs style. That is certainly true. In the run-up to the firm’s own IPO in May most were speculating that Goldman would seek to use its new-found capital to expand either its investment-banking activites through merger or acquisition, or to buy an asset management firm. It has done neither.
Goldman has embarked on this strategy mainly, says Niederauer, “because we would like to see the market structure in the US substantially altered. I’m confident the NYSE and Nasdaq can both adapt, but we need to have other options if their organizational constraints prove insurmountable. ECNs could become less relevant if the primary exchanges innovate, but ECNs could also substantially alter the course of market structure if the exchanges choose not to.”
To a greater or lesser extent, most banks’ recent investments are defensive. But that is not the only option they have. One of the first things investment banks might use e-commerce for is to turn the tables on their clients: more transparent information can reveal as much about the value of the investor to the bank as vice versa. It becomes a method of directing resources more efficiently. Indeed, to become or remain a leading player, the sooner a bank moves onto the offensive, the better. The first step is to learn some constructive lessons from the unbundling of an investment bank’s services. In other words, while this process will show a bank’s weak areas, it will also show its strengths. E-commerce can help to leverage off these.
Lehman Brothers, for example, has already begun to tap into one of its core strengths, the mortgage-backed debt markets and has extended that into the more mainstream market by making investments in two related entities, a mortgages origination institution called Aurora, and a savings bank in Delaware now called Lehman Brothers Bank. It is hoping to close another investment to round off the business, this time in an on-line credit-checking company.
A more obvious option for the pure investment banks is to use technology to expand into the retail market. Given the growth in the retail-investing sector, mainly in the US, but also in Europe (most notably Germany) it is a logical business decision.
Some efforts have already been made, of course: JP Morgan and CSFB distribute their research to Schwab, and also allocate portions of deals to the retail broker to sell. Lehman Brothers struck a similar deal with Fidelity in June. The Boston-based fund manager has also struck a deal with start-up online retail investment bank WR Hambrecht, to allow its 2.7 million retail customers to bid for the bank’s IPOs over Fidelity’s website. Several others make their research available to on-line brokers a few days after it is sent to institutional clients – Robertson Stephens, for example, has an agreement with E*Trade. And let’s not forget the merger that kicked off the latest wave of consolidation, that between Morgan Stanley and Dean Witter in February 1997.
But technology now allows for a more direct approach. Goldman had never been in the retail market before, but technology means that the US investment bank can begin to explore its potential. That, in part, explains why Goldman Sachs has bought a 20% stake in on-line retail investment bank Wit Capital.
Competitors also point out that it saves Goldman having to rely on big retail brokers such as Salomon Smith Barney, Morgan Stanley or Merrill Lynch, which just happen to be its competitors in investment banking. It remains debatable whether Wit Capital is the right vehicle. Until its recent link-up with AOL, it had just 68,800 registered clients, good enough no doubt for a portion of an internet IPO but hardly a large base for divesting a broader range of stocks.
As much as technology might be breaking down barriers to allow more to play in the financial markets, it also breaks down the economic barriers that previously prevented large houses from getting involved in smaller deals and with less active clients. “It used to be the case that 80% of an investment bank’s business would come from 20% of its client base,” says Cooper at Momentus. “There were too many constraints on resources to be able to cover everything.” Technology is changing that, a good example being IPOs. Deutsche Bank is already benefiting from this. “We’ve been able to do more business in the sub-$50 million IPO market as a result of the internet and add significant value to technology-related IPOs by targeting those private investors most interested in these companies with an affinity to the respective technology,” says Moeller. “In fact, we’ve done the largest number of internet-distributed deals so far this year. Since the launch of IPO@db.com in March 1999, more than 20 German deals have also been distributed via the internet.” Recent deals include IPOs for the German online auction house ricardo.de, the entertainment company RTV Family Entertainment and the interactive architect GFT Technologies.
The outcome
What the outcome will be, no-one knows. Is it a question of staying ahead of the game, then? Not always, says one banker at a top-three investment bank. “I wouldn’t say that we necessarily are ahead of the game. It’s work in progress, and what we have to do is make sure that we’re flexible.”
Your view on its impact on investment banking depends on whether you see e-commerce as an evolution or a revolution. It’s easy to make comparisons with the industrial revolution – to envisage today’s leading firms brought low – but is that warranted? Surely there is no way the Merrills, the Goldmans and the Morgan Stanleys can lose the advantage they’ve built up over the last decade? Is there?
