19 March, 1999

Online Trading in the UK

Introduction

Over the past few years, the trading of stocks and shares via the internet (online trading) has taken off dramatically in the United States. By comparison, the UK market has, until recently, been characterised by smaller scale attempts from traditional brokerage firms experimenting with the internet as an alternative channel, and take-up has been relatively slow. Only recently have some more mature UK offerings begun to emerge, and now the number of online investors is growing appreciably. The next six to eight months will be a time of rapid change for UK online trading, with a plethora of new entrants (both local and US-based) planning to enter the market. This article examines trends in global online trading and their relevance to Europe, and looks at current and forthcoming players in the UK online trading market.

Structure of a UK stock transaction

The individual investor wishing to purchase shares interacts with a broker who typically provides trading services for a commission (usually a percentage of the transaction value). Brokers will often also set clients up with nominee accounts (thus holding certificates on behalf of customers, which affords greater anonimity) and will manage client portfolios. Brokers may provide an 'execution-only' service (trading without advice) or an 'advisory' service (where the broker advises on suitable stocks). When a trade is to be made, the broker will find available prices by calling market makers. Market makers are obliged to provide bid and offer prices during market hours for the stocks in which they trade - they make money from the difference (or 'spread') between the bid price and the offer price.

Aside from calling market makers by phone, there are two alternative means of obtaining prices and conducting transactions:

(1) Brokerage firms may install a retail service platform (RSP), which presents real time quotes and allows trades to be executed electronically. These proprietary systems are offered in the UK principally by three banks - Merrill Lynch, Dresdner Kleinwort Benson (in collaboration with Winterfloods), and UBS.

(2) Brokers may opt to use 'SETS', the electronic order book of the London stock exchange. Here, sellers and buyers directly quote the prices and volumes at which they are willing to deal, and counter-parties select suitable offers from the screen. SETS also automatically matches buy and sell orders. The advantage of SETS is that it is totally anonymous, automated, and instant. SETS is available for FTSE-100 and ex-FTSE-100 stocks only.

Once a trade is conducted, it must be recorded with the London Stock Exchange. Additionally, trades in CREST registered stocks (which includes almost all LSE and AIM stocks) must be recorded in the CREST electronic settlement system. CREST provides the option of trading without paper certificates ('fully dematerialised' transactions) by holding share certificates in electronic form on behalf of the end user or their nominated broker (the 'nominee').

The internet offers a means of facilitating electronic interaction between individual investors and brokers. When combined with an RSP, this allows the trading process to be made fully electronic all the way from end-user through to settlement. However, many online brokerages will opt to use a human to intelligently filter internet trading requests, and will opt to call market makers (in search of the best price), instead of using an RSP.

The online trading market

Online trading has been available in the United States since 1995, and growth has been dramatic. Charles Schwab, an established retail brokerage with numerous offices across the US, launched an online service four years ago, and has seen online trades grow to comprise over 50% of all trades conducted. The volume of online trades in the US increased by 34% in the last quarter of 1998, and by Q2 1999 there will be an average of 425,000 online trades conducted per day. There are approximately six million online investors in the US, and at least 3.5 million new accounts are expected to be opened in the coming year. More interesting for brokerages is the discovery that online customers tend to trade 3 to 4 times as often as those using traditional means. Real-time price tracking, portfolio management and information gathering capabilities provided by the net make stock research and trading both faster and easier.

The US market differs from the UK market in significant ways. In the United States, higher disposable incomes and an economic structure that drives Americans to save extensively for their children's education and for their own retirement has created a culture of active personal financial management. This culture is set against the backdrop of a twelve year bull market and widespread awareness and use of the internet. A larger population, greater share ownership and more frequent trading in the US makes for tremendous liquidity, which drives down spreads, increases competition and enables commissions to fall as low as $7.95 per trade. UK savers are less active managers of their finances and have tended to prefer managed pension funds as an instrument of investment (many also entrust independent financial advisors with the management of their portfolios). Share ownership is considerably lower in the UK, and around 75% of share owners own mostly privatised utilities (which they hardly trade, once purchased).

There a few other points of difference between the US and UK markets

• In the US, it is common practice for market-makers to pay brokers a percentage of their profit in return for passing orders through them ('payment for order-flow'), which reduces broker costs. This practice is illegal in the UK because of concerns that it may lead to customers not getting the best prices.
• Trading on margin is widespread in the US, and this can increase the total amount invested several-fold. A margin requirement of 25% would mean that you can borrow and invest four times as much as you have in your cash account. Margin requirements are considerably more stringent in the UK, and margin trading is not as common.
• The widespread use of RSPs in the UK, and the fact that UK online trading applications were only recently developed has allowed UK technology to 'leapfrog' US online trading technology in some respects. While leading UK systems allow trading at the quoted price with immediate confirmation, US online systems do not show the actual price at which a trade will occur until after the fact.
  

Key factors that point to increased and more active share ownership are in place in the UK. Disposable incomes are rising, there is an increased pension shortfall, and falling interest rates make stock market investment more attractive. Internet usage is growing rapidly, and the emergence of new interactive platforms, including digital television, may introduce a wider demographic to the online trading concept. In addition, a number of high profile new entrants are likely to launch online trading services backed by considerable marketing spend over the next six to eight months. The UK online trading market will go through dramatic change over this period, and the entrance of new players will in itself drive share ownership upwards.

Existing UK players

There are six companies currently offering internet trading services in the UK. Five allow trading via a browser interface. The sixth, Infotrade (a Mitsubishi company), uses a proprietary client. Additionally, Barclays Stockbrokers has rolled out a service to selected customers and is likely to launch within a month. Here is a summary of the existing players:

Fastrade (www.fastrade.co.uk)

Fastrade , run by Torrie & Co., offers customers a simple secure HTML interface which transmits stock orders by e-mail. Incoming orders are checked by brokers for validity before continuing their journey, and confirmations take about two minutes to be e-mailed back to the client. Fastrade feels that while the market has yet to mature, customers appreciate the added level of protection against errors that is afforded by the brokers who check every order. Fastrade is marketed separately from Torrie's telephone based service, and a significant proportion of Torrie & Co's customers are now trading via the internet. Fastrade advertises on the UK Motley Fool site (a popular discussion site for new and experienced investors).

Icon (www.jbrearley.co.uk)

The Icon service, offered by James Brearley & Sons, offers a similar interface to Fastrade (both were developed by Investornet). James Brearley sees the internet channel as a simple extension of the straight-through processing system (RSP) that was already installed for its brokers. Again, incoming orders are vetted by brokers before being executed, and confirmations are sent by e-mail. The relatively low profile of the internet offering means that a small proportion of James Brearley customers are using the internet channel, although the site is advertised through a link on the Market Eye financial site. The company is looking to increase revenues from cross-selling of other financial products, such as ISAs, via the web.

Xest (www.xest.com)

Xest, run by Charles Stanley & Co., was an early starter in this market and began with a cross-framing arrangement with the ESI (Electronic Share Information) financial portal whereby Xest would provide online trading framed within the ESI site, and ESI would provide stock information, charts and news framed within the Xest site. Xest is one of the more mature offerings in the UK market, and was re-launched around 24th February with real time stock quotes, stock news and charting tools for members. The Xest interface, like that of Icon and Fastrade, uses a secure HTML form that routes orders to brokers by e-mail. Approvals are received within about two minutes. Xest is moving towards becoming a content aggregator and creating a financial destination site for its customers through the provision of additional tools and financial products such as ISAs.

Stocktrade (www.stocktrade.co.uk)

Stocktrade, run by Brewin Dolphin Securities, has taken an unusual approach in this market by working with a Swedish technology firm (Interbizz) to develop a Java applet that offers real time quotes, live and dynamic portfolio valuations (with up to 15 stocks), and the ability to trade in CREST registered stocks at the quoted price with immediate approval. However, this applet is quite large (at around 1MB) and takes a few minutes to load each time you visit the page. It is best used with a high specification system and a reasonably good internet connection. This applet is an extension of the retail service platform used by Brewin Dolphin brokers. Stocktrade is the only one of the UK online brokers to enrol every customer in personal membership of CREST (rather than the broker acting as the nominated CREST member on behalf of the customer). In fact around 50% of all CREST personal members are Stocktrade users. Personal membership means that company annual reports and dividends are sent directly to the customer.

Charles Schwab (www.schwab-worldwide.com/Worldwide/Europe)

Charles Schwab is the only US online broker currently operating in this market, and comes here with the experience of managing over 2 million online accounts in the US (it has slightly under 10,000 in the UK). The Schwab service allows UK customers to trade in either UK stocks or US stocks. It provides an indicative real-time quote when an order is placed, but cannot guarantee that execution will occur at that price. As with most of the systems above (with the exception of Stocktrade), limit orders are possible. Schwab's basic service includes free access to Reuters news and trading volumes information, and transaction history and portfolio management services. Charles Schwab also offers a range of additional Reuters financial information, including sophisticated charting tools, for an extra £10 per month.

The following chart shows comparative charges among five UK players:

Service	Contact	Min	Commission *	Max	Setup	Annual Fees
Fastrade (Torrie & Co)	0131 225 1766 www.fastrade.co.uk	£15	0.5% (for trades > £3000)	£50	£0	£2.50 nominee charge per stock per half year. Waived if you make >10 transactions per year
Icon (James Brearley & Sons)	01253 628 686 www.jbrearley.co.uk	£20	1% (for trades >£2000)	£50	£0	None
Xest (Charles Stanley & Co.)	+44 (0) 20 7739 5151 www.xest.com	N/A	Fixed £20 (trades of up to £50k)	N/A	£20	£45 annual service, charged every April (regardless of sign up date)
Stocktrade (Brewin Dolphin Securities Ltd.)	0131 529 0403 www.stocktrade.co.uk	£25	0.2% (for trades >£12,500)	N/A	£0	£25 annual personal Crest membership
Barclays Stockbrokers	0345 776 776 www.barclays-stockbrokers.co.uk	£17.50	1.5% (first £5000) 0.85% (next £10,000) 0.5% (above £15,000)	N/A	£0	None
Charles Schwab Marketmaster Account	0870 608 0141 www.schwab-worldwide.com/Worldwide/Europe	£15	0.90% (first £2500) 0.75% (next £2500) 0.10% (above £5000)	£75	£25	£1/stock/quarter nominee charge (min £5, max £30 / quarter)

* Commissions do not include mandatory stamp duty of 0.5% on all purchases.

For comparison - here are the rates offered by two typical discount brokers in the US market:

Service	Contact	Min	Commission *	Max	Setup	Annual Fees
Suretrade	+1 401 642 6900 www.suretrade.com	N/A	Fixed $7.95	N/A	$0	$0
E*Trade	+1 800 ETRADE 1 www.etrade.com	N/A	Fixed $14.95 (NYSE) $19.95 (NASDAQ) (Add 1¢/share above 5000 shares)	N/A	$0	$0 (Customer is offered frequent flier miles on account setup)

* There is no stamp duty (or equivalent tax) payable in the US.

It is important to remember that while commission charges are more visible to the user, spreads (and hence a broker's ability to deal at the best price) may have a greater material impact on the value of a transaction.

Forthcoming entrants

Barclays Stockbrokers

The next entrant in the UK market will most likely be Barclays, which plans to launch an online trading service within a month or so. This system will be among the more advanced in the market, with a straight-through execution system that offers a real-time quote and allows the customer fifteen seconds within which to execute at that price. Additionally, the Barclays system utilises an innovative price comparator technology which examines prices across multiple RSP systems as well as the SETS order book, and delivers the best available price. Barclays claims this will significantly reduce spreads and will provide a better deal than a single RSP system for up to 50% of trades. Interestingly, Barclays will not initially provide a nominee service - this means that customers must hold paper certificates for the shares they own, and must mail these in after a sale is complete. The nominee service will be added a few months after launch. The online trading service will be free to join and will offer £17.50 minimum commissions. Barclays already has an extensive internet banking presence, has recently launched free internet access, and benefits from a considerable existing customer base to which it can sell a variety of value-added services online.

E*Trade

The pioneering US online broker, E*Trade, is launching a UK service in the second quarter of 1999 as a joint venture with ESI (Electronic Share Information). When the service is launched it is likely that ESI will drop its existing gateway arrangements with other brokers. E*Trade is reluctant to offer details before launch, but it is likely that the service will feature competitive flat rate pricing and that the launch will be accompanied by a significant marketing and advertising campaign. US brokers tend to have a different outlook to UK brokers in terms of the value they attribute to an internet customer. Most UK brokers are looking for consistent profits as they grow and hence are reluctant to spend more on customer acquisition than they are likely to earn in the coming year. Some US brokers, on the other hand, have adopted an internet business outlook which states that the value of a customer is determined by the future e-commerce opportunities presented by that customer's loyalty to their online brand. In the United States, E*Trade is no longer simply an online broker - it is a successful internet brand - and this gives it the potential to move into online credit cards, internet banking and a host of other related services. US brokers consider the net present value of an online customer to be in the region of $700, and hence are prepared to spend as much as $300 per customer in acquisition costs.

NatWest

NatWest is taking a cautious approach to online trading and views its existing trading clientele as the immediate fraternity for what it sees as simply an additional communication channel. The Natwest online service will be launched within a few months, and will feature a secure, non real-time HTML interface with commission rates that match those of its telephone service.

Other Entrants

Other likely entrants into the UK online trading market include Virgin Direct, DLJ Direct (a US online broker), Interactive Investor (a financial portal), The Exchange (an IFA website), The Yorkshire Building Society and The Alliance & Leicester.

Some UK brokerage firms offer a trading service that aggregates orders as they come in and conducts trades only three times per day, in bulk. This is particularly suited to less volatile shares, where larger order sizes may result in better dealing prices, and it is possible that this model will be made available over the internet too. A possible entrant in this area is the Share Centre (http://www.share.co.uk).

Market trends

Here is an outline of key trends in the online trading market:

- Increased market volatility and more frequent trading

Customers trading via the internet tend to trade more frequently (3-4 times as frequently, in the US) as customers using a telephone service. The range of information that the internet provides (and the self-empowerment that this offers) is compelling, and this has led to a rapid increase in day-trading (quick buying and selling of shares, often on the same day) by individual investors. Interactivity means that investors no longer just consume information, they feed back their opinions into the pool. The flourishing on-line communities that contribute to this tide of information have precipitated a change in the markets - share prices rise and fall based increasingly on market sentiment rather than fundamentals alone. The increased volatility that this causes has raised concerns even among pioneering online brokers - recently major brokers moved to reduce customer ability to trade certain internet stocks 'on margin' (using borrowed money). While some brokers voice concerns about day trading, others emerge to fill the gaps - RushTrade.com recently opened in the US specifically to service day-traders. This shift in the behaviour of markets is here to stay, and will become increasingly evident in Europe over the next three years.

- A move towards 24 hour trading

Currently, individual investors are somewhat prey to the movements of the market after hours. The difference between the price of a stock at close, and the price of the first trade the following day can be considerable, particularly if news is released after hours. However, certain institutions have the ability to trade (and thus to drive prices) after hours (for example Instinet, a Reuters company, allows institutions to trade after the market has closed). Eclipse Trading, a New York based electronic communications network recently announced a system which will provide individual investors their first chance to trade after-hours. The London Stock Exchange has indicated that it may extend the trading day by an hour to align with continental Europe, and the New York Stock Exchange is considering expanding the trading day by up to five hours in order to compete effectively with exchanges in the European time zone. These effects of globalisation, coupled with the growing automation of trading and the world-wide reach of the internet point to a world in which stocks with sufficient liquidity will be tradable online twenty-four hours a day.

- Distribution of initial public offerings (IPOs) on line

A growing appetite among retail investors for shares in new internet companies often drives internet IPOs to begin trading at several times the offering price on their first day of trading. Traditionally, retail investors (i.e. individuals, rather than institutions) have only been able to buy in this frenzied 'after-market', while the investment banks managing these offerings have been able to offer IPO shares at pre-launch prices to favoured institutional clients. The use of the internet to distribute initial public offerings to retail investors was pioneered in the United States by Witcapital, which positioned itself as fighting for the 'common man'. While some IPOs may be in hot demand, for many others investment banks are concerned about generating enough demand. Use of an electronic manager is a good way to make IPOs available to a wider audience, and the internet is particularly suited to IPOs of internet companies because the share-buying audience is probably also familiar with the company on offer. In Europe the tech IPO phenomenon is yet to take off. However, the increasing availability of venture funding and the growth in technological entrepreneurship is likely to generate some high profile European technology offerings over the next few years and this could fuel a tech-IPO frenzy similar to that currently being seen in the United States. Online brokerages in Europe will increasingly begin to distribute US technology offerings, perhaps followed by local tech IPOs, online.

- Growth in cross-border trading

Links between different exchanges (such as that between the LSE and Deutsche Bourse, the creation of the EuroNM, and links between the NYSE and European exchanges) are indicative of a trend towards global trading. The internet's ability to deliver financial information on a global basis is driving interest in international stocks, and the relative unimportance of geographical proximity will mean that internet trading firms will be among the first to offer cross-border trading. There is considerable US interest in trading European stocks. Ameritrade, the US discount broker recently announced an agreements with Deutsche Bank and with Cortal (the online subsidiary of Paribas) which will enable online investors in France, Germany and the US to trade in each others markets within the next six months. The entry of US brokers into the UK will also enable UK citizens to trade US shares. E*Trade has an electronic presence in around seven countries already, and will likely move towards global trading in each of its markets. It is not inconceivable that these trends will eventually make trading in foreign stocks as easy and as cost-effective as trading in local stocks.

- Entry by large investment banks

Initial forays into online trading have largely been made by newer financial institutions or by smaller discount brokers. However, as the tremendous power of the internet to drive trading becomes evident, the larger investment banks are beginning to sit up and take notice. It is likely that larger financial institutions such as Goldman Sachs, Merrill Lynch and Paine Webber will begin providing online trading (and IPO distribution) services soon, either through joint ventures or through acquisition of existing online brokerages.

- Creation of an investment extranet

Many investors in the UK entrust their investment decisions to an independent financial advisor. While IFAs usually have efficient in-house systems for managing portfolios and keeping records, these are not usually linked to trading sites. It is possible that trading sites could deliver portfolio information, transaction records, tax information etc. via an extranet to both IFAs and investors, making tracking and management of personal investments easier. This could be linked with the government's initiative to enable internet submission of tax returns.

- Development of trading services into communities and brands

While there are a number of financial portal sites in the UK (including ESI, iii, MarketEye, Hemmington Scott, Moneyworld, and FTQuicken), these have remained largely distinct from online trading services. At present there are only tentative links (such as Market-eye's links to James Brearley & Fastrade, or Schwab's sponsorship of the FTQuicken porfolio). It is likely that we will see these links develop into fuller relationships, and many online brokers will begin to transform themselves into financial portals through the addition of financial content, services, and community features. Firms that offer these features may be in a position to charge higher commissions as consumers will rate services on a 'value for trades' basis. In the US, Charles Schwab is investigating the possibilities of adding message boards and live chat capabilities to its site, blurring the distinction between stockbroker and financial community. There are significant regulatory concerns in this regard, although Schwab feels it is successfully treading around them, and a model for regulation of such an environment has yet to emerge.

 

Jay Marathe
Head of Consulting
Durlacher

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