The opportunities for institutional trading houses to profit from the Internet have received far less media attention than their retail brokerage counterparts. But consultants at Bain & Company argue that the former is leading the way online to lowering costs and boosting net income

Capital markets trading houses are leading the way for financial services firms in making the Internet pay. While retail brokers like Schwab and E-Trade hogged the limelight by using the web to drive sales growth, bulge bracket dealers have been the first to take substantial costs out of their operations by harnessing Internet technology. Companies like Goldman Sachs and Merrill Lynch have cut trading costs by moving treasury customers on line. Their success will become the standard by which their broker competitors, and players in other sectors, are judged.

Stock traders that use electronic communications networks to complete trades electronically may tout moving 40 percent of all NASDAQ trades onto the Internet. But treasury traders at big institutional trading houses are quietly trumping them. Goldman Sachs now conducts 75 percent of its treasury trades online, and Deutsche Bank is not far behind with 70 percent.

More importantly, these players are reaping the cost benefits of online trading. Goldman Sachs and Merrill Lynch have made cutbacks on their government sales desks that appear attributable to recent investments in automation. Also, the coupling of Bank of America's recent announcements of a $70 million investment in e-commerce initiatives and of 10,000 lay-offs suggest it too may be cashing in on web-enablement.

Internet-based technology is linking institutional customers directly to the dealers' back-office, so that order entry, portfolio tracking and account management can all be done automatically. Not all front office applications interface perfectly with back office systems today. Yet as technical wrinkles are ironed out, we can expect to see transaction costs cut by 15 percent a year for several years, according to Credit Suisse First Boston. As these savings impact prices, bulge bracket firms that have been slower to embrace web technology will suffer, unless they act swiftly to catch up with the leaders.

Bulge-bracket dealers were the first horses off the blocks in a race for web-enablement among financial service providers. And they are streaking ahead. They are shifting their repeat institutional purchases (typically less than $100 million) online, freeing up traders to handle more complex, higher value trades. Other players have moved on-line successfully, but have yet to make their investments pay - think of the credit card companies like Capital One that services six percent of customer accounts online, but hasn't reduced its average servicing cost per loan. Or retail banks, who've migrated 20 to 25 percent of customers to bank online, but have yet to link this achievement to any branch closures or other cost reductions.

In Government bond trading, the race to streamline operations will probably be over within a year. After that, prices will start to fall. Why should a corporate treasurer pay $1,500 to place a simple order investing a surplus five million dollars in a bond? Cantor-Fitzgerald, the leading inter-dealer broker, has already cut commissions by 40 to 50 percent for its online offering, eSpeed. And Forrester Research projects that online broker spreads will fall to half those found offline in the high-yield and asset-backed markets. Any broker who hasn't found a way to use the Internet to take costs out of trading operations is going to be in trouble.

And there will be other races. Most large financial institutions have been spending $300–400 million per year on the Internet. Institutions need to start counting the cost of these investments, and looking for ways to make them pay. Otherwise, web-enabled competitors will undercut their prices and put them out of the running.

Why trading works online

There are three reasons why major dealers have become the first real Internet success story among established financial institutions. First, buying treasury services is straightforward. It's the financial services equivalent of buying a commodity. The product is easy to specify, customers understand it and they buy repeatedly. There's little a human being can add. This is in stark contrast to IPO products, which are more like buying a tailored suit. Here, customers need a lot of help before they decide to buy, making it hard to issue equity online. This is the prime reason for the failure of web IPO underwriters such as WitSoundView and W.R. Hambrecht's OpenIPO.com to establish themselves as lead transaction managers in the IPO market.

Second, before the Internet came along, the buying process was cumbersome. In the offline world, trading counterparts made an average of three telephone calls per trade. This labour-intensive approach frustrated both corporate treasury and money manager customers, so an overhaul was long overdue. For managers looking for cost-reduction opportunities, treasury trades were low hanging fruit. Now, simple transactions can be executed in a few thousandths of a second, freeing customers to focus on one-off and high value orders.

Third, web-enablement of the broker-customer interface comes at a perfect time to match up with straight through processing in the back office of many institutions. Some online transactions, like buying a mortgage, aren't particularly quick or cheap because the back-end—including income verification, a valuation report and legal checks—is still managed the old way. By contrast, online trading is the last in a chain of activities that can now be completed electronically.

Leaner, Fitter Brokers

Online institutional trading has arrived just in time. Web-enablement has already allowed some brokers to slim down ahead of the current economic downturn. In the last five years, Goldman Sachs' revenue grew by 30 percent per year, while headcount trailed this expansion, increasing at only 20 percent annually. While web-enablement won't mean firing the most sophisticated traders, recruitment will slow and the axe will fall on a combination of junior traders, trading assistants and sales people. The people who remain will shift away from small trades in highly liquid markets and focus increasingly on the highest value, most complex transactions in less liquid markets.

Over the next few quarters, we expect to see a wave of cost reduction announcements from the major dealers, as other areas that are moving online begin to deliver cost savings, and other types of trade become more streamlined. Likely candidates for headcount reduction are sales and trading staff in foreign exchange, corporate bonds and asset-backed securities. Pressure is mounting for the laggards. Financial institutions that are not achieving cost savings through web-enablement will find they can no longer compete as they lose today's lucrative profit sources—simple transactions that currently carry a high price tag—to their peers.

Managers trying to keep up need to do the following: First, work to transition the right customers onto the web. Target those with lowest value and highest volume. In the treasury market, for example, routine trades for corporate treasurers account for three quarters of transactions, but only a third of the market by value. Second, put in place both the front-office technology that clients expect and the back- office technology you need to service those clients. Systems such as Credit Suisse First Boston's Prime Trade software and Goldman's Web.ET are made available on clients' desktops, providing a direct link to the dealer's back office, for accounting and settlement purposes. Third, prepare for painful changes in your organisation. Cutting back on traders in a traditional trading environment can have serious impact on morale and, therefore, productivity. Look for ways to move talent to activities where employees add value to transactions, and then make the most painful changes quickly.

Time is of the essence on all fronts. During a period of intense technological change such as this, there is scope for some major shifts in market share towards those who catch on quickly. The starting gun has fired, its time to join the race.