Schwab Puts It All Online Schwab bet the farm on low-cost Web trading and in the process invented a new kind of brokerage.
By Eric Schonfeld Reporter Associate Eileen P. Gunn

(FORTUNE Magazine) – Deep in the bowels of Charles Schwab's San Francisco headquarters, in the offices of its electronic brokerage division, there is a glass cabinet containing the relics of the company's past forays into cutting-edge technology. The Pocketerm, a clunky hand-held device that downloaded stock quotes through an FM receiver, dates back to 1982. Schwabline, a terminal that gathered market data over a phone line and printed it out on a roll of adding-machine paper, was state of the art in 1986. There are also souvenirs of online-trading experiments, including boxes of software with names like the Equalizer and StreetSmart. What you won't see in this technological curiosity cabinet, however, is the latest product in Schwab's long line of technology gambles: its investing Website, The Web venture has turned out to be most conspicuously not a dead end for Schwab. It represents arguably the most successful embrace of E-commerce by any major corporation outside the technology industry. And its story is an object lesson in how the Net can transform an entire enterprise.

To anyone who knows Schwab mainly by its bustling branch offices or by its scrupulously efficient phone reps, it's startling to learn how deeply the Internet has infiltrated the company's business. Three years ago Schwab's exposure to the Web was zero. Now more than $4 billion worth of securities are traded every week on Schwab's Website, well over half the company's total trading volume. That easily makes Schwab the No. 1 Internet brokerage; its 30% share of daily trading volume roughly equals that of its next three online competitors combined (E*Trade, Fidelity, and Waterhouse Securities). Of its 5.5 million customers, two million are active Web investors, who collectively account for about a third of Schwab's $433 billion in customer assets. An amazed Charles Schwab says about the Internet's impact on his business, "We are just beginning to grasp what it is."

Part of the impact, of course, has been lower prices. To compete with other Internet brokerages, Schwab dropped commissions to a flat $29.95 for most online transactions, compared with the $80 it used to get for the average trade conducted through a live broker at a branch or over the phone. But that is hardly the whole story. After all, Schwab's online commissions remain considerably higher than those of Internet competitors like E*Trade and Ameritrade, with their cut-rate $15 and $8 commissions.

No, the truly surprising effect of has been to make Schwab much more of a threat to its traditional foes, the full-service brokers. "Price is not the transforming event," explains Schwab co-CEO David Pottruck. "The transforming event is the ability to deliver personalized information to the customer in real time, at virtually no cost." In other words, the Web finally lets Schwab--the original no-frills discount broker--get into the advice game.

One more thing. It's important to recognize that Schwab's Internet success did not occur by accident. It happened because last fall co-CEOs Schwab and Pottruck were willing to bet their company's future on the Web's transforming technology. They couldn't know for sure how their actions would turn out; all that their research told them was that lowering prices to compete on the Web would cost them as much as $125 million in forgone revenues, and they knew such a hit would draw plenty of fire from Wall Street. The alternative, however, was to risk ending up on the wrong side of history.

But we are jumping ahead of our story. The first chapter in Schwab's journey into E-commerce opened in late 1995 with a series of messages to chief information officer Dawn Lepore from one of her research groups. The group, she remembers, wanted to show her some experimental software that would allow Schwab's different computer systems to talk to one another. It was the sort of project that software designers love: challenging, technically complicated, and intended to solve such an obscure problem that it was difficult to explain its merits to anyone but other techies. So, prior to inviting Lepore to see it, they cobbled together a separate piece of front-end software that would show one possible application out of many. Lepore scheduled a demonstration and brought along one of the company's biggest technology nuts, Schwab himself.

As it turned out, the application the engineers chose was a very simple Web-based stock trade. Their program allowed a Schwab server to take an order from a Web browser on a PC, route it through all of Schwab's sophisticated back-end systems and mainframes, execute it, and send a confirmation back to the PC. At the time, most existing Web trading systems required that orders be printed out and entered by hand into another system, sort of defeating the point of automated trading. Lepore's computer researchers were less interested in online brokerage than in winning Lepore's approval to continue work on their obscure middleware project. But Lepore and Schwab instantly recognized the implications of the patched-together demo. Says Schwab: "I fell off my chair."

Within weeks an independent project team was assigned to get Web trading up and running at Schwab. The leaders included Schwab executives and an Israeli engineer named Gideon Sasson, whom Lepore had hired away from IBM to be the team's head of technological development. Working in secrecy at first, the team grew to 30 people and evolved into a separate electronic-brokerage unit, called e.Schwab, that bypassed Schwab's normal hierarchy and reported directly to Pottruck.

A handful of deep-discount brokerages, such as E*Trade and Ameritrade, were racing to perfect Web trading at the same time. "We had to figure out how to compete with these small brokerages," says Pottruck. "So we needed a group that felt like they did: nimble, unshackled from the larger bureaucracy." And indeed, the early days were packed with intense, freewheeling meetings in which everyone fit into one room and could shout ideas back and forth. But there was also an element of caution in e.Schwab's quarantine from the rest of the company. Says Dan Leemon, head of strategy: "We created e.Schwab because we wanted to learn. But we did not want to risk the whole company."

By the middle of 1996, e.Schwab was ready. Investors had to send in a physical check (or wire transfer) to open an e.Schwab account, but after that they could trade any security available through a regular Schwab account--stocks, mutual funds, options--by logging on to e.Schwab's Website. And instead of Schwab's usual sliding scale of commissions--bigger commissions for bigger trades, with a minimum of $39.95--they would pay only a flat $39 (quickly dropped to $29.95) for any stock trade up to 1,000 shares. The only publicity for the launch was an announcement at the annual shareholders' meeting.

Despite the lack of fanfare, the new service was an immediate success. Says Sasson: "We were totally unprepared. Customers began voting with their keyboards, and in two weeks we reached 25,000 Web accounts--our goal for the entire year." By the end of 1997, all online accounts, both at e.Schwab and at regular Schwab, had grown to 1.2 million. Online assets mushroomed 94%, to $81 billion, about ten times the assets at E*Trade. Schwab executives were ready to declare victory.

For customers, though, the online brokerage's independence had a downside. Regular Schwab phone reps and branch officers could not help e.Schwab customers; except for one free phone call a month, all questions had to be addressed to e.Schwab via E-mail. If you couldn't part with the option of speaking to a human, you could keep your regular Schwab account and still trade online. However, you got only a 20% discount off the regular Schwab commission schedule.

Not surprisingly, the double standard didn't sit well. Schwab's phone and branch representatives, the employees in direct contact with customers, were beginning to report that not everything was so peachy. The dual pricing structure confused and annoyed clients. The problem only got worse as online trading grew, forcing more and more Schwab customers to choose between service and price. "So here we were, the No. 1 player, but we had customers who were not happy," says Pottruck. "That's not a way to build a huge business success."

Someone had to make a tough call, and as usual, the job fell to Pottruck, a 27-year financial services veteran who is Chuck Schwab's day-to-day general. Pottruck certainly looks like a man born to tough calls. He has a wrestler's physique topped with a rather menacing broken nose, courtesy of his days on the mat at the University of Pennsylvania. But the looks are misleading: The man talks management strategy like a McKinsey consultant, drinks phantom lattes (decaf with nonfat milk), and speaks with a disarmingly soft, lilting voice.

It was obvious to Pottruck what the customers wanted: no more e.Schwab, no dual pricing, and $29.95 Web trades for everyone. Web trading would be good for Schwab too: It is the cheapest, fastest way to enable millions of people to invest at the same time. But switching to one low online commission could cost Schwab heavily. Commissions make up nearly half the company's revenues, and chief strategist Leemon calculated that dropping the price would reduce revenues by a staggering $125 million, even allowing for the additional assets and heavier trading volume the lower commission might occasion. Wall Street was not likely to react kindly to that kind of sales hit. And since employees own 40% of the stock, neither would Pottruck's colleagues.

After grappling with the decision for most of 1997, Pottruck made the case to Schwab in a series of conversations in the boss' office that fall. Pottruck told Schwab that he thought it was time to move to one-price Web trading, but he wanted to lay everything on the table and make sure the two of them were in agreement. As Pottruck recently recalled (and Schwab confirmed), the series of exchanges boiled down to this:

Pottruck: "We don't know exactly what will happen. The budget is shaky. We'll be winging it."

Schwab: "We can always adjust our costs."

Pottruck: "Yes, but we don't have to do this now. The whole year could be lousy. And the stock."

Schwab (after a fleeting pause, while he thinks of his 52 million shares, worth some $2 billion): "This isn't that hard a decision, because we really have no choice. It's just a question of when, and it will be harder later."

Now there was only one major issue left that Pottruck had to resolve: how to merge the fiercely independent e.Schwab team into the rest of the organization. The e.Schwab managers did not seem particularly eager to hasten the transition, but Pottruck needed them to make the strategy work. Pottruck had already started moving people around and was looking outside for a seasoned executive to head up the electronic-brokerage unit. But Sasson came to Pottruck and asked whether he could throw his hat into the ring. In the end, he got the job. It was the first time in Schwab's history that anyone besides a CIO had moved from a technical to a general-management position.

Sasson turned out to be highly qualified to merge Net anarchy into Schwab's buttoned-down culture. He was already responsible for a companywide relaxation of the dress code. After Sasson's suggestion that it would help slightly in recruiting from Silicon Valley, Pottruck agreed to a country-club-casual dress policy but insisted that jeans, sneakers, and sweatshirts would still be unacceptable. A year later Sasson came back and said, "We want our jeans." Pottruck hated it, but he caved in again, simply admonishing people, "Please cover your body parts."

While it was important to support Sasson and his group, it was also important not to alienate the rest of the company. The strategy was to integrate the Web into Schwab--not to bulldoze all of Schwab's bricks-and-mortar branches and call centers in favor of the Web. Even so, Lepore, as head of all the company's technology efforts, listened to a lot of non-Web employees grumbling that the electronic-brokerage division got all the money and the nicest office space. "We had to tell the branch people we were not choosing the Web over them," she says. Among other things, Lepore gave Web access to Schwab's 4,000 branch and phone reps so that they too could see the technology's benefits (and log on to the company's internal Website, SchWEB).

Finally, on Jan. 15, 1998, Schwab was ready to step into its future. As anticipated, dropping online commissions across the board initially hurt both revenues and profits. By the end of the first quarter, the average commission for the company as a whole had sunk to $57, from $63 the quarter before. Revenues dipped 3%, to $604 million. And earnings came in $6 million short of expectations, at $68 million. The stock fell 9% on the day of the earnings announcement.

Schwab has been able to make up most of its shortfall, however, through productivity gains and lower costs. Many of those savings came from improvements in Schwab's traditional telephone technology, but others were unexpected benefits of switching business from the phones to the Web. For example, the number of trades Schwab handles per day has doubled over the past two years, but the number of telephone calls has stayed relatively flat. Reason: The Web now handles five times as many trades as the call centers. "I call that the Web dividend," says CFO Steve Scheid, who estimates that it adds up to about $100 million a year in savings. Without the efficiencies of electronic trading, Scheid says, Schwab would have had to build four new call centers and hire 1,500 more people. As of Sept. 30, quarterly revenues were $100 million above the first quarter's level. Today the stock is at $50, up from $37 the day after the disappointing first-quarter announcement.

It was a shock to some Schwab veterans that, after taking the revenue hit, the company did not bother to advertise the Web price cut. Many of the senior people at Schwab came out of the old discount business, where price drops were promoted aggressively. But Len Short, head of advertising, was afraid that focusing on $29.95 would validate price as the most important factor in online trading. Having previously worked on MCI's "Friends & Family" ad campaign, and on AT&T ads before that, Short was all too familiar with the damage that price wars can wreak. (Besides, Schwab didn't have the lowest price.) So Schwab's marketing treats the Internet as just one of three channels investors can access for great service.

Therein lies perhaps the most surprising lesson of Schwab's Internet gamble: What makes it work is service. Yes, price matters a lot to the active traders who were the early adopters of Web trading. But the great center of the market, where Schwab makes its money, cares less about what is fast, cheap, and cool than about what is simple, reliable, and--especially--informative.

"The world before the Internet was one where few had access to information," explains Sasson. "And the rest of us had to listen to them." The Internet has the power to change all that by democratizing the distribution of investment information. On Schwab's site you can look up real-time quotes, news, historical financial data, or use sophisticated software tools. You can customize the home page to see your personal account when you log on. You can set up your own asset-allocation model, screen for the best-performing mutual funds that fit that model, and then buy the funds through Schwab. Who needs a broker? Any investor with a modem and a Schwab account now has at his fingertips much of the information for which he used to have to pay full-freight commissions to Merrill Lynch or Prudential. "The help and advice we are giving to customers over the Internet is the most profound change the company has ever gone through," says Pottruck.

One kind of assistance that Schwab cannot generate itself, however, is Wall Street stock research--buy, sell, and hold calls on individual stocks. So Schwab set out to provide them from another source. About a year ago Schwab started talking to First Call, a research firm partly owned by a consortium of major brokerages, which distributes analyst reports from every leading Wall Street firm to institutional investors. In an apparent coup, Schwab signed a contract last December that it believed guaranteed it access to First Call's research. At the last minute the full-service firms in the consortium woke up to what First Call was planning and forced it to renege on the contract. Just last October, however, Schwab announced that the investment banks Credit Suisse First Boston and Hambrecht & Quist would allow Schwab to distribute their research. (Unlike Merrill Lynch and other full-service brokerages, neither CS First Boston nor H&Q has an army of retail brokers.) In the long run, Schwab may add more sources of research, perhaps even from mutual fund companies with which it has strong relationships.

Schwab has also realized that a Website needs an attractive design to draw customers. In its early versions it was a mess, according to Julio Gomez, president of a research firm in Concord, Mass., that ranks online brokerages. (Check out his Website at Schwab's mutual fund area looked and felt different from the brokerage area, which was different from the content area. (That people were willing to put up with it says a lot about the power of Web investing.) In another departure from usual practice, Schwab went outside the firm for help, eventually settling on Razorfish, a Website-design firm in New York that Schwab's head of Web development, Tom Lawrie, calls "the keeper of the story." Razorfish gave all the areas on the site a consistent look and made them easier to navigate. The site, previously No. 20 in Gomez's ranking of online brokerage sites, jumped to No. 10.

As with all Websites, remains a work in progress. A desperately needed feature that is now being piloted will show investors the total returns on the securities in their portfolio. Also in development are more advanced, graphically rich E-mails that alert customers to such events as when their portfolios are not in balance with their asset-allocation models. Schwab hopes these touches, although they're automated, will strengthen its relationships with customers. It is even thinking about creating a personal-finance E-zine on the site.

All this may give Schwab a dramatic advantage in what is shaping up to be the fiercest battle in financial services: who will be the one-stop shop for people's finances. Citigroup and BankAmerica have already determined that size will be the decisive factor. But they may be wrong. "BankAmerica and Citigroup will say they have a financial supermarket that has everything," says CS First Boston analyst Bill Burnham. "But it is a communist supermarket." Like Moscow's old GUM department store, the big banks tend to offer only one line of products: their own.

Pottruck thinks the Internet makes that a liability. Online, after all, the competition's products are just a mouse click away. "Companies don't own the customer anymore," says Pottruck, "so trying to build walls around the customer is not going to work." In Schwab's view, the future lies with those that give customers the most freedom to make informed decisions. That's why Schwab is teaming up with search engine Excite and Intuit's to share content between Websites about retirement, investing, mortgages, taxes, and insurance. By consolidating as much reliable information as possible, and pairing that with a multitude of products, Schwab hopes to gain not only customers' loyalty but more of their assets as well.

Chuck Schwab has a vision of how people will handle their personal finances a few years out. "It is as simple as turning on your computer, and right there are all the pockets of your financial life on the screen," he says, "from your 401(k) and IRA to your brokerage and bank accounts." And guess where Schwab fits in: "We'll be the consolidator, the integrator. We'll be the utopia."