| 23 September 2009

Summertime in the financial industry used to be anything but volatile. It wasn't all that long ago, for example, that most of Manhattan's financial centers would clear out for the entire month of August.

But this summer, much like last summer, online brokers have experienced a whiplash of activity. New account growth is slowing, activity is up, profits are down and regulators are hot under the collar.

This all comes at a time when the overall markets are performing well and money is reportedly flowing out of traditional money management firms and into online brokers as more investors ditch their advisers to go-it alone. But if money is flowing out of traditional firms and new accounts are slowing at online firms, then where is the money going?

Hang On Tight, Volatility Will Likely Increase

We know that brokers are, by and large, losing profit but gaining activity. We reported online broker results this summer and the refrain was similar. Charles Schwab (SCHW) saw slowing growth, E*TRADE Financial (ETFC) reported its eighth consecutive quarterly loss, TD Ameritrade (AMTD) saw their profits drop, as did Interactive Brokers (IBKR) and optionsXpress (OXPS).

Profits may be dropping, but activity is still on the rise. TD Ameritrade, Interactive Brokers and optionsXpress all saw an increase in trading activity. Schwab announced that it is adding nine new ETF products to its line-up to cater to more active investors. New mobile products and trading platforms were announced almost weekly to keep up with the demand brougth by more active traders.

Most interesting is that three investor education firms have been swooped up by online brokers in just the last three months. TD Ameritrade bought thinkorswim, optionsXpress bought Optionetics and MB Trading announced that it was buying WizeTrade. These acquisitions bring new accounts, to be sure. But more importantly, given the pace and depth of education offered by the educational firms, they bring a dramatic increase in speculative trading activity to the brokers. Whether this activity would have existed in the marketplace without a purchase, one can only wonder. But the combinations certainly indicate an interest in the direction taken by the education firms and bring more resources to bear on their capabilities.

Follow The Money

If trades are up and yet results are mixed then the question is, where is all this activity coming from? In an interesting article IBD's Doug Tsuruoka interviews Gabriel Dalporto, chief strategy officer for Zecco.com. According to Tsuruoka, Dalporto says that, "leveraged ETFs have 'consistently' been among the most popular trades for Zecco's clients. He says investors are keen on both long and short ETFs."

This is no surprise to us given the huge popularity of securities such as Direxion's 3X Bear (FAZ), consistently one of the most traded products in the markets. The problem for investors is that the risks associated with leveraged ETFs are often not well understood. FINRA issued a terse warning to brokers, cautioning that leveraged ETFs are only suitable for short-term traders familiar with the risks. They later backpeddled on those warnings.

The problem for brokers is that the costs are so low on these products, and the suitability risks so high, they make less money on each transaction and at greater risk.

Edward Jones, Ameriprise (AMP), LPL Holdings and UBS Investment Management (UBS) all pulled the products from their shelves after the FINRA warning, promting us to wonder if the whole category was about to implode. But then Schwab and Fidelity merely issued statements to account holders clarifying the potential dangers and suitability. Schwab called for investors to "proceed with extreme caution," and Fidelity declared the products for "sophisticated investors" only.

Warn all they want, leveraged ETFs continue to grow. In similar fashion, the foreign currency markets also continue to grow. In his article Tsuruoka quotes figures from research firm Aite Group that says average daily trade volume in the retail Forex market jumped 500% from 2001 to 2006, to $77 billion per day in 2007. The firm expects retail forex trading activity will hit $110 billion in daily volume by the end of 2009.

This increase in activity comes despite the new first-in first-out regulation created by the NFA that went into effect just over one month ago. Though we can't yet confirm this is the case, it appears that firms that couldn't meet these requirements simply shifted accounts off-shore. Other firms that could meet the requirements, such as GFT Forex, used the changes to establish additional credibility.

Likewise, traditional stock and options trading firms picked up activity if they introduced a forex platform this year. According ot Tsuruoka, "Dalporto says Zecco got a boost when it launched its 'Zecco Forex' trading platform in April."

The money, it appears, is flowing into ETFs and foreign currencies. We'll keep a close eye on the next round of earnings reports coming up shortly to see if this is, indeed, the case. If it is, and if leveraged ETFs continue to gain in popularity, we suspect volatility in the markets will increase accordingly and online brokers will continue to shift their strategies to meet these new demands.