The State of the Online Financial Services Industry

1735 Tiburon Boulevard Tiburon CA 94920 May 18, 2001 Dear Financial Services Executive: Tiburon Strategic Advisors is frequently contacted by senior executives seeking presentations of our industry research to augment management team offsite meetings, board meetings, strategic planning sessions, and other similar events. We call these Tiburon Market Seminars and we are proud to announce the newest addition to our growing menu of market seminar topics... The State of the Online Financial Services Industry The emergence of online financial services has been nothing short of phenomenal. The brokerage and investment management industry has never seen such an all-encompassing innovation that impacts the strategy of virtually every financial institution, and has opened the door for so many new entrants. In explaining this topic, Chip Roame, Managing Principal at Tiburon Strategic Advisors said, The online financial services industry is evolving very rapidly. While some players went down the path of online-only offers, the market has repeatedly proven that consumers are actually seeking multichannel offers where the web is an integral part, not a stand-alone offer. This market seminar offers Tiburon s view of how the web is drastically changing the playing field in the already rapidly growing and evolving investments industry. Tiburon believes that the future is bright for the industry as a whole and consumers are sorting themselves and their attitudes out on the web at a time when wealth is increasing rapidly. As a result, the web will drive the evolution of online brokers, full-service brokers, banks, and other industry players. Tamas Szarvas, Tiburon s lead consultant in this area added, In this market seminar, Tiburon can explain how the different segments of the industry, such as online brokers, full-service brokers, banks, insurance companies, mutual fund companies, and independent financial advisors, are reacting to the changing landscape. Tiburon s Managing Principal, and well-known industry expert, Chip Roame, can present this comprehensive research as a private briefing to your management team over the course of four to six hours. Together, you can interpret the data to gain strategic insights into how your firm can capitalize on this fast growing segment of the industry. This market seminar is appropriate for executives of all types of financial institutions as the online financial services industry is rapidly evolving to become an integral part of any successful financial services strategy. For more information or to schedule a Tiburon Market Seminar, please contact Krista Jenssen at 415-789-2540 or kjenssen@tiburonadvisors.com. Best Regards, Krista Jenssen Director of Marketing

-- MARKET SEMINAR RELEASE -- The State of the Online Financial Services Industry TIBURON, CA, May 18, 2001 Tiburon Strategic Advisors, a strategy consulting and market research firm, today released its newest market seminar topic, The State of the Online Financial Services Industry. Obviously the web is growing and evolving very quickly and Tiburon has many new insights to share. The market seminar is organized into a series of chapters: The Growing Use of the Web The Use of Online Financial Services The Replacement of Price With Other Competitive Issues in Online Brokerage The Economics of the Online Brokerage Business The Impact of the Web on Other Channels and Product Companies The Growing Use of the Web The ramp up of new internet users has been at a faster pace than the adoption of any other new media in the 20 th century. 34 million households now have access to the web and this is expected to grow to 107 million households by 2003, which is the equivalent of the entire US population today. This rapid growth in the web can be attributed both to the reduced cost of access and the improved quality of services available online. The demographics of web users are rapidly broadening. While the web using population was historically dominated by white males, we now see females web usage growing to 49%, or almost half of all users today. In addition, the age of web users is also increasing from the historically younger age groups to include older users. For instance, web usage by women 55+ years old grew by 98% between 1999 and 2000. 34 Million Households Have Web Access Today and 107 Million Will Have it by 2003 15 U.S. Households with Web Access (Millions) 34 107 1996 1999 2003 Note: There are only 108 million households in total today Source: 9/00 Red Herring; 7/28/00 HD Vest Meeting (Vest); 7/27/00 J.P. Morgan Research Report (IDC); 7/24/00 New York Times (Strategis Group; International Data Corporation); 12/6/99 The Industry Standard (Media Metrix); 7/18/99 Jupiter Communications (NFO Interactive); 7/12/99 New York Times (Commercenet; Nielsen Media Research); 4/12/00 The Wall Street Journal (Nielsen/Net Ratings); 7/31/99 Los Angeles Times (Forrester Research; Jupiter Communications; Family PC Magazine); 12/97 MSDW Research Report; Tiburon Research & Analysis The size of the World Wide Web is unimaginable to most. It is believed that as many as 550 billion documents are now stored on the web. However, despite this size, a relatively few web sites garner most of consumers attention. Interestingly, this concentration is actually increasing. Users are less curious, are becoming more experienced, and now tend to revisit only those sites that offer the best information. 2

The Use of Online Financial Services Online activities such as reading news, obtaining stock quotes, and researching investment ideas are quite popular uses of the web today and are expected to grow rapidly. 27% of all households use the web for these activities. However, financial advice and transactions on the web have a long way to go. Only 9% of all households use the web for financial advice or transactions. Banking and buying insurance online are expected to grow rapidly. For example, it is expected that by 2002, 37% of the population will be buying insurance online, 35% will be managing their finances online, and 23% will be banking online. However, the real excitement is in online brokerage There are currently 12 million online brokerage accounts and this number is expected to grow to 20 million by 2003. Online accounts are growing at about 40% annually. Along with the growth in online accounts is the growth in assets in these online accounts. Today there is more than $1 trillion in client assets in online accounts, and this is expected to grow to $3 trillion by the end of 2003. Online Brokerage Accounts Will Grow to 20 Million by 2003 1.5 2.2 Online Brokerage Accounts (Millions) 4.6 10.0 12.2 15.0 20.0 Dec-96 Dec-97 Dec-98 Dec-99 M ar-00 Dec-02e Dec-03e Trading volumes today average about 800,000 trades Note: Source: Online brokerage accounts are growing about 40% annually; ten million more consumers will come online in the next 3-4 years 9/00 Red Herring (Cerulli); 8/25/00 The Street.com Web Site; 7/28/00 American Banker (IDC); 7/28/00 HD Vest Meeting (Vest); 7/20/00 Gomez Web Site; 4/00 LightPort Presentation (Bentley) (Forrester Research, NASDAQ, IDC); 12/6/99 Business Week (Jupiter Communication); 7/12/99 The Wall Street Journal (Gomez Advisors); 5/16/99 New York Times (NFO Interactive); 11/30/98 Investment News(Forrester Research); Tiburon Research & Analysis per day. Many may think that day traders dominate online trading activity. However, it is not the day traders generating the majority of the activity, online investors contribute nearly two-thirds of all online trades. When we looked at the buying behaviors of online investors, we found several interesting behaviors. One was a significant trend towards online investors buying individual stocks, and very specifically, technology stocks. 44% of online investors have invested in internet stocks versus only 15% of investors overall. As we see online investing continue to grow, online account monitoring continues to be by far the most popular investor activity on the web. 71% of investors say that the adoption of the web has primarily influenced them to monitor their accounts more. In contrast, only 31% reported that they trade more because of web access. The Replacement of Price With Other Competitive Issues in Online Brokerage With the introduction of online trading came the beginning of the price wars and online trading commissions began their downward spiral towards zero. As online brokers battled for market share, we saw commissions fall dramatically. Commissions now seem to have settled in at around $14.95 per trade, however firms such as American Express are now even offering selected online trades at zero. With prices nearly at zero, online brokers are now facing a whole new set of competitive issues: 3

Information, Research, Tools, and Advice Offerings. Online brokers will compete on the amount and quality of the information, research, tools, and advice they offer to consumers on their sites. Here, they compete not only with other online brokers, but other news and search sites as well. Schwab s Smart Investor Center and E*Trade s Learning Center are good examples of strong offers in this area Commissions Will Continue to Come Down Note: Note: Source: 60 50 40 30 20 10 0 Average Commission Charged By the Top 10 Discount Brokers 1Q96 3Q96 1Q97 3Q97 1Q98 3Q98 1Q99 3Q99 4Q99 2000 2001 It is not entirely clear that discount brokers charge lower fees than full service brokers; three factors are worth addressing- bid/ask spreads, margin loan rates, and money market rates. For instance, a 100 share trade with an extra 1/8th spread at a $10 commission would really cost the client $135. Secondly, while average money market fund rates were 5.04% in 1998, Datek s was paying 3.50% and Ameritrade was paying 2.00%. We expect that pricing on institutional business will also be realigned with the traditional 6 cent/share giving way to a charge for research and a lesser charge for execution 3/13/00 Barron s (Credit Suisse First Boston; Piper Jaffray, Jupiter Research); 10/99 Registered Representative (IBC); 9/27/99 SG Cowen Conversation (Heald); 2/22/99 Business Week (Credit Suisse First Boston); Tiburon Research & Analysis Product Range. Online brokerage firms will need to continually broaden their product offerings to compete. For example, Schwab and E*Trade have added IPOs, banking services, mortgage lending, insurance, and are now sorting out one of the newest product innovations resulting from the web - stock baskets or folios Ease of Use. Ease of use can range from a variety of financial benefits awarded to the consumer to the look and experience of the web site. Offers include no minimum deposit to open an account, easier and quicker account opening processes, quicker funds transfers, and easy downloads of account information. Aggregators are getting a lot of attention as they struggle with the ultimate ease of use offering which is to provide consumers with a consolidated view of their entire financial situation Reliability. Reliability of web sites received a lot of attention in early 1999 when E*Trade was crippled during trading hours and had several shut downs. Consumers expect their online brokers sites to have continual reliability and speed to keep up with the market Customer Service. Consumers who trade online still want to have easy access to help. Consumers reported that customer service is their number one criteria for selecting a broker. E*Trade lost focus on customer service in 2000 which resulted in losing the top spot in the Gomez rankings. Schwab has responded with its Signature Services initiative to add dedicated customer service to its valued clients Channel Multiplicity. Whether a firm s roots are in discount brokerage or full-service brokerage, it is imperative that they come to understand that the future is not about advice or the web, but rather about advice and the web. Successful firms will have a branch system, call centers, and online access. Even the online only firms have realized this and have begun efforts to build-out their multi-channel offers. For example, E*Trade has gone from declaring that it was an online-only, single channel firm to opening a branch, putting kiosks in Target Stores and Oracle office buildings, purchasing an ATM network, and creating an alliance with Ernst & Young to deliver advice through its CPAs A wide variety of ranking firms rank a number of online brokers. There are over 100 different online brokerage firms now and about 21 different ranking firms. The leading 4

ranking firms are Gomez Advisors, Forrester Research, Gartner Group, Tower Group, Jupiter Communications, and Dalbar. The leading consumer finance publications like Money, Smart Money, and Kiplinger s also rank the online brokers. Amongst these experts, there is a wide variety of factors that are important, with the most common ranking criteria being content and cost. But, in the end, it is all somewhat of a game. With a little insight, it appears that one could manage to place highly in each survey. Tiburon found that once one sorts through all the details, the rankings are understandable and easily teachable to firms looking to obtain higher rankings. That said, after reviewing the work of most of the experts in the industry, Tiburon still felt the need to solve the question of which web site was best, so we undertook our own review. Our summary conclusions about the sites were: Charles Schwab offers by far the best educational center for investors, amongst the sites we evaluated. Schwab offers interactive learning as well as thorough coverage of most investment areas. We think Schwab is really trying to make the average consumer a smarter investor Fidelity offers the most comprehensive retirement center. They introduce this section of the site with a long discussion about why retirement planning is important. They focus on many different age groups; every age category can find answers to their questions. Finally, Fidelity offers consumers a great selection of retirement products E*Trade offers the best account aggregation. E*Trade does a very good job of combining banking and brokerage accounts onto one statement Datek offers the best personalization capabilities for traders. The ability to get news sent via email on specific companies the customer selects is very helpful. Also we thought the feature that automatically displays significant changes in a customer s account the next day to be very helpful for investors Yahoo offers the most comprehensive mutual funds center. They offer a mutual fund screener that is the best we ve seen. It allows consumers to pick out the top performing funds no matter what their preferences are. Yahoo displays mutual fund research by Morningstar, offers a mutual fund calculator, and also a prospectus finder MLDirect, a recent entrant, offers the best analyst research. Also, Merrill s stock screener makes picking and evaluating stocks a lot easier The Economics of the Online Brokerage Business Projections suggest annual growth of at least 34% for web-based consumer financial services over the next four years, growing to nearly $435 billion. All sectors of the online financial services industry are expected to benefit. Online brokerage commissions specifically are expected to grow to $3.5 billion by 2002. Many of us remember when Schwab s market cap passed that of full-service firm Merrill Lynch in 1998. Today, although the online brokerage firms are younger and smaller, when compared to the brick and mortar full-service firms, online brokers have higher valuations per employee. For example, E*Trade has a $3.3 million market cap per employee, while Goldman Sachs has $2.2 million per employee, Morgan Stanley has $1.2 million per employee, and Merrill Lynch has only $0.5 million per employee. However, the economics around the online brokerage business are widely misunderstood and evaluating the business prospects of this industry segment can be 5

quite tricky. Online brokers make money from three different sources: 1) commissions, spreads, margin interest, and fees from proprietary money market and mutual fund balances primarily paid by the customer; 2) payment for order flow paid by the market makers; and 3) shareholder accounting fees paid by mutual fund companies. This breakdown helps to explain why day traders are considered the most lucrative clients in the online brokerage market. They trade frequently, which generates revenues from commissions, but also generates revenues from the market makers as payment for order flow. Furthermore, most day traders often have margin accounts, providing another source of revenue. The online brokerage firms heavy reliance on transactions may be dangerous. In the second quarter 2000 alone, transaction volumes decreased by 20%. Unfortunately, the future does not look bright for the online-only offers. Recently, all online brokers have seen revenues per online brokerage account decline due to smaller average account sizes and lower commissions. For instance, in 1996, average revenue per online brokerage account per year was approximately $1,200; as of 1999, the average revenues per online brokerage account fell to approximately $500. Additionally, the new demographics of online financial services will cause the averages to trend even further downward as new clients are younger, have lower incomes, and have less investable assets. Finally, several online services, such as online brokerage, online auto insurance, and online credit card services are experiencing margin erosion as prices continue to come down. And, acquiring new customers is quite expensive. For example, in 1999 it cost E*Trade an average of $250 to acquire each new customer, and just a year later in 2000, that cost had risen 16% to $290 per Source: customer. Evidence again suggests that a multi-channel offer versus online-only may be the solution. And the Reason is Clear, Acquiring a Customer For Online Brokers is Expensive, E*Trade's Costs are Rising Customer Acquisition Costs (Dollars) $246 + 16% 2Q/99 2Q/00 8/1/00 E*Trade Web Site; 7/20/00 Gomez Wire; Tiburon Research & Analysis The Impact of the Web on Other Channels and Product Companies Beyond online brokerage, all other industry participants in the brokerage and investment management industry will need to sort out their web strategies: Full-Service Brokerage Firms A new type of investor, called validators, has emerged and grown very quickly over the past decade since information has become more plentiful. Validators are a blend of the investor who wants to do it him/herself (the traditional discount brokerage customer) and the investor who wants to delegate his/her investment decisions to someone else (the traditional full-service brokerage customer). As the discounters continue to expand their $286 6

help and advice offering to reach these validators, and full-service brokerage firms add online trading capabilities and fee-based brokerage accounts for the same purpose, the two industries are on a collision course to creating the same firm. Schwab has even declared itself a full-service brokerage firm! The full-service brokerage firms are responding to the discounters success and are at varying stages in developing their online brokerage capabilities. There seems to be three stages to this development. First, all brokers go through the information, research, and tools phase (for example, this is the status of Smith Barney). In this phase, the brokers create a web site to accommodate customers and offer them information. The second stage is to offer online As a Matter of Fact the Online Brokers, Discounters, and Full Service Firms are Beginning to Aim for the Same Clientele Age Bracket Source: Under 35 35-45 45-55 55+ Less than $50,000 Competitive Positioning 7/10/00 Sanford Bernstein Presentation; Tiburon Research & Analysis $50,000- $250,000- $250,000 $1 Million Investable Assets $1 Million+ trading only within fee accounts (for example, Prudential and PaineWebber are at this stage). The final stage is a true online trading phase which means that the firm offers everything in both stages one and two, and also stand-alone online trading like the discounters and online brokers (for example, Morgan Stanley and Merrill Lynch have stand-alone online offers today). It is not imperative that full-service firms go to stage three. Frankly, most will struggle and find it unprofitable. But stage two is essential. Merrill s Unlimited Advantage account, a fee-based brokerage account that offers online trading, is an example of stage two and has been a huge success. The fee works for consumers and the annuitized income stream works for brokers. Consumers confusion over the differences between discretionary fee-based accounts and fee-based brokerage accounts may have actually helped Merrill s Unlimited Advantage program to be so successful. Retail Banks Banks have come a long way in their move to the web. All of the twenty largest consumer banks now offer online services. This shows that the largest banks recognize that developing a multi-channel offer is critical to success. And, online-only banks have learned that they need to have some type of physical presence to succeed. For example, E*Trade Bank purchased an ATM network; several online-only units have been pulled back into their parent organization and repositioned as a channel; and Directbanking.com, another online pure-play, recently opened a branch in Boston. These moves make it clear that consumers want multi-channel offers. Secondly, the emerging trend is the move towards a full-service financial supermarket accessible online, where banks are beginning to combine banking services with online brokerage and insurance. For example, First Union purchased Professional Direct Agency to move into online insurance. More impressively though, as banks lose more and more of their customers and assets to online brokers, adding online brokerage to 7

their current offer is becoming the required model. It is expected that the percentage of major banks offering online equity trading will skyrocket from 10% in 1998 to 86% by just 2002. Mutual Fund and Insurance Companies Mutual fund and insurance companies have been slow to the web. Mutual fund companies may have taken their eye off the ball as it pertains to the web. Most have weak strategies and have long lost substantial client relationships to the supermarket model. However, mutual fund company clients are moving to the web at a rapid pace. At the end of 1998, 34% of mutual fund owners visited these sites, and at the beginning of 2000 this number climbed to 47%. The Percentage of Major Banks Offering Online Equity Trading Is Expected to Skyrocket From 10% to About 86% By 2002 Top Fifty Banks Which Offer Online Equities Trading (Percent) 10% Source: 4/15/99 Securities Industry News (Data Monitor); Tiburon Research & Analysis 86% 1998 2002e Meanwhile, mutual fund companies have been focused on wireless delivery methods; almost two-thirds of mutual fund companies are planning to add wireless internet services over the next year. These convenience devices, however, don t provide the fund companies with a good distribution mechanism. And while innovating in the wireless arena, mutual fund companies have been attacked by a wide variety of new web-enabled investment products (ETFs, folios, and online separate accounts) seeking to dethrone them as the investment product choice of today s investors. Life insurance companies have struggled the most with the web and could possibly have the most difficult obstacles. Life insurance and annuity products seem to be less appropriate for online commerce because of their complexity. Additionally, leveraging an agent force into an e-commerce strategy is challenging. Insurance companies also have the added burden of being in a state-regulated industry. That said, the web is starting to change the insurance industry at an unprecedented pace. Savvy insurance companies are hurdling these obstacles to ensure their survival and are attempting to compete with banks and brokerage firms. Both mutual fund and insurance companies need to catch up with their web distribution strategies to compete with the brokerage firms and banks who are quickly widening the competitive advantage gap. Registered Investment Advisors The registered investment advisor community has not yet widely embraced the web. RIAs claim to use the web for a variety of activities such as, 80% use the web to do investment research, 74% use the web to communicate with clients, and 62% use the web to download custodian forms. However, the potential of the web for this cottage industry seems entirely underutilized. 8

Surprisingly, only 56% of RIAs today have a web site themselves. RIAs are still using the traditional methods of marketing and communications, such as brochures, toll-free numbers, and newsletters. A few RIA firms do have impressive web sites that can be used as an example. Condor Capital, a fee-based advisory firm has a web strategy that includes providing a market databank, top holdings of the firm, a customized stock ticker, and several useful calculators. This strategy is a great way to provide customers with the research and information they are seeking. Surprisingly, More Advisors Have Brochures, Toll Free Phone Numbers, and Even Newsletters than Have Web Sites Though Brochure Toll Free Telephone Number Regularly Published Newsletter Marketing Materials Across All Independent Advisors There is a tremendous amount of potential in this market for using Web Site 56% the web. For example, RIAs should be able to do trading and Source: 12/00 Proprietary Tiburon/Rydex Benchmarking Tool Survey; Tiburon Research & Analysis administration over the web which could lower operating costs. Other examples include, posting client statements, online planning with clients, and access to new web enabled investment opportunities such as ETFs, folios, and online separate accounts. So much potential! 58% 62% 72% **************************************************************************************************** Tiburon Strategic Advisors Tiburon Strategic Advisors, based in Tiburon, CA, was formed in 1998 to offer market seminars, market research, and strategy consulting to financial institutions, investment managers, and financial advisors. The firm has served over 100 corporate clients and completed over 275 research and strategic planning projects in that period. The firm s knowledge base ranges from the RIA market to online financial services, bank/broker mergers, mutual fund distribution, and alternative investments. Visit Tiburon at www.tiburonadvisors.com. 9