All the World's an Auction Now

The Net makes markets more efficient

By Christopher Farrell
Business Week

October 4, 1999

Nowhere has telecommunications and information technology had a greater impact than on the capital markets. European merchant bankers used carrier pigeon networks in the 18th century to get an edge on their rivals. Thanks to the telegraph, the ticker, and the telephone, stock trading in 19th century America went from a local business to a national one dominated by Wall Street.

In recent decades, financiers in industrial nations have poured trillions into building proprietary satellite and fiber-optic communications networks that span the globe. Walter Wriston, the former chairman of Citicorp (C) and a leading architect of modern electronic finance, once declared that "information about money has become almost as important as money itself."

Well, you ain't seen nothin' yet. The Internet is a revolutionary communications technology driving a global financial transformation. The change is being propelled by a series of simultaneous, self-reinforcing trends. The Web sharply lowers the cost of saving and borrowing; the pool of investment capital soars as more people gain a direct pipeline into the markets; financial innovators exploit new opportunities to create products and markets, which in turn further lowers the cost of capital; and so on in a dynamic dialectic. "The Internet hastens the speed of financial flows and the pace at which the world is getting smaller," says Jeff Bahrenburg, global investment strategist at Merrill Lynch & Co. (MER) Adds John J. Sviokla, partner at consulting firm Diamond Technology Partners Inc. (DTPI): "The Internet will fundamentally change the capital market system."

Click Here For Capital. At its most basic level, capitalism will work better than ever, thanks to a more efficient and open financial system. The capital markets are a dazzling social and economic institution for communicating all kinds of data, information, and knowledge through price changes. The more pervasive the financial markets, the more investors will find and fund profitable ideas bubbling up from university labs or garages. At the same time, they'll flee from failed management strategies with the click of a mouse. "The most significant effect of the Internet on finance is that it will greatly facilitate the efficient matching of borrowers and investors in the global economy," says Mark M. Zandi, chief economist at Regional Financial Associates. Put somewhat differently: "The Internet creates a larger pool of investors for entrepreneurs to tap," says Andrew W. Lo, an economist at Massachusetts Institute of Technology.

There is a rub. Financial crises reminiscent of the Asian contagion of 1998 are likely to keep erupting as the markets flow through more countries and pick up speed. Still, the new world of Internet-driven finance is altogether good news for economic growth. Sure, when markets are this liquid, investors can buy and sell securities on a whim, a rumor, a whisper. But there's an upside. As investors gain confidence that they can easily bail out of their investments, they become more willing to fund innovative companies with an uncertain payoff, such as a biotech startup or an e-commerce grocery store chain.

Liquid and open markets also give investors the power to drive change. For instance, when U.S. companies stumbled badly in the 1980s, investors put enormous pressure on managements to restructure their workforces, break down bureaucratic barriers, build an information infrastructure of computers, software, and telecom equipment, and focus on core competencies. In sharp contrast, Japan's financial mandarins continued to pour money into the profitless operations of established customers during the economy's decade-long decline during the 1990s.

Large markets allow investors to design a diversified portfolio so they don't have all their financial eggs in one basket. They also encourage financial engineers to create securities or strategies that protect against big swings in prices. It may be no coincidence that as average daily trading volume on the New York Stock Exchange soared from around 45 million shares in 1980 to nearly 800 million currently, the pool of venture-capital investment in entrepreneurial companies rose from $698 million in 1980 to nearly $19 billion last year, according to the National Venture Capital Assn. In roughly the same time, foreign direct investment by U.S. corporations grew from $215 billion to $861 billion in 1997, the latest figure available.

An efficient capital market can work wonders for economic development, too. Take the emergence of the U.S. economy in the 19th century. Commentators often attribute the American economy's rapid growth back then to new technologies, transportation innovations, and the opening of the West. But these same growth drivers were also found in Canada, Mexico, Brazil, Argentina, and other parts of the New World. Only the U.S. had a vibrant stock market and an intensely competitive banking system at the time. That financial system paved the way for a huge flow of investment capital from Europe to America. "The U.S. financial system was so good that the assets it generated appealed to foreigners," says Richard Sylla, an economic historian at New York University Stern School of Business. "The U.S. was the most successful emerging market ever."

Razor-Thin Spreads. It may take decades for the Internet to reshape finance around the world. But the signs of more efficient markets already abound. For example, banks can conduct online business with their retail customers at a fraction of the cost of more conventional channels. The banking industry's average cost per transaction is 1 cents on the Internet, vs. $1.07 at a branch, 54 cents on the phone, and 27 cents at an automated teller machine, according to Merrill Lynch. A recent Microsoft Corp. (MSFT) study estimates that switching the mortgage-origination process to a full-service Web-based electronic business could eliminate two of the three percentage points people currently pay in closing costs. One reason: Lenders would have easier access to data about borrowers. Another is that lenders could quickly bundle the loans together and sell them to investors. Forrester Research Inc. expects online mortgage loans will grow from $18 billion in 1999 to more than $91 billion in 2003.

Plenty of investors have already seen the Internet light. Online trading accounted for 37% of all retail trades for the first half of 1999, according to Stephen C. Franco, research analyst at U.S. Bancorp Piper Jaffray, up from 30% in the second half of 1998. That's partly due to cheap commissions--online individuals can get in and out of markets at a razor-thin price. "The trend is toward individuals trading at pennies per share," says Spenser Segal, vice-president for interactive strategy at American Express Financial Advisors.

The competitive pressure on financial institutions to bring down costs is relentless. One innovation likely to take hold in the next several years is the emergence of Web-based "aggregators" that will automatically allow individuals to simultaneously monitor all their financial relationships, from their 401(k)s to their mortgage loans and their money-market mutual funds. Somewhat further off are programs that will continuously calculate an individual's net worth by keeping track of all assets and liabilities. These programs will even search the universe of financial institutions for the highest-yielding money-market rates and lowest-interest mortgages or warn when a desired asset allocation is out of balance, says Stuart Madnick, professor of information technology at MIT.

As investing moves to the Internet, traditional Wall Street firms may soon be joined by some high-tech outfits. "The Internet is changing the face of financial services more rapidly than we imagined," says Sharon Osberg, executive vice-president of the online financial services group at Wells Fargo & Co. (WFC) "And everybody is our competitor, including AOL (AOL), Yahoo! (YHOO), and Intuit (INTU)."

High-tech competitors aren't just competitors, though. They are catalysts for much of the Internet wealth being created. Internet companies are coming to market every week in Britain, Australia, and Scandinavia. Germany's equity market appears more hospitable than before to small high-tech firms, and there could be plenty of room. A recent study by the Italian Treasury estimated that information technology made up 3.6% of America's gross domestic product, vs. 2.9% in Japan, 2.4% in Germany, and 1.5% in Italy. "As these gaps narrow, the other G-7 countries could experience growth rates in the information technology sector comparable to the U.S. after 1992," says David Hale, economist at Zurich Financial Services Group.

The end result will be phenomenal investment sums available in the Internet Age. In 1980 the world's stock of equities, bonds, and cash totaled some $11 trillion; by 2000 these financial assets will total some $78 trillion, estimates Lowell Bryan, director at McKinsey & Co.

Virtual Roadshow. In this environment, financial institutions are understandably shedding their traditional aversion to taking risks--at least with their strategies. Bank of America, the nation's largest bank, bought a 5% stake in E-Loan Inc. (EELN) by handing over its 80% piece of to the online mortgage lender. Goldman, Sachs & Co. (GS) owns a hefty stake in Wit Capital Corp. (WITC), which has pioneered distribution of stock to individuals over the Net. Even the New York Stock Exchange plans an initial public offering.

Perhaps the most significant impact the Net will have, however, is in the way new securities are sold. While Wit is reinventing initial public offerings for stock, Lehman Brothers Inc. (LEH) and other investment banks are using the Net to distribute information to potential investors, conducting "virtual" roadshows for IPOs online. And there is a move toward Internet-based open auction systems, somewhat akin to eBay Inc. (EBAY) W.R. Hambrecht & Co., a California-based investment bank, has auctioned two IPOs on the Net. As a result, the companies were able to raise the maximum amount of capital, rather than settling for a price that was half the closing price at the end of the first day of trading.

As all these trends play out, the fundamental structure of the capital markets will be more consistent. There have long been two competing models of financial organization: the Anglo-American freewheeling, capital market financial system and the Continental bank-dominated system. The bank system works well when information about business enterprises is costly to acquire. Now that is changing. "If the cost of acquiring and disseminating information falls, then the advantage of the German model falls, too," says V.V. Chari, an economist at the University of Minnesota. "Decentralized markets with widely held ownership is the way the world will work."

The spread of market-based finance is pressuring companies and governments toward greater openness and transparency. The demand for information by global investors is nearly insatiable in a market-dominated system. The financial world is increasingly hostile to closed-minded bureaucracies, which can be troubling to both companies and insular governments. "As we all become more accustomed to information available to us immediately, we all will expect a very fast response, too, especially shareholders," says Patrick McCormick, partner with Arthur Andersen's finance solutions business team.

Governments may be the slowest to come to terms with the new world, though. The same technologies and financial innovations that promote the trade in goods and services across borders and enhance global risk-taking are also remarkably vulnerable to abrupt shifts in investor sentiment. Investors, panicked by the devaluation of the Thai baht in July, 1997, set off a terrifying series of currency, banking, and stock market crashes in the emerging markets of Asia, Latin America, and Russia by tapping a few keys on their computers.

Panic Button. Financial engineers and their powerful computers at hedge fund Long-Term Capital Management lost billions and nearly took down the global financial system when their highly leveraged bets went bad last summer. "The widening access to information on the Internet and the ability to act quickly on that information could lead to panics and crises," says William N. Goetzmann, financial economist at Yale University. But the Net will resist the traditional impulse by countries to seal off their borders to the free flow of capital. Government officials around the world will be forced to recognize Federal Reserve Board Chairman Alan Greenspan's tongue-in-cheek observation that "our productivity to create losses has improved measurably in recent years."

Nevertheless, the global financial markets are the marvel of the world economy. Yes, fortunes will be made and lost seemingly overnight as Internet-based finance becomes the dominant force in the world economy. Yet the real significance of finance is not--and never has been--money flow. The more individuals trade, the more innovative financial securities are created, and the more information becomes easily available, the better the capital markets work at their fundamental task. They transmit valuable knowledge about everything from how to organize a productive factory to government policies that encourage growth. When it comes to finance, the Internet is a force for bringing everyone hope for a better material life.

Copyright 1999, by The McGraw-Hill Companies Inc. All rights reserved.