Party Like It’s 1999: From ETrade to eToro
Plus: Nubank, Wirecard, What’s in a Picture?
|Marc Rubinstein||Mar 19||21|
Happy Friday and welcome to another issue of Net Interest, where I distil 25 years’ experience of investing in financial companies into a weekly email. If you’re reading this but haven’t yet signed up, please join over 15,000 others by clicking here. And to my regulars: thanks for spreading the word.
Party Like It’s 1999: From ETrade to eToro
Towards the end of 1999, two authors published a book called Dow 36,000. Over almost 300 pages, they laid out a view that the Dow Jones index would go on an almighty run. From an already elevated level of around 10,000 at the time of publication, they projected that the index would rally to 36,000 over the next few years. Needless to say, it didn’t.
Over 20 years later, however, we’re finally getting close. This week, the Dow broke through 33,000 for the first time, putting us within a whisker of Dow 36,000.
The current stock market rally has many features in common with 1999. Chief among them is the involvement of retail investors. Dow 36,000 was written for a retail audience all-in on the market of the late 1990s. Around 20% of US households directly owned stocks at the time, up from 15% in 1995. Their path to the market was aided by online trading platforms that offered cheap trading and an easy user interface. These platforms, operated by ETrade, Ameritrade, Charles Schwab and others, collectively picked up around 12 million new accounts in the late 1990s.
Today, we’re going to look at eToro through the experience of ETrade. The outlook for ETrade looked pretty rosy in 1999. Revenues were anticipated to continue to grow as the internet revolutionised the way the public managed its money. Sadly, the journey was more painful. Is the set-up for eToro similar?
ETrade: “It’s Your Money”
Prior to 1975, commission on stock trading was fixed by statute, and it was expensive. The market was dominated by full-service firms competing for business by bundling services such as research and advisory. The economics of the equity research business were grounded in that environment, as we discussed here a few months ago. These full service firms – firms like Merrill Lynch (now part of Bank of America) and Dean Witter (now part of Morgan Stanley) – operated a dense network of branch offices and enjoyed sticky client relationships.
After deregulation, firms were allowed to compete on price for the first time. Discount brokers like Charles Schwab dispensed with research and advice and offered their unbundled stock trading product at a discount price. By the mid 1990s, discount brokers were offering their services at about $40-60 per trade, roughly half the rate prior to deregulation in 1975. In order to remain competitive, full-service brokers lowered their commissions by around 20%. Across the market, though, retail investors paid a premium to institutional investors, whose commission rates had come down much more sharply. By the mid 1990s, the cost of stock trading was ten times higher for retail investors than it was for institutions.
That all changed when online brokers emerged on the scene. ETrade had been founded in 1982, initially as a provider of back-office online processing services for discount brokerage firms. In 1992, the company formed its own securities business and began to offer retail brokerage services directly to investors. Rather than deploy a network of branch offices, it reached investors “by means of the CompuServe, America Online, direct modem access, touch-tone telephone and, to a lesser extent, interactive television.”
With the internet, though, business really took off. ETrade launched internet stock trading in February 1996, processing 1,300 trades in its first week; by May of that year, it was doing 11,000 trades a week.
ETrade took the discount brokerage model a step further. Its online platform allowed customers to easily monitor the market and their portfolios, and its lower cost distribution enabled lower prices. It charged commission rates of ~$20 per trade. Although it was first, the barriers to setting up an online trading platform were not as high as establishing a branch network, and other players poured into the market. The number of online brokerages increased from around 12 in 1994 to over 120 in 1999. They competed on two dimensions: price and marketing heft.
On price, firms first started to segment the market based on customer activity but eventually dropped prices for everybody. Some, like Datek and Ameritrade, went after more active traders with lower prices of $5-10. One broker – Web Street Securities – even offered free trades, as long ago as 1999, to customers trading over 1,000 shares of NASDAQ listed companies.
A major turning point came in June 1999, when Merrill Lynch gave into the channel conflict it had resisted until then and embraced an integrated online strategy. ETrade’s average commission rate fell from $21 per trade in 1996 to $13 in 2001.
On marketing, firms spent aggressively to solidify their position. In summer 1998, ETrade raised $400 million via a private placement with Softbank, giving it enormous firepower to invest in marketing. (Sound familiar?) That September, it launched a $100 million, 12 month advertising blitz, a budget more than three times larger than it spent on marketing the prior year. By the end of 1999, the industry was spending around $1 billion a year on advertising.
Alongside the advertising there was the buzz. Howard Stern (the Dave Portnoy of his day?) said on his radio show, “Datek Online. I love Datek Online. It’s the fast, easy and fun way to trade stocks online. Stuttering John [Melendez, part of the Stern crew] uses it, and he’s making money. You get lots of free charts and you can check your account online.”
Yet the potency of marketing spend diminished; by 2001, it was costing ETrade $280 to acquire a customer, up from below $220 in 1998.
These deteriorating customer economics prompted a two-pronged strategic response. The first was consolidation, in an effort to extract the benefits of scale. ETrade bought many smaller online brokers including Web Street. There was constant speculation about a massive ETrade Ameritrade tie-up. Over time market share concentrated around fewer players (e.g. Ameritrade acquired Datek).
The second was expansion into other revenue sources. In 1998, nearly two-thirds of ETrade’s revenues came from trading commissions (around 3% came from payment for order flow) with most of the rest coming from interest income it earned on customers’ cash balances. But ETrade wanted to become more like a bank. It invested heavily in “value-added services in banking, lending, planning and advice.” In February 2002, it rebranded itself from ETrade Securities to ETrade Financial in order to convey its broader offering.
ETrade grew quickly. When it IPO’d in 1996 it had only 65,000 accounts. By the time the market peaked in March 2000, it had over 2.4 million. The market collapse in 2000 stymied its growth, and that of all the online brokers, but it took a while to sink in. Even after the market had peaked, ETrade would go on to win more than another 500,000 net new accounts over the following six months and almost a million by the end of 2001.
On a conference call in March 2001, Charles Schwab, the man, talking about the performance of Charles Schwab, the company, admitted, “We've come through a highly speculative technology bubble. Maybe I should have been more emphatic about understanding that this was a temporary phenomenon.”
ETrade implemented a number of restructuring initiatives to streamline its operations in the aftermath of the market downturn. Although brokerage revenues went into reverse as a result of lower trading activity and continued pressure on price per trade, overall revenues held up due to the diversification into banking. For a while anyway. When the financial crisis hit in 2007, ETrade found that it had inadvertently diversified into crappy mortgage assets and had to be bailed out by Citadel.
Through the 2010s, ETrade operated under the continued backdrop of falling commissions. In 2017, its average fee per trade dropped below $10. Finally, in September 2019, it acquiesced and went all the way to zero. A few months later, Morgan Stanley bought the firm for a headline price of $13 billion.
eToro: “Trade Like Steve”
The catalyst to take fees to zero ultimately came from the disruptive influence of Robinhood. But Robinhood isn’t the only new broker in town.
Outside the US, gambling is more popular than stock trading. I sometimes wonder whether shareholder culture would have taken root as firmly in the US had gambling been more loosely regulated. There’s a spectrum, obviously, with slots at one end and buy-and-hold investing at the other. But towards the centre, there’s a market which has gained popularity outside the US (and Belgium, where it is also prohibited): contracts-for-differences (CFDs).
CFDs are derivative instruments that allow traders to bet on the direction of an asset, either up or down. Unlike stocks, they don’t grant economic rights to the underlying asset. In some markets they bear tax advantages (for example in the UK, traders don’t have to pay stamp duty which they would be liable for on a stock purchase). As derivative instruments, they also embed leverage.
eToro was founded in Israel in 2007 as a platform for CFDs. Its initial focus was foreign exchange. For brokers like eToro, CFDs can be very profitable as long as customer acquisition costs are kept under control. At a minimum they make money from spread fees if they hedge their clients’ exposure (either internally or via a prime broker). But customers typically lose money – because of the leverage employed – and so brokers can also make money by taking the other side. Overall, around 80% of customers lose their money across the industry – which explains why customer churn is very high; one of eToro’s competitors, Plus500, disclosed that its customer churn last year was 30%, down on 64% the prior year (in eToro’s case, churn last year was around 18%).
This feature of being on the other side of the customer aligns CFD brokers more with bookmakers than with financial brokers. Customers’ median holding period can be less than an hour, adding to the analogy.
Despite these origins, eToro’s founders had long been interested in stock trading. CEO Yoni Assia had been trading stocks since the age of 13 after his father funded a trading account for him as a Bar Mitzvah gift. Yoni was one of the many investors active in the late 1990s. He recalls doing very well in the period 1996 to 1999 but wasn’t able to manage his account as actively in the downturn, having been drafted into the army in March 2000.
In 2009, eToro launched WebTrader, a new platform for trading a range of financial assets including commodities and indices. Alongside it, it launched a chat room. Before long, the team noticed that users were more active in the chat room than they were on the trading platform. Indeed, only 30% of registered users funded an account at all; the majority were there just for the chat.
What Assia and his team identified was that there’s a social aspect to trading that other platforms were not fulfilling. It’s an observation that’s well known in institutional markets. eToro’s chat room predates WallStreetBets by a few years, but the discussion on WallStreetBets around GameStop has been likened to the ideas dinners that hedge funds host. And, as we discussed here in our Bloomberg piece, Bloomberg is the original social network for traders. Howard Lindzon, one of the original investors in eToro, says, “Fire was the first social network, then smoking, maybe, and then Bloomberg.”
The eToro founders invested in the social side of their business and in 2010 rolled it into the trading product in a new platform. Traders could see each others’ portfolios and interact.
On top of this, eToro built a new feature – the ability to ‘copy’ another trader’s portfolio. By hitting the copy button on another trader, his portfolio (yes, his: 90% of users are male) would be replicated inside your own; every time he makes a trade, you automate the same trade at the same price. Again, the idea is not far-fetched. Any investor with Berkshire Hathaway stock in their portfolio is essentially hitting the copy button on Warren Buffett.
Within the eToro platform, the copy function turns portfolios into user-generated content – the lynchpin of many social networks. In order to incentivise users to create content in this manner, they can get paid when they engage sufficiently and accrue enough copiers. The company currently has around 1,400 so-called ‘Popular Investors’ on its platform, being copied by tens of thousands of users. They recorded an average return of 51% in 2020. The best can get paid up to 2.5% of the value of the assets they are indirectly managing. One of the top popular investors on the platform has around 45,000 users copying him with more than $130 million under management. Check out this guy: Jaynemesis.
Over the past ten years, eToro has added other features to its platform. It launched a mobile app in 2012, stock trading in 2013, Bitcoin in 2013, additional cryptocurrencies in 2017, zero-commission trading in 2019, fractional share trading. In addition, the company introduced a ‘copy portfolio’ feature that enables users to copy portfolios it curates rather than copying individual traders; the company builds these portfolios around strategies or themes it sees being popular on the platform.
The copy features are a hit. Around 30% of new customers use copy as their first action and 20% of the assets on the platform are invested via copying. The feature solves a problem that is endemic to many app-based investing tools: that grabbing attention – which is what many of them are optimised to do – is not consistent with long term investment performance. The company also invests in customer education, allowing users to trade phantom portfolios before upgrading to real money.
In April last year, eToro received regulatory approval to launch stock trading in the US, which it plans to roll out later this year. The company has been offering crypto trading in the US since 2019, and has seen around 700,000 downloads of its app in the past two years, out of 8.5 million worldwide (according to Apptopia). Breaking into the US won’t be easy – it’s a highly competitive market – but profits from CFD trading overseas will subsidise the initial entry. In both the UK and in Germany, eToro remains a top three CFD trading platform alongside companies such as Plus500, IG Group and CMC Markets.
As at end January, eToro had 18.7 million registered users on its platform, of which 1.2 million (i.e. 6%) operated funded accounts. The big gap reflects users who are trading a phantom portfolio as well as churn. In 2020, most of its revenue derived from the spread the company earns between the buy and the sell prices when a customer trades; crypto contributed a lower share of total revenue compared with prior years (16% versus 63% back in 2017) with a much bigger share coming from equities (44% versus 11%). Average revenue per user was around $800.
From ETrade to eToro
Investing is directly linked to money and also to status. So it’s no surprise that every generation creates its own investing platform in response to its unique relationship with status. In a purely offline world, a game of golf with your Merrill Lynch broker cuts it, but that doesn’t work in an online world where followers count. In this framing, ETrade was simply the stepping stone between Merrill Lynch and eToro. It provided the means for users to accumulate wealth but it didn’t vertically integrate that into status. ETrade’s marketing tagline in its 2000 heyday was “It’s your money.” Contrast that with eToro’s: “Trade like Steve.” One’s solitary; the other is social.
It's quite neat that just as ETrade gets delisted from the market following its takeover by Morgan Stanley, eToro gets listed. But ETrade’s founders might be puzzled by the valuation. In October 1999, when Dow 36,000 was hitting bookstores, ETrade had a market cap of $5.5 billion. That valuation was equivalent to around $3,500 per user and 8.2x trailing revenues.
By contrast, eToro is valued at $10.4 billion in the SPAC transaction – a valuation that has since gone up – equivalent to over $8,500 per user and 17.2x trailing revenues.
Clearly, there’s a lot of growth baked into the valuation. The company projects that revenues will grow at a compound rate of 33% per annum out to 2025. But the linear nature of the revenue projections belie the way markets work – as evidenced in the recent past, when revenues bounced around (e.g. 2019 revenues were lower than 2017 and 2018 revenues). CFD brokerage peers like Plus500 and IG Group trade on 4.5x projected revenues, and revenues are forecast by analysts to decline off the peak 2020 trading year.
There are lots of differences between the environment now and the environment in 1999. One metric is the “exuberance index”: the number of companies with price/revenue ratios greater than 10x whose stock price has more than doubled in three months. That index is a lot lower today than it was back then. But the valuation of those companies at the heart of the market, that allow investors access to it, are worth monitoring carefully. Financial markets are inherently cyclical and revenues strapped to them don’t go up in a straight line.
More Net Interest
Nubank is Brazil’s largest digital bank. Founded in 2013 as an app-based credit card lender, it has over 33 million customers and over 8% of the Brazilian credit card market (by number of issued cards). It added a deposit product in 2017 which it uses as an anchor to cross-sell other products to users like retail brokerage (following the acquisition of Easynvest last year) and life insurance (launched last year). The bank’s founder, David Vélez, cites Tinkoff, which we looked at here a few weeks ago, and Capital One as models.
This week, Nubank released its 2020 financials. Deposits jumped to R$29 billion or R$880 per customer, up from R$560 per customer at the end of 2019. Credit card transactions hit R$95 billion (+49% y/y) and revenues hit R$5 billion (+79%).
Competition in the Brazilian banking market is high – lots of digital banks have been launched in the country over the past few years (with digital wallet PicPay close to IPO). However, the option slowly to reduce rates on deposits, to leverage the credit card background of the company to do more lending and the opportunity to cross-sell non balance sheet intensive products, all provide upside. In 2020, Nubank’s net loss was R$230 million, but it has a path to profitability.
Olaf Storbeck, the Frankfurt correspondent for the Financial Times, has been live tweeting the Wirecard parliamentary hearings being held in Germany this week. Yesterday Daniel Steinhoff, Wirecard’s head of compliance, was on the stand. He says there was disagreement between the company and the regulator over whether Wirecard was a financial services company or not. He actually thought it was, which had implications for the way the group managed anti-money laundering compliance. But regulators were less sure.
Although Wirecard has gone away, this debate over what is and what isn’t a financial services company has not gone away. The BIS published a briefing note this week on Big Techs in Finance: Regulator Approaches and Policy Options. It concludes: “Big tech risks have not yet been fully captured by regulations, and a rethinking of the policy approach is needed.” It’s an issue we’ve discussed here before but it is getting louder.
What’s in a Picture?
Years ago, engineers played with using image recognition technology to identify apes in photos. Now, they’re moving up the evolutionary ladder to look at sell-side analysts and portfolio managers.
In one study, a team of researchers used machine learning-based algorithms to extract key impressions about personality traits from LinkedIn profile photos of sell-side analysts. They used the photos to identify measures of trustworthiness and dominance, which they then regressed against the analysts’ performance. A high degree of trustworthiness was reflected in earnings forecasts closer to management guidance; and high dominance was linked to more active participation in conference calls. The researchers also measured attractiveness, and concluded that any benefit that provided for forecast accuracy diminished after Reg FD!
A different group of researchers, though, looked at whether being attractive holds any advantages for portfolio managers. They concluded that “even after controlling for fund characteristics, performance measures and manager characteristics, mutual funds managed by ‘attractive’ managers receive higher fund flows.” Based on their work, the attractiveness bias is predominantly witnessed within retail investors.
I will leave you to draw your own conclusions.