Online Investment Business Models PDF

Online Investment Business Models 4 CONTENT AREAS Introduction Business Models Providing Online Investment Services Key Risks for Online Investment Businesses Key Succe...

Online Investment Business Models 4 CONTENT AREAS Introduction Business Models Providing Online Investment Services Key Risks for Online Investment Businesses Key Success Factors for Online Investment Businesses Measures and Trends Summary LEARNING OBJECTIVES 1 | Describe the origin and growth of the online investment industry and benefits and drawbacks of each business model. 2 | Identify the risks and key revenue sources within each business model. 3 | Discuss the key success factors in the industry. 4 | Describe key industry metrics and trends. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 3 INTRODUCTION In the previous chapter, we focused on the private client brokerage business. For executives operating in this branch of the securities industry, an understanding of all aspects of the business is necessary to ensure that risk management policies and procedures are appropriate and adequate. We now turn our attention to online investment models. Originally, this category included only the discount brokerage model, a non-advisory service dedicated to the self-directed investor. Until recently, discount brokerage dealers provided the only widely available online investment service in Canada. These entities were registered as investment dealers, with additional restrictions placed on the type of business they could carry out. In most cases, they were limited to executing orders and could not provide advice. Clients could direct trades either over the telephone or electronically. With the advent of the digital age, additional models have emerged that provide various forms of investment advice almost exclusively online. These models are known collectively as online wealth management or robo-advisory services. In this chapter, we explore the features of the various online investment models, and we discuss their revenue sources and risks. As an executive in the securities industry, it is important that you understand the different types of firms that operate in this growing field of investment services. BUSINESS MODELS PROVIDING ONLINE INVESTMENT SERVICES As mentioned, online investing services are provided through either of two business models, discount brokerage or online wealth management. Discount brokerage is an order-execution-only (OEO) model. This model was designed to provide investors who are comfortable making their own investment decisions with a lower-cost alternative to the traditional, full-service dealer model. Clients of OEO firms have access to an online trading platform that allows them to trade securities on their own. The firm does not conduct a suitability assessment, nor does it make recommendations as based on their registration, OEO firms are not permitted to carry out these activities. Online wealth management is an advisory model, as the alternative name, robo-advisor, suggests. Several online advisory businesses have launched since 2014, when Canada began permitting discretionary portfolio management outside of a physical location. Although less common, non-discretionary online wealth management is also available. In both discretionary and non-discretionary models, a client questionnaire is used to determine an appropriate asset allocation in a portfolio based on the client’s required rate of return and risk profile. A telephone call typically follows, during which a portfolio manager verifies that the algorithmically generated portfolio is suitable for the client. The portfolio manager then implements the recommendation. In a discretionary service, the portfolio manager makes ongoing changes to ensure that the portfolio remains optimal, without the need to obtain the client’s consent. In a non-discretionary service, the manager must consult with the client before making any change to the portfolio. Online clients generally fall into either of two broad segments: Investors Online investors generally understand the principles of portfolio diversification and know the value of investing. Some use the services of an advisor, and others are self-directed. Self-directed investors manage their own investments with tools such as research and equity screening. Clients in the investor segment are considered to be accumulators who are focused on the long-term; they do not trade very often. Self-directed investors typically use a discount broker. They prefer a variety of account types and a broad range of products, including mutual funds and fixed-income products. Some investors require guidance but want to make the © CANADIAN SECURITIES INSTITUTE 4 4 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 final decision each time a portfolio change is required. These investors may use a non-discretionary online wealth management service. Investors who wish to be less engaged in the process may be comfortable with a discretionary online service. Traders Traders are sophisticated and knowledgeable clients who focus full time on market activity and whose trading activity usually exceeds 25-to-30 trades per month. They use real-time news, streaming quotes, charts, and specialty trading platforms, among other tools, to make trading decisions. Technology and reliability are a necessary minimum standard for traders. Discount brokerage is the channel of choice for this client segment. As consumers become more knowledgeable about investments, competition for their business in the online investment industry drives prices down, and as technology improves, client expectations continue to rise. To be successful, the online investment business model requires a commitment to technology, client service, and operational excellence. DISCOUNT BROKERAGE When revisions to the Bank Act in 1987 enabled banks in Canada to acquire large investment dealers, all of the major banks did so except Toronto-Dominion Bank (TD). During the years that followed, TD instead focused on building its franchise in discount brokerage. In the early 1990s, TD played a dominant role in the fledgling discount brokerage industry, with an unprecedented market share of approximately 90%. By 1993, each of the six largest Canadian banks had also established discount brokerage operations. Several independent firms subsequently entered the space, which intensified competition in both innovation and pricing. Typically, the larger investment dealers, such as those affiliated with Canadian banks or other large financial complexes, established their own discount brokerage channels to cater to clients who did not require or want a full-service investment dealer. In the early days of discount brokerage in North America, clients born between 1946 and 1964 (the baby boomer generation) were entering their high-earning years. These clients were typically more informed investors than previous generations and had a different approach to investing for retirement. They embraced technology for business purposes, especially online service. The equity bull market in North America throughout the 1990s also propelled the growth of discount brokerage. Innovations such as direct market access and online tools provided investors with enhanced capabilities. Investors also acquired access to research reports and other information that was once available only to professional traders. TRENDS IN DISCOUNT BROKERAGE Trends in the discount brokerage business align with changes in both demographics and technology, as described below. DEMOGRAPHICS One of the key driving forces behind the discount brokerage industry was the widespread shift across the globe to an older demographic. In North America, and to a lesser extent in Europe, the introduction of discount brokerage coincided with the baby boom generation entering its prime earning years. These clients would soon be preparing for retirement; they were rapidly adopting new technology and wanted to control their own financial destiny. In the changing workplace, new technology allowed people to work from remote locations, an option that was growing in popularity. This evolution provided perfect conditions for the discount brokerage industry to thrive. TECHNOLOGY Tremendous change occurred during the period between 1983 and 2008, in both the social environment and in technology. In 1983, relatively few people were investing in the retail securities market. Furthermore, commissions were regulated, and investment choices were limited. By 2008, the self-directed investor had more information available through several delivery channels, more choices in where and how to invest, and more flexibility in commission structures. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 5 As more people adopted internet technology, they became less dependent on direct investment platforms. Those providers were under pressure to reduce costs as much as possible through technology, but they could not do so at the expense of regulatory compliance or client service. Differentiation among discount brokerage firms became a key focus, and 2016, the biggest differentiator in industry surveys was identified as the “client experience”. With more and more clients using automated systems, technology continues to be an agent of change in the discount brokerage business. Some self-serve platforms now handle up to 90% of their business as electronic orders. The continuing application of new technology has also had a positive impact on business profitability. The discount segment produced over 15% of the industry’s operating profits in 2008, up from 5.7% in 2001. The timing of the discount brokerage model’s launch on the internet, coupled with the boom in internet use, resulted in its widespread acceptance by consumers as an investment tool. CHALLENGES IN DISCOUNT BROKERAGE The discount brokerage industry has faced four main challenges during its growth, as discussed here: Channel conflict The biggest challenge discount brokerages faced in the beginning was their rejection by the full-service securities houses owned by the banks. The perceived threat to the dominance of full-service providers in the retail securities market, coupled with the reluctance of those providers to accept the changes that were taking place, made it extremely difficult for discount brokerages to gain acceptance. Most bank-owned discount brokerages spent several years after the deregulation of commissions convincing their banking parents that the business was here to stay and could become a significant force in the securities industry. Regulatory Further challenges to discount brokerages came from the existing regulatory framework. considerations In the beginning, regulators held the same requirements for discount brokerage accounts and orders as they did for full-service retail brokers. As with accounts held by full-service dealers, every client order required a suitability check. Accounts had to be approved for opening based on the knowledge, net worth, investment objectives, and risk tolerance of the client. The process was time-consuming and cumbersome, especially given that discount brokerage clients expected to take responsibility for their own investment decisions. As accounts and transaction activity grew, industry participants lobbied for regulatory changes they considered necessary to handle consumer demand and client expectations. As a result, the regulators changed the rules to remove suitability requirements and allow for order-execution-only accounts, as long as the firms followed certain documentary procedures. The recognition of the order-execution-only account and the elimination of standard suitability requirements for the discount brokerage industry were ground-breaking changes. They opened the door to continued rapid growth and the implementation of additional high-speed technology. The discount brokerage category became a recognized business with unique rules within the securities industry. Although suitability rules have been relaxed, discount brokers must still adhere to compliance requirements similar to those imposed on full-service dealers. In fact, in some instances, more attention should be paid to discount brokers, given the possibility that these institutions may be used to carry out inappropriate or illegal behaviour such as money laundering. © CANADIAN SECURITIES INSTITUTE 4 6 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Guidance Note 3400-21-003 – Guidance on Order Execution Only Services and Activities sets out CIRO’s expectations and the regulatory requirements applicable to all OEO firms. The notice also outlines the scope of tools that are considered to be consistent with the OEO framework. As part of an OEO firm’s registration, such firms are exempt from the requirement to assess suitability of client orders, given that the OEO concept is to allow clients to make their own investment decisions. Furthermore, the OEO registration rules prohibit them from providing any form of recommendation. To remain exempt from the suitability requirement, OEO dealers must make sure to refrain from recommending the products and services they offer. They must also be mindful of their gatekeeper responsibilities and not allow unfettered access to the markets. Order-execution-only firms must exercise caution to avoid the appearance of providing recommendations to clients. In referencing the concept of a recommendation, regulators consider that the manner in which the firm communicates the offer of a product is also relevant. In this context, the tools that OEO firms offer must be seen as not influencing clients to make a particular investment decision. A firm may be subject to criticism and potential enforcement action if the regulators decide that the tools or services it offers lead clients to trade securities in a particular manner. For example, certain trading tools that automatically trade on behalf of an OEO client are effectively providing recommendations to clients and are therefore prohibited. (In contrast, order-execution tools that support the client’s decision as to how or when to trade are generally acceptable.) Pricing pressures A challenge for discount brokerages is to maintain a distinctive offering in a market that is extremely price competitive. Commission discounts were typically provided only to highly active traders based on trading volumes over specific periods or to asset accumulators who held significant account balances. However, since 2015, many firms have waived most qualifying requirements, instead reducing commissions across the board for most client segments. Commoditization to Because online innovations are readily copied, the greatest challenge for discount maintain a competitive brokers today is maintaining a competitive edge. In addition to price competitiveness, edge clients expect, at a minimum, ease of website navigation, mobile applications, portfolio- building tools, sophisticated order types, and streaming news and quotes. REGISTRATION CATEGORIES Regulators in the securities industry differentiate between firms and registrants. Full-service investment dealer members must register their advisors as RRs, with permission to advise. Discount dealer members must register the personnel who accept securities transactions as IRs, who are not permitted to advise. Discretionary asset management firms, including online businesses or robo-advisors, are required to register their advisors as Portfolio Managers (PMs). The key differences among the three categories are shown in Table 4.1. Regulators have also articulated the behaviours that are acceptable in each registrant category. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 7 Table 4.1 | Registration Categories Investment Representative Registered Representative Portfolio Manager Deals solely with transaction-only Has a relationship with the client in a Has a relationship with the client in accounts. traditional model. a traditional model. Online models mostly provide clients Online models mostly provide with call-centre or online access to clients with call-centre or online an advisor. access to an advisor. Does not provide advice; Has a duty of care, according to the Has a fiduciary responsibility under therefore, is not responsible suitability standard. the best-interest standard. for ensuring the suitability of May have a fiduciary responsibility in products or investment strategies. some cases. Understands the products. Is responsible for knowing the Is responsible for knowing the essential attributes of products, essential attributes of products, in in accordance with the Know Your accordance with the KYP rule, to Product (KYP) rule, to determine determine whether they are suitable whether they are suitable for the for the specific client. specific client. Accepts only unsolicited orders. Solicits orders from clients, but must Portfolio investments and changes obtain their consent prior to the are made at the discretion of the transaction. portfolio manager, without the client’s consent, but in keeping with Has a duty to take appropriate the client’s investment objectives/ measures to deal with an unsuitable KYC information. order. These include advising against proceeding with the order and recommending suitable alternatives. BUSINESS MODELS WITHIN DISCOUNT BROKERAGE Various business models emerged during the early growth period of the discount brokerage market and were readily adapted to the Canadian marketplace. These models came about to address specific business strategies, to attract specific target markets, and to take advantage of new technologies. The models are described in detail here: Multi-branch, The multi-branch, nationwide network call-centre system supported a business model nationwide network that was established in Canada by TD Green Line. This model was based on the U.S. call centre model originated by Charles Schwab & Co. The original objective was to make individual investing accessible to all Canadians, regardless of their affiliation or relationship with any other financial institution. The model also provided the opportunity to build a stand- alone brand when it was first introduced. © CANADIAN SECURITIES INSTITUTE 4 8 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Multi-call-centre The next system to emerge was the multi-call-centre structure. This system involves structure with regional regional salespersons marketing the discount brokerage business to their personal bank sales personnel branch and initiating client seminars and demonstrations. With the exception of TD, resource allocations to bank-owned discount brokerage operations were minimal in the beginning. The industry was small, resistance from the full-service retail brokers was strong, and the structure and potential for financial return were not clear to senior bank management. It became evident that a discount brokerage’s success depended on its ability to leverage the parent banks’ name and multi-branch network to add new clients and their assets. Personal bankers at the time were fully occupied with a varied product array, and their role had changed to focus mainly on sales. Sales practices and measures were put in place that left little time for bankers in any organization to take on more responsibilities. The business seemed destined to move assets such as mutual funds from the bank branches. Provincial operations One model that emerged to address the issues that the firms were facing had a with regional sales provincial operations office and a call centre with regional sales personnel. At the personnel time, national registration was not yet in place, so registrants were licensed only in the provinces in which they operated. They were mandated to sell discount brokerage to major branches of the parent bank and encouraged the opening of accounts for suitable clients. Coupled with media advertising, this approach brought a good measure of success. By using provincial operations centres, new account applications could be processed locally, thus speeding up the process for clients. Limited branch with The limited branch model was similar in structure to the provincial operations model, street-level locations with the addition of one or two street-level locations at high-profile points in key market areas. The street-level branches had two-to-six registrants and provided a contact point for new and existing clients. They also served as an education centre. This model allowed for limited use of expensive real estate while creating a market presence in specific locations. Technology-based The advent of the internet in the mid-1990s opened the discount brokerage market firms to technology-based participants. With their very limited physical presence, these firms focused their spending on advertising and creating awareness of high-speed capabilities. The technology enabled volume trading and greater access to timely market information. Some firms focused on providing access to most global markets. Others focused on the hyperactive trader, providing trading platforms that made complex charting available for a price. These firms also provided multi-level quotes, multiple and detailed news feeds, and low pricing or specific pricing packages. Different trading platforms met specific client needs. As a result, business leaders had to understand and prioritize market segments and allocate appropriate resources to each. Although the technology-driven model had prominent media presence, it suffered from a weak attachment to the parent bank and low bricks-and-mortar distribution for some time. However, as younger investors became more comfortable dealing with virtual firms, some technology-driven firms succeeded, and their culture of innovation often placed them at the top of industry surveys. As partnerships formed to gain distribution, the Canadian discount brokerage industry saw some consolidation during this period. Technology-based firms continue to have a client base that is skewed to the active trader. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 9 INDUSTRY IMPACT OF DISCOUNT BROKERAGE The impact of the self-serve investment industry in a relatively short time had broad repercussions. For example, the rapid pace of technology development by the discount industry helped to drive the operational and technological areas of full-service brokerage firms. Carrying brokers, who provide back-office services for discount brokers, experienced high growth in account openings, securities transfers, account transfers, order flows, and, consequently, work flows. The self-serve industry, with low pricing, high capability, and strong technology, drove other industry changes as well. Clients began to question the value of their full-service advisors and to ask for direct internet access to view their accounts. These issues forced the full-service firms to modify and accelerate technology plans to satisfy their clients’ demands. The investment scene was also set for market segmentation. NEW WEALTH MANAGEMENT MODEL The term wealth management appeared in the late 1990s, when many full-service firms began to move clients into managed asset products or accounts. This shift toward wealth management reflected an attempt to protect revenues by creating constant and recurring revenue streams and through client retention. The emergence of the self-serve investment industry accelerated the growth of wealth management platforms delivering complex asset management programs and holistic solutions for high-net-worth clients. Faced with competition from the discount brokerage industry, full-service advisors had to add value to retain clients. This need gave new meaning to the relationship approach, in which, in addition to advice, they provided an array of tailored services catering to their clients’ individual needs. By 2016, full-service brokerage established a holistic approach to wealth management that was increasingly supported by technology. This approach is typified by the unified managed account, a platform that enables advisors to create an asset allocation across household accounts using a broad range of products. It also allows the advisor to optimize tax management when rebalancing, among other features. DISCOUNT BROKERAGE REVENUE SOURCES As a transaction business model, discount brokerage during its high-growth stage enjoyed significant operating leverage, but it was heavily reliant on commission revenue. The model needed some diversification in revenue to provide stability in times when market and client trade activity were low. By 2015, commissions represented less than 30% of discount brokerage revenues. “Other” revenue sources comprised almost 60%, of which a significant proportion was spread revenue. Interest spread income provided a further lift to a firm’s revenue stream. Margin loans, which offset cash in accounts, can provide large favourable spreads. By scaling interest rates paid, firms can also increase surplus cash revenue. Other fees used to generate income, levied at various rates by different firms, include fees on the following account types: Inactive accounts Registered accounts Account holdings less than a minimum balance ONLINE WEALTH MANAGEMENT In recent years, a new online investment service has emerged that provides clients with advice, in contrast to the OEO model of discount brokerage. Popularly known as robo-advisors, these firms began to appear in the United States after the 2008 financial crisis, but they did not gain traction until 2012. By 2015, they had amassed $45 billion in assets under management. © CANADIAN SECURITIES INSTITUTE 4 10 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 The collapse of the technology sector in 2000, symbolized by the sharp decline in the technology-heavy NASDAQ Composite Index, caused many investors to revisit the need for professional advice. Charles Schwab & Co., a pioneer in the discount brokerage industry in the United States, responded to the change in sentiment by focusing on its marketing of financial advice. The firm launched new advisory offerings for the retail client, along with services for intermediaries such as advisors and company sponsors. During this time, discount brokers in Canada were not permitted by to provide advice, given their OEO limitations. Instead, they enhanced their online tools and access to information so that self-directed investors could make better decisions. However, with the 2007/2008 financial crisis taking a bite out of their retirement savings, investors felt more acutely the need, not simply for guidance, but for holistic solutions. Financial firms in both Canada and the United States grappled with the need to refine client segments according to their investment needs and channel preferences. Financial technology firms, known as fintech firms, entered the fray with yet another offering, popularly known as a robo-advisory. This model is a fee-based, algorithmically driven investment tool that deals primarily in exchange-traded funds (ETFs). Robo-advisor firms in Canada mostly offer discretionary online investment management. As such, robo-advisors operate under the same registration category as portfolio managers of traditional discretionary firms, which were previously referred to as “ICPMs”. It should be noted that some robo-advisors have terms and conditions imposed on their registration to recognize the unique nature of the business model being offered to clients. This is not to say that such terms are or should be of concern, rather, they reflect what these particular registrants can and cannot do. Like traditional portfolio managers, robo-advisors are regulated directly by provincial securities commissions. These types of institutions are typically also able to offer discretionary advice at a lower cost than traditional, bricks-and-mortar investment dealers. Investments through these channels, however, are limited to ETFs or investment products that are low cost and easily scalable and typically are designed to track stock market indices. LAUNCH OF ROBO-ADVISORS Many variations on robo-advisor services exist in the United States and Canada, but most share several of the following attributes: They provide clients with goal-based online investment management. They create portfolios using algorithms based on modern portfolio theory and on online client questionnaires. A telephone call with an advisor verifies that the computer-generated portfolio is suitable for the client. Advisor support is offered to varying degrees, typically online or by phone. Portfolios are built primarily with ETFs. Portfolios are regularly rebalanced (time-based or according to asset thresholds, or both). Financial planning may be offered in varying degrees. Service may be provided to the end client as well as to intermediaries such as advisors and employers (in the latter instance, often in the form of a “white labeled” offering branded for a larger organization but driven by a proprietary robo-advisor offering). Competitive positioning is based on the client experience, which typically encompasses the following features: Ease of online navigation Speed of account opening and transfers Integration of service delivery across devices Transparency of performance and fees Optimization of portfolio management (such as through tax-efficient rebalancing across account types). © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 11 In Canada, online investment advice platforms began to proliferate in 2014, with multiple service providers registered in several provinces by mid-2016. Unlike in the United States, where the term is applied equally to discretionary and non-discretionary automated investment services, robo-advisors in Canada are commonly understood to be discretionary asset managers. As such, non-discretionary advice platforms, such as BMO adviceDirect, are not classified as robo-advisors. TRENDS IN ONLINE WEALTH MANAGEMENT Four trends that have given rise to robo-advisors are described here: Shifting demographics Robo-advisors are often portrayed as the investment channel of choice for the so-called millennial generation (i.e., people born between 1982 and 1997). They are considered a natural fit for a generation that readily uses and trusts technology in everyday activities, and that already relies on algorithmically generated advice for shopping and entertainment. This generation is comfortable with discretionary online investment solutions that simplify the investment experience, minimize engagement, and reduce costs in comparison to standard investment advice. Two other demographic trends may influence the development of some online advisory services: As baby boomers begin drawing down retirement assets held in multiple accounts, tax efficiency becomes a concern. Robo-technology may be better able to do the necessary computation, with either the clients or their advisors providing the appropriate inputs. Many advisors are aging along with their clients, and as they retire (and their clients’ accounts shrink), the industry will likely look to robo-technology to enhance advisor productivity. Passive investing Robo-advisors have capitalized on the passive investment trend by building portfolios mostly with ETFs, both passive and active, and both third-party and proprietary. Some active management strategies used in ETFs alter the composition of the underlying benchmark to reduce the concentration risk of capitalization-weighted indices. Other active ETF strategies, known as smart-beta, use a rules-based approach to capitalize on specific areas of market inefficiencies. The millennial generation’s typical preference for hands-off investment solutions has converged with the trend toward passive and automated investing. Technological changes Robo-advisors are a natural outgrowth of the digital age, and, as such, they use the following types of digital technology: Mobile devices for convenience Cloud computing to deliver real-time information and a consistent experience across devices Predictive analytics to pinpoint exactly what the client needs and deliver it when it is needed Social networking to communicate with client communities © CANADIAN SECURITIES INSTITUTE 4 12 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Technology also enables an integrated offering of online and call-centre services. As well, firms that provide an advisor-led service offer one-on-one advisor-client collaboration in which technology plays a vital supportive role. In addition to enhancing the client experience, today’s technology can help mitigate risk and reduce the cost of the rebalancing process used to ensure that portfolios remain suitable at all times. A computer-generated investment process also reduces the potential for conflict between the client and the advisor, given that subpar investment returns are often attributed to a lack of discipline in adhering to an investment plan. Demand for The second phase of the CRM initiative required that fees and performance be more transparency transparent. This, along with the CFRs, may make clients more discerning as to the value they derive from advisors and products. As a result, competition in the industry will possibly heighten, which may result in lower fees and better service. Robo-advisory services may be the answer for firms seeking to reduce costs through economies of scale, especially in continuing to service smaller accounts. A full or partial online offering is also better able to capture data to provide clients with increased transparency. CHALLENGES IN ONLINE WEALTH MANAGEMENT Robo-advisors, and fintech firms in particular, face the following key challenges: The need for scale to As with discount brokerage, online wealth management models have considerable attain profitability operating leverage, which allowed early entrants in the U.S. robo-advisory space to enjoy exponential growth rates. However, multiple companies attracted by low barriers to entry are joining the robo-advisory ranks, and it is becoming increasingly difficult for fintech firms that pioneered the space to maintain their advantage. It is especially difficult to achieve the necessary scale in the face of competition from traditional firms with recognized brand names that add digital wealth management to a breadth of other service types. High client acquisition Fintech firms in the United States are incurring client acquisition costs that may be costs difficult to recuperate during the expected lifetime of the client relationship. Faced with these challenges, some fintech robo-advisors have formed partnerships with traditional firms to leverage their brand and customer network. In return for brand recognition, the fintech firms provide technological expertise and a ready-made platform, possibly relieving the larger firms of the need to build their own platform. The need to With the influx of many competitors, the robo-advisory industry faces the threat of differentiate their commoditization in much the same way that discount brokerage has. Asset allocation, offering rebalancing, and tax optimization are formulaic processes that can be automated, and passive investments are all that is required. In this environment, no single firm appears to have a competitive advantage. In an attempt at differentiation, some robo-advisors use actively managed proprietary ETFs and investment funds. Another approach is to differentiate based on the client experience by seamlessly integrating online, mobile, and advisory services, or by providing a service in which advisors assume a more prominent role. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 13 Regulatory changes As of mid-2016, the rules governing discretionary and non-discretionary online advice were the same as those for traditional models. In this regard, the Canadian Securities Administrators (CSA) published Staff Notice 31-342, Guidance for Portfolio Managers Regarding Online Advice, provided the following guidance: There is no “online advice” exemption from the normal conditions of registration for a PM. The registration and conduct requirements set out in [NI] 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations are “technology neutral”. The rules are the same if a PM operates under the traditional model of interacting with clients face-to-face and if a PM uses an online platform. The CSA notice emphasizes that firms offering online discretionary asset management should still place the onus for suitability and KYC requirements on a registered PM, as with face-to-face models. As such, the CSA views existing robo-advisors as a hybrid model, rather than an exclusively online discretionary model. The CSA allowed an opportunity for the future development of new rules if robo-advisors depart from existing business practices. One such departure that might lead regulators to reconsider the ability of robo-advisors to fulfill their fiduciary obligations might be the use of more complex or riskier products than those currently offered. Subsequent to the CSA notice, the Ontario Securities Commission (OSC) raised concerns about whether robo-advisors could reasonably fulfil their suitability and KYC obligations if their low or no account minimums result in a high ratio of clients to portfolio managers. The OSC guidance noted that a reasonable level would depend on factors such as the business model, the types of products offered, and the robustness of the online system for KYC. This guidance allows for the fact that an automated process may allow the portfolio manager to serve a greater number of clients than one who deals with clients face to face. The OSC requires that firms identify the conditions under which a PM will contact the client. Firms must also provide clients with reasonable access to a PM, either online or by telephone. National Instrument 31-103 governs the registration requirements and responsibilities of both discretionary and non-discretionary firms. As with PMs who interact with clients mostly online in a discretionary service, regulations do not recognize a separate online category for RRs in a non-discretionary model. The expectations therefore are identical, ensuring that registrants engage in meaningful discussions with clients during the onboarding process as well as throughout the life cycle of the client relationship. © CANADIAN SECURITIES INSTITUTE 4 14 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 EXAMPLE In 2012, BMO InvestorLine was granted an exemption by IIROC from certain advisory regulations for its BMO adviceDirect offering, a non-discretionary online advisory service with a broad product suite, including individual securities. BMO InvestorLine was exempted from the requirement to register BMO adviceDirect as an advisory offering. However, BMO adviceDirect advisors fall under the category of RR, as opposed to the discount brokerage agent category of IR (i.e., non-advisory). The IIROC exemption stipulated that BMO adviceDirect accounts must be governed by the suitability requirements pertinent to dealer members which place the primary responsibility for suitability and KYC obligations on the RR. IIROC’s exemption order recognizes and allows that KYC information is gathered and a suitability assessment made primarily by a computer system. The RR must call the client to verify that the portfolio is suitable. For BMO adviceDirect accounts, the RR plays a supportive role, rather than the traditional primary role. The exemption order imposes a number of conditions on BMO InvestorLine in the operation of BMO adviceDirect. BMO InvestorLine must operate adviceDirect as a separate unit from its discount broker. It cannot alter its KYC process without prior regulatory approval, including various suitability alerts, escalation and remediation processes, and a suitability call at the inception of the client relationship. ONLINE WEALTH MANAGEMENT GROWTH RATES AND BUSINESS MODELS Growth rates in the United States were exponential for fintech firms that had an early advantage in launching robo-advisors. In Canada, early entrants in the segment have been operating since 2014. As competition intensifies in both the United States and Canada, business models are becoming increasingly diverse in an attempt to gain a competitive edge. Four forms of competition between models are described here: Discretionary versus The term robo-advisor is commonly used in Canada to describe an online discretionary non-discretionary offering, chiefly because most virtual Canadian firms have adopted this model. In business models contrast, both discretionary and non-discretionary models are common in the United States. This difference can be largely attributed to differences in financial services regulations and in the competitive landscape. Canadian regulators have stated that discretionary virtual models at this time fit the existing regulatory framework, and therefore a new category of registration is not warranted. However, the rules may be amended as new models develop. The regulatory picture is less clear for non-discretionary offerings. As regulatory guidance and new rules emerge, and as the success of existing models are tested in the market, non-discretionary models may emerge. Note, however, that discretionary online firms can serve smaller accounts at lower cost, simply because client consent does not have to be obtained each time changes are made to the portfolio. Moreover, discretionary management seems to satisfy the millennial generation’s preference for simplicity in investment matters. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 15 Online-only versus Canadian regulations mandate access to an advisor who is registered in the capacity hybrid models required to deliver the specific form of investment management. The degree of advisor support required is based on the target client segment and the comprehensiveness of the offering. At a high level, clients are segmented according to their wealth or stage in the life cycle. For robo-advisors that have built their business by appealing to the tech-savvy millennials, an online offering with minimal advisor support may be appropriate. Investment needs at this stage are generally straightforward, and automation allows for clients with low-average account sizes to be served at lower cost. On the other hand, older or wealthier clients with more complex needs require more extensive advisor support or even a dedicated advisor. As client segmentation becomes more refined and products become increasingly sophisticated, the degree of advisor support may develop along a continuum of service, where advisor support increases along with client needs. Investment Most robo-advisors provide investment management only, because portfolio building is management versus more amenable to automation than holistic financial planning. However, some robo- holistic financial advisors do offer financial planning, depending on their target client segment. Robo- planning advisors that offer financial planning usually provide more extensive advisor support, which is especially valuable during the discovery process. Certainly, if a comprehensive financial plan is to be implemented, a robo-advisor would have to broaden the product offering beyond investments to include, at the very least, insurance. Retail versus Some robo-advisors dedicate their services to the retail investor. Others have added institutional platforms an institutional platform that services intermediaries, such as third-party advisors and employers. Some robo-advisors also support group-retirement savings plans by providing rebalancing and advisor support. Distributor-only versus Early entrants into the robo-advisory space offered mostly third party products and integrated model focused their expertise on distribution. As the market developed, a few asset managers launched robo-advisors that facilitate the distribution of proprietary products, either exclusively or in addition to third-party offerings. Some robo-advisors that started as distributors have also expanded into asset management by adding proprietary products to portfolios. INDUSTRY IMPACT OF ONLINE WEALTH MANAGEMENT Online wealth management services have changed the industry in several important ways, as described here: Reduced cost of wealth Before online wealth management services emerged in the industry, clients in their early management accumulation phase (i.e., those with less than $100,000 in investable assets) could choose between two options: A non-advisory discount firm offering portfolio-building tools only An advisory firm offering mutual fund wrap products (i.e., security selection plus asset allocation) at an average fee above 2% © CANADIAN SECURITIES INSTITUTE 4 16 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 After the launch of online wealth management services, robo-advisors became a third option. Most robo-advisory firms have low or no account minimums, at a price range from 0.65% to 1.05% for a $100,000 balanced portfolio. In making a choice, clients can compare the cost and service levels of a robo-advisor with a traditional model. They can also compare the level of advisor support provided by various robo-advisory firms. Growth of personalized Some robo-advisors have developed an offering to attract clients with investable assets advisory services between $100,000 and $1 million. This group is sometimes referred to as emerging affluent clients. As the competition for affluent clients (i.e., those with more than $1 million in assets) intensifies, traditional advisory firms are increasingly focusing on the emerging affluent segment, who are likely to meet the minimum investment levels for more personalized offerings. A robo-advisor may provide a continuum of service, along which clients can be transitioned according to their evolving needs and the firm’s ability to serve each segment profitably. Increased productivity Given the rate of retirement among advisors, integrating technology with face-to-face of traditional advisors offerings will be necessary to increase the number of clients per advisor. Accordingly, some robo-advisors have created a platform for traditional advisors or advisory firms interested in automating elements of the investment process. This model can allow more time for the advisor to focus on the client relationship. Vertical integration As initially conceived, the robo-advisory model was not simply a distribution strategy; of distribution and it was an approach to wealth management premised on the view that asset allocation, portfolio management rather than security selection, is the greatest contributor to investment returns. High fees were seen as the largest hindrance to wealth growth. As such, ETFs continue to be core products offered by robo-advisors. However, there is a trend among these firms toward offering proprietary products at higher price points, particularly actively managed ETFs. In some cases, they offer managed products that apply a traditional, fundamental investment approach. As a result, asset managers who enter the robo- advisory space have enhanced the direct distribution of their products. KEY RISKS FOR ONLINE INVESTMENT BUSINESSES Online investment businesses, much like traditional investment dealers, incur a number of risks that can threaten their operation. The key risks they face are process risk, business disruption risk, technology risk, staffing risk, and regulatory risk, all of which can be considered subcategories of operational risk. Each of these risks is defined briefly below. PROCESS RISK Process risk is the risk of internal disruption in the performance of current processes. Processes at risk includes such tasks as opening accounts in a timely manner, processing orders, managing payments, and handling incoming and outgoing mail. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 17 BUSINESS INTERRUPTION RISK Business interruption risk is the risk that an outside factor could affect a firm’s ability to continue operations. Potential disruptions include power failure, chemical spills, fire, earthquake, health epidemic, or any toxic or catastrophic occurrence affecting the work environment. An alternative site may be required in such cases for business continuity. Under the IDPC rules, a dealer member must establish and maintain a business continuity plan identifying the necessary procedures to be undertaken during an emergency or significant business disruption. The procedures must provide reasonable assurance the dealer member stays in business long enough to meet its obligations to its customers and capital markets counterparts, and must be based on the dealer member’s assessment of its critical business functions and required levels of operation during and following a disruption. A dealer member must update its plan in the event of any material change to its operations, structure, business, or location. A dealer member must also conduct an annual review and test and an appropriate executive must approve its business continuity plan. Similarly, OSC-registered firms are required to establish a business continuity plan in compliance with Section 11.1(b) of NI 31-103. Furthermore, NI 21-101, Marketplace Operation stipulates testing requirements for business continuity and disaster recovery plans. TECHNOLOGY RISK Technology risk, which is the risk of system failure, falls into either of two categories: technology operational risk and Internet security risk. Both risks are described briefly below. TECHNOLOGY OPERATIONAL RISK Technology operational risk is the risk of system or hardware failure affecting areas such as connectivity, information storage, online transaction records, and account recordkeeping. Backup systems are usually required, and all systems must be stress-tested to ensure peak capacity, capability, and reliability in times of high volumes and volume fluctuations. CYBERSECURITY RISK Internet use carries specific risks that apply to all business conducted through its channels. Clients of online brokers must take precautions to ensure the security of their accounts and client information, as is required of all internet users. Clients should be advised to keep their password confidential and review transaction activity in their accounts regularly. They should also ensure browser security and avoid using public computers to access their accounts. Firms can implement certain the following measures to reduce the likelihood of unauthorized transactions in client accounts, among others: Encryption technology Secure login processes Firewalls Virus protection Cases of security breaches that occurred in the past all involved the fraudulent scheme known as “phishing”, which is the act of posing online as a legitimate company to obtain security codes or other protected information. Monitoring of computer use at public sites to obtain secured information was also a prevalent scheme. More recently, the regulators have focused the investment industry’s attention on cybersecurity issues in general and have provided guidance regarding which form of security is critical to the stability of firms and to the © CANADIAN SECURITIES INSTITUTE 4 18 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 investment industry in general. CIRO (formerly IIROC) put forward detailed guidance to support investment dealers (both traditional and online), to ensure that their operations are prepared for and protected from such risks. STAFFING RISK The investment business by its nature experiences rapid growth patterns and seasonal fluctuations. These shifting patterns necessitate the hiring of additional staff at predictable and unpredictable times. For example, periods of unforeseen growth may necessitate rapid expansion of staff without much notice. More predictable staffing needs occur in first two months of the year, when contributions to RRSPs tend to increase. Close monitoring of business metrics is required to ensure that firms are able to hire registrants in time to be trained and licensed, thus ensuring that customer service is maintained. Additional staffing needs must be met by reputable, capable, and trustworthy persons. Approval is required for licensed representatives from the firm’s regulator. REGULATORY RISK Registered dealer members must meet all applicable regulatory requirements in addition to SRO rules. They must abide by privacy regulations and all regulations aimed at preventing money laundering and terrorist financing. Many of the privacy requirements are met through secure login and record retention processes. Computer recognition, passwords, high-level encryption techniques, and other secure means allow clients to log in securely. Anti-money laundering and terrorist financing regulations are fulfilled through proper account opening procedures (including a robust client identification program), account supervision, and reporting requirements. Online investment businesses may incur other risks, depending on the nature of the business. One such risk is credit risk, which is the risk that the firm will be unable to cover margined accounts and or that clients and counterparties will fail to pay their obligations. The success of an online investment business is dependent on a positive reputation. All aspects of a firm’s business, including the above factors, play a part in maintaining a strong reputation. Robo-advisors may derive a significant portion of their revenues from referral-based relationships with unregistered individuals, such as financial planners and life licensed agents. As a result, and given the low impact “hands off” nature of what a robo-advisor does, it is very important for a robo-advisor to ensure that its onboarding process is being completed by end-clients who may then receive direct advice from a licensed portfolio manager and not an otherwise unregistered individual. KEY SUCCESS FACTORS FOR ONLINE INVESTMENT BUSINESSES To remain competitive and sustain growth, it is critical that online investment firms understand what clients are looking for and which types of clients they want to attract. A firm’s strategy dictates the direction of the business and the type of clientele it seeks, whether they are passive or engaged investors, high-activity traders, or asset accumulators. Market segmentation is necessary for the appropriate allocation of resources at the various types of businesses. For example, discount brokers must determine where to allocate resources based on their strategy. One firm might spend more resources on representatives who can assist clients with technology and implement investment strategies. Another might focus on building a superior trading platform that is specifically geared to provide high- volume traders with news, data, analysis, and rapid response. Depending on whether the online offering is discount brokerage or advice, and depending on the market segment the business is intended to serve, success may rely on the following factors, among others: Trust Client experience © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 19 Product and account availability Reliable, up-to-date technology Investment performance TRUST Brand strength and recognition can take years to build and must be protected by maintaining the trust of both seasoned and new investors. All investment dealers are covered by the Canadian Investor Protection Fund, and bank-owned online investment firms are generally perceived to be more trustworthy. However, younger investors are generally more comfortable dealing with digital start-ups, and some have influenced their elders in this respect. With online platforms, trust is engendered largely through transparency, which allows clients to track money movement, performance, and fees anywhere and at any time, with the device of their choosing. Fintech firms still require substantial advertising as well to build a strong brand. Some discount brokers and robo- advisors build trust by partnering with a recognized firm or by outsourcing brokerage, clearing, and custody to a well-established third party. Both online firms and more traditional firms use these methods to build trust and convince clients that their money and investments are secure. Furthermore, robo-advisors that include financial planning in their online offering require innovative approaches to building trust in the advisor-client interaction. CLIENT EXPERIENCE The client experience has become a strong competitive factor for online investment firms. This term encompasses website navigation and the integration of the offering across devices, ease of accessing a representative, and first- call resolution of client complaints. Although younger investors generally prefer to interact exclusively online, other client segments may place a high value on personal interaction. This type of communication can take many forms, including problem resolution or dealing with a licensed representative, operations personnel, or client service representative at a satellite branch office. Operations must be efficient and well run to support client needs and to ensure client satisfaction. PRODUCT AND ACCOUNT AVAILABILITY Clients of discount brokers want choice, so it is important that those firms provide it. They must have a full and complete product array, and they must bring new suitable products into the suite of choices immediately. Since the early 2010s, new offerings at discount brokers have included currency and commodity trading, as well as registered accounts in U.S. dollars. Robo-advisors, on the other hand, do not compete based on an expansive product selection. Firms that target younger clients with simple investment needs tend to promote the benefits of passive investing, which can be implemented mostly with broad-based ETFs. For clients with more complex needs, such as retirees who need to create an income stream, robo-advisors supplement basic ETFs with a few carefully selected alternative products. Portfolio optimization across all account types, including tax efficient rebalancing, is more pertinent to the competitive position of a robo-advisor than product breadth. RELIABLE AND UP-TO-DATE TECHNOLOGY The nature of the online investment management business demands reliability and up-to-date technology. Clients want their transactions completed quickly and accurately, and technology risk is a key concern. Loss of access caused by technology failure is not acceptable. Market data, technical analysis, and other technology linkages are critical, not only for the active participant, but also to provide a sense of security to all clients. Fintech firms were able to pioneer the robo-advisory space because they offered platforms that incorporated the latest technological © CANADIAN SECURITIES INSTITUTE 4 20 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 innovation much faster than traditional advisory firms were able to. Advanced technology in a secure environment is the benchmark for the online offerings of fintech firms. INVESTMENT PERFORMANCE For the self-directed discount brokerage client, investment performance is solely the outcome of individual decisions and choices, which the tools provided by the firm facilitate. However, for robo-advisors offering discretionary asset management with model portfolios, investment performance is a competitive factor. For asset management firms that distribute products with long-term track records through their online platforms, investment performance is promoted as an advantage. Even in these early days, comparative analysis of online wealth management offerings has highlighted the fact that model portfolios at various robo-advisory firms for the same client profile can differ substantially. At the very least, online wealth management will increase the level of performance transparency. OTHER FACTORS Beyond the key success factors described above, business growth is also stimulated by clients consolidating assets and opening new accounts. In this regard, free trade offers at discount firms and fee waivers at robo-advisors are useful strategies. For discount brokers, one method to achieve profitable growth is to attract active accounts that maintain a reasonable account balance. A matrix used to monitor the firm’s success measures trades per account per year. New account openings can forecast potential increases in transaction volume and should be reviewed carefully. This information is critical in determining server capacity and requirements for support personnel. As the discount brokerage industry continues to mature, it caters to a more diverse client segment, including the asset accumulator segment. For this reason, spread revenue has become as important a measure of business performance as commissions. Online platforms provide firms with operating leverage to enhance profitability. Achieving economies of scale is therefore critical for both discount brokers and robo-advisors. Fintech robo-advisors, no matter how technologically advanced, may still have trouble achieving scale. Many firms face client acquisition costs that outpace the lifetime value of a client. Factors hindering scalability include relatively low account values, high advertising costs to build brand recognition, and increased competition. For robo-advisors focused on the business-to-customer market, success may depend on their ability to use their technology in the institutional market. For traditional advisory firms, robo-advisory platform can increase advisor productivity and allow the firm to provide continuous service throughout a client’s life cycle. For asset managers, a measure of success for their robo-advisory offering is the ability to monetize an existing client base by gaining a greater share of their assets. MEASURES AND TRENDS The key metrics of a business are necessary tools to ensure accurate tracking of business changes and client trends. A good understanding of the numerical impact of these changes allows for good planning and provides insight into future technological and personnel requirements. Given the training and licensing requirements of the industry, a business can position itself to handle the impact of sudden changes by taking action at the appropriate time in the business cycle. For example, a sudden rapid increase in new account openings could indicate a future rise in transaction volumes for a discount brokerage, or it could signal an early start to the RRSP season. Account retention is a key factor in business success because it is more expensive to attract new business than to expand existing business. By monitoring lost business through outbound transfers, firms can identify contributing factors that must be rectified, such as poor service standards or product shortcomings. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 21 The following key indicators can provide insight into the business performance of a discount brokerage: Number of specific types of accounts Daily transaction volumes Total daily commissions Mutual fund revenues Other fee revenue Average margin loans outstanding Productivity ratio Investment, margin, registered, and high-volume trading accounts Gross revenue and percentage of assets under administration Total number of revenue transactions Average commissions per trade Average number of trades per account per year Average credit balances Number of account transfers out, and where the accounts were transferred BUSINESS AND PRODUCT LINKAGES Discount brokerage has thrived by offering a broad range of products. Online wealth management, on the other hand, offers a comparatively narrow selection for the most part. Traditional portfolio managers that enter the robo- advisory space enjoy the benefits of vertical integration with their existing operations. For firms with multiple distribution arms, product linkages can be established to allow for common product design across channels. These links ensure that both traditional and online advisory services have similar products available, which enhances client retention. Similar investment solutions across channels may be packaged differently (e.g., as mutual funds, pools, or segregated accounts) at different price points. Price differences reflect bundling discounts or differences in average account size or service levels. Thus, the firm is able to transition clients from one service to another throughout their life cycle. With proper mechanisms and products in place, clients can be referred to businesses within the same financial group or partnering institution. In this way, a firm can increase its profitability while improving the client experience. When referred to the appropriate business segment, clients are less likely to take their business elsewhere. EXAMPLE An advisory client wishes to invest in some equities and mutual funds directly, which the robo-advisor is not able to facilitate. The firm refers the client to the discount broker owned by the parent, thus retaining the client’s business. A client continually, on her own volition, seeks to buy non–recommended or unsuitable investments from a full-service advisor. The advisor refers the client to the parent’s discount brokerage operation, where suitability requirements do not apply. At the discount brokerage, the client is able to purchase higher-risk investments based on her stated investment objectives. A discount brokerage client constantly seeks advice, which regulations do not allow the broker to provide. Instead, the broker refers the client to the parent firm’s full-service or robo-advisory division. The client could also be added to a firm’s pipeline and be transitioned to a more personalized offering when he meets the account minimum. © CANADIAN SECURITIES INSTITUTE 4 22 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 EVOLVING COMPETITIVE FACTORS Understanding the business environment is a success key factor for online investment firms. However, business is constantly changing, and new trends and developments affect both clients and business leaders. In this section, we discuss some of those factors. INFORMED CLIENTS With ready access to information, clients are becoming more knowledgeable about the investment market. Sources include internet sites, specialty publications, business news television shows, informative radio programs, and the education system. In response to demand, discount brokers are providing broader research and greater access to technical analysis. As a result, many clients feel prepared to manage their own investments and make knowledgeable choices about advisory services. On the other hand, robo-advisors that offer managed accounts encourage clients to leave the complexity of investment decisions to the professionals. But even clients who opt for discretionary management must be knowledgeable enough to choose the right firm for their personal needs from among the wide range of robo- advisors. PRICING PRESSURE With the dramatic drop in discount brokerage commissions over the years, pricing has become less of a consideration for the self-directed client. Prices for this type of service are typically somewhat consistent across different firms. For managed assets, however, pricing pressure is expected to increase, primarily for those firms that focus on the mass affluent market. Additionally, as the trend toward passive investing intensifies and fee structures become more transparent, some clients may question the value they receive in return, in particular as they relate to the returns on their investments. Online wealth management firms have built their offerings primarily with low-cost ETFs. To compete effectively against these robo-advisors, traditional channels will have to either justify a higher price point through their value proposition or adopt technology to lower costs. A strategy that combines both solutions may be necessary. Continual improvements in technology and the automation of operational support have helped firms to become more efficient and will continue to do so. Increasing efficiency will allow them to reduce pricing, expand market share, and emerge as market leaders and innovators. Client acquisition costs, however, will remain a challenge for stand-alone fintech firms that do not have brand recognition in the market. A dynamic environment of partnerships between fintech and traditional firms is one strategy that allows firms to lower acquisition costs and build scale rapidly. PACE OF TECHNOLOGICAL CHANGE Public acceptance of internet technology first fueled the growth of discount brokerage and is now propelling the rapid expansion of robo-advisory accounts. The internet provides a robust and fast-expanding learning forum for users of self-directed services, and many firms contribute to service. They offer education on topics ranging from basic conservative portfolio structure to complex product features. The trend is to develop as many tools and learning aids as possible to increase self-directed investors’ confidence in their knowledge of products and risks. In providing self-help tools, firms also build relationships with their clients by keeping the clients connected to their websites. Continuous competition in technology has also led to the adoption of cloud computing and data mining techniques in all forms of online investment management. For the robo-advisory client, innovative technology contributes to the optimization of asset allocation across accounts and households. It also provides access to alternative products, tax efficiency, and dynamic, cost-effective rebalancing to ensure that the portfolio reflects the strategic mix at all times. © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 23 CLIENT SEGMENTATION Advanced technological applications can be used to segment a client base into new client categories with specific needs. For example, high-volume traders demand more market information, quicker access to global news releases, and speedier market access and order execution. These clients also look for sophisticated charting and analysis, as well as real-time reporting and alerts. Specialty high-volume trader platforms have been designed specifically for and made available to this client segment. The demographic makeup in North America has had a strong influence on the development of online investment services. The growth in discount brokerage was largely driven by baby boomers’ desire to control their own finances. Millennial investors in general prefer a more hands-off approach, which makes them good candidates for discretionary online offerings. As technology continues to develop, client segments are likely to become more refined to reflect niche investment needs and preferences for specific delivery channels. It remains to be seen whether millennial investors, accustomed as they are to self-service, will want to deal with an advisor when their asset levels qualify them for personal service. Firms will have to focus on the changing needs of these clients to ensure that their value proposition remains sufficiently compelling. CLIENT EXPECTATIONS Clients in the wealth management industry have high expectations and are likely to become more demanding over time. Although online reliability is high, any downtime represents a huge reputational risk. Innovation ranks highly with clients who seek and expect ongoing improvements in service and technology, such as an integrated offering across platforms. They expect new product additions to be prompt and effective. Younger adults in particular expect frequent improvements to technology and rapid implementation. The ultimate goal of every firm is to attract and retain the greatest possible number of satisfied clients. A 2015 survey on discount brokerage conducted by J. D. Power and Associates ranked the following key factors in order of importance to clients: Client interaction (trading and operation support) Account information and statements Trading costs and fees Account offerings Information resources Problem resolution The same survey found that, although less than a quarter of discount brokerage clients were aware of automated portfolio management services, most of them, especially younger clients, were interested in such a service. To achieve the highest ranking among clients, online investment firms must commit to providing excellent service that incorporates state-of-the-art technology and operations. © CANADIAN SECURITIES INSTITUTE 4 24 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 SUMMARY In this chapter, we discussed the following key aspects of risk management in the context of online investment business models: Discount and online investing services are provided are provided through two business models: Discount brokerage, which is an order-execution-only model Online wealth management, which is a robo-advisory model Trends in the discount brokerage business are driven by changes in demographics and technology. Challenges include: Conflicts with other investment channels Regulatory considerations Pricing pressures Commoditization to maintain a competitive edge The different discount broker models include multi-branch, nationwide network call centres; the multi-call- centre structure with regional salespersons; provincial operations office with regional sales personnel; the limited branch model with street-level locations; and technology-based firms with a very limited physical presence. Technology plays a critical role in discount brokerage, providing clients with direct links to order-processing platforms. Rapid public adoption of the self-serve investing model is driving rapidly increasing technological capability. The discount brokerage was heavily reliant on commission revenue during its high-growth phase. However, firms have more recently focused on diversifying revenue to provide stability in times when market and client trade activity is low. In regard to online wealth management, robo-advisors provide advisor support and financial planning to varying degrees, typically over the internet or by telephone. This investment model relies on a passive investment approach by building portfolios mostly with ETFs. The millennial generation in particular has readily adopted this lower-cost, lower-service alternative to standard investment advice. In contrast to discount brokerage, a robo-advisory firm is predominantly a fee-based model. To gain a competitive edge, robo-advisory businesses are becoming increasingly diverse. Variations include discretionary and non-discretionary models, online-only and hybrid models, and retail and institutional platforms. Two key effects of robo-advisors on the wealth management industry are reduced costs and increased productivity through automation. The risks in the online investment industry are generally similar to those faced by traditional investment dealers. The key risk is operational risk in its various forms. Cybersecurity risk in particular is concern for both discount brokers and robo-advisors, given their reliance on internet transactions. Privacy regulations are another key concern, with secure login and record retention processes being of the utmost importance. Depending on whether the online offering is discount brokerage or advice, and depending on the market segment the business is intended to serve, success may rely on the following factors, among others: Trust Client experience Product and account availability Reliable, up-to-date technology Investment performance © CANADIAN SECURITIES INSTITUTE  CHAPTER 4      ONLINE INVESTMENT BUSINESS MODELS 4 25 Evolving competitive factors in the industry include greater access to information, which means clients are less likely to see value in the client-advisor relationship. Other factors include pricing pressure, rapid technological change, and changing client expectations. Achieving a high ranking in the industry requires a commitment to technology, client service, and operational excellence. The material in this chapter should expand your knowledge of the different types of firms that operate in the growing field of online investment services. In the next chapter, we focus our discussion on the investment banking business. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 4 Review Questions. © CANADIAN SECURITIES INSTITUTE