“What regulatory issues does the brokerage industry face with respect to the retail investor and the advent of online securities trading?”
The number of securities trades conducted online has taken a dramatic increase in recent years, rising from under 100,000 trades per day in 1996 to over half a million in 19991. The SEC (Securities and Exchange Commission) expects the level of online brokerage assets to rise to $3 trillion dollars by the year 2003, from a meager $415 billion in 19981. The appeal is that the Internet provides “real time” stock quotes, previously available only to brokers and their firms, in addition to a wealth of information on just about every company that is publicly traded. A new breed of investment firm has been born, conducting its business solely on the World Wide Web, and the average fee charged by one of these companies is now only $15.75 per trade , a fraction of the cost at a full-service firm. Online trading has given rise to a greater frequency of trades as well. While online traders only currently represent about 10 percent of the market, they tend to trade two to three times as often, making up approximately 30 percent of all trades, up from 17 percent in 1997 . Many people have given up their jobs to become full time traders, with mixed success. In fact almost all day traders lose money, and the recent market turmoil has left many gasping for breath. In its new form as the “Online” brokerage firm, the business is still flourishing. Despite being forced to lower their commissions and advertise more to attract new business, they are managing to adapt. DLJ Direct, for example, has posted an 82 percent increase in revenues from 1998 to 1999 , and as of July 1, 1999, online transactions accounted for 52 percent of all trades at broker Charles Schwab . With the general trend of the market moving towards computerized trading, the brokerage industry is being forced to evolve as well.
Due to the high volume of trades conducted via the World Wide Web, several problems have been encountered regarding both the application of current trading laws to cyberspace and the integrity of internet users with regard to the brokerage industry. The Securities and Exchange Commission has recently published a report concerning on-line brokerage, which attempts to determine what the place of the brokerage firm will be in this Internet scenario, and what measures can be taken to regulate the transactions conducted on the world wide web. Many of the problems encountered with the advent of the Internet are analogous to those in conventional trading, and are addressed by existing laws and regulations. However, the Internet also presents unique situations that will require new methods of surveillance and enforcement by the regulators.First, there is the issue of computer systems: how to ensure that a firm’s system has enough capacity to handle the marked increase in the number of investors that the Internet has generated. Second is a given firm’s obligation to execute a customer’s trade at the best monetary terms readily available(known as the “Best Execution Responsibility”). Third is the application of the suitability doctrine , which requires a broker to recommend to his/her customer only those investments that are deemed “suitable” for that individual. Fourth is the general concern over privacy of investor’s personal information, and the ability of a firm to ensure it. Last is the issue of insider trading and fraud, and the regulatory issues concerning these problems.
First, there is the issue of systems capacities. In the past, many systems have suffered from things such as delays and outages, causing serious customer concerns over reliability.Firms will be forced to issue disclosure statements regarding the reliability of computer systems, and clients will tend to gravitate to those firms with the most dependable systems, and the systems that can handle the most customers. The SEC Report concludes the following.
“The Commission should focus on methods to ensure more adequate systems capacity at all broker-dealers.
The Report recommends that the Commission consider requiring broker-dealers to:
1.Maintain and periodically test contingency plans;
2.Maintain records of significant systems outages;
3.Conduct regular systems testing and evaluation; and
4.Include plain English disclosure of the risks of systems delays or outages in new account documentation”
Although occasional systems failures are inevitable, sincere effort has and will be devoted to ensure that such outages are infrequent.
Second is the question of “Best Execution”. This concerns a broker’s responsibility to seek for their clients the most favorable terms that are readily available . Dealers must implement a regular analysis of transaction systems and investors must realize that however fast the Internet is, trades are not instantaneous. Consequently a uniform system must be developed to ensure that all orders are executed in a nearly equal and thus fair window of time. Failure to do so may be a violation of the antifraud provisions of the federal securities laws, in addition to quickly alienating customers who are now capable of quickly switching the companies with which they do business. Typically, however, orders are fed first come, first serve into a computer database of numerous markets, and are filled automatically by the system at the best terms readily available.
Third is the concept of suitability, and its application to online investing. The primary difficulty with this concept, however, is drawing the line between providing information and making a recommendation to a customer. It is generally agreed that when a firm provides pure order entry and execution services, the doctrine of suitability does not apply. It would also appear that when a customer disseminates information from a firm’s website and subsequently purchases shares in the applicable corporation, the firm supplying the information is not liable under the suitability obligation, because the information is not customer specific. A gray area, however, is when a customer is sent information specifically tailored to his/her requests or history on the Internet. One of the participants in a “Roundtable” discussion hosted by the SEC suggested “the benchmark for suitability should be whether a customer reasonably believes that the information sent to him took into account his ‘personal circumstances.’”Currently, the Commission is taking a flexible view of the suitability obligation and its application online, and will continue to revise its policy as technology makes it necessary.
Fourth, there is the question of privacy concerns online. How does the online brokerage firm ensure the privacy of investor information? In a recent survey of Internet users, the Georgia Institute of Technology found that “more than 87 percent of Internet users were either somewhat of very concerned about their personal privacy while on-line.”Many people feel that online registration forms requiring personal information aren’t worth the risk, because there is frequently no indication of how the information will be used. One piece of legislation however, has attempted to regulate the sharing of information, both on-line and off. The Gramm-Leach-Briley Act provides that a firm must notify a customer before disclosing nonpublic personal information, and that the customer has the opportunity to opt out of such disclosure. With the development of technology at its current pace, however, increased vigilance may be necessary to ensure investor’s privacy.
Also present is the issue of insider trading, made easier by anonymous bulletin boards and chat rooms. In his speech at the National Press Club, SEC Chairman Arthur Levitt comments that “they(chat rooms) have been compared to a high-tech version of morning gossip or advice at the company water cooler. But at least you knew your co-workers at the water cooler. That just isn’t true on the Internet, and I hope investors recognize that.”He goes on to compare regulation in chat rooms to a neighborhood watch program, saying that this will be a primarily investor-regulated field. With regard to false press releases and junk email touting small or nonexistent stocks, most of these perpetrators are traceable. Investors, however, should be extremely cautious when relying on these dubious sources of information, and should definitely consult several additional independent sources of information before making a decision.Some recommendations issued by the SEC are as follows.
1.“Get financial statements from the company and be able to analyze them;
2.Verify the claims about new produce developments or lucrative contracts;
3.Call every supplier or customer of the company and ask if they really do business with the company; and
4.Check out the people running the company and find out if they’ve ever made money for investors before.”
In addition, the SEC is actively prosecuting Internet fraud allegations, and have achieved more that a few indictments.
The SEC has been regulating the exchange of securities for many years, and the question they now face is how to impart some form of regulation to the Internet, and when. At what point does the World Wide Web rise above the floor of the stock exchange in sheer volume of trades, and is it wise to wait until then? These are questions that have yet to be answered.
As for the Wall Street brokerage firm, it has already begun to evolve with the Internet, and will most likely continue to change for some time yet. Although the change in the markets will reduce the need for such positions as stock brokers and exchange floor clerks, among others, the economy tends to create jobs where they are needed. There will be even more need, for instance, for computer support people, systems analysts, researchers, and many others. Additionally, regulators will be forced to adapt to the changing face of the securities markets, and laws specifically tailored to the Internet may very well be required.
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