Secondary Trading of Securities in Cyberspace.
THE INTERNET AND THE CYBERSECURITIES MARKETPLACE
Denis T. Rice, July 1998
A. Discount Broker-Dealers.
Even before it was used for offerings of securities, the Internet had begun developing a new dimension for secondary trading in already-issued securities. Small discount brokerage firms were the first to offer full online trading services and research to account holders in 1995. By October 1996, investors checked stock prices electronically and obtained other information from the NASD Web site 2.1 million times in just one day. The online firms allowed It was estimated that in 1966, there were 1.5 million online accounts, almost double a prediction made in late 1994. In 1997, the number had grown to almost three million, and the number is expected to be 14 million by 2002. Internet-based trading accounted for 17% of total retail sales in 1997 according to one survey, with that figure expected to increase to 30% by the end of 1998.
The online firms allowed investors to have access to their portfolios 24 hours a day and to place orders anytime. Online brokers typically have provided news and stories about the investor's portfolio holdings, free quotes on stocks, bonds, and mutual funds, some even send an e-mail at the end of the day with closing quotes for an entire portfolio.
Seventy-six brokers were offering some form of electronic trading in mid-1998. The most prominent are Charles Schwab & Co., which offers full-service cyberbrokerage through its StreetSmart and other systems, and E-Trade. As of March 1997, Schwab had 700,000 active on-line accounts and $50 billion in on-line customer assets, and by December 1997, Schwab's sales by means of electronic trading for the month for the first time were more than half the firm's total retail sales.
Assets managed by on-line investors are predicted to grow from over $100 billion today to $524 billion in 2001 and account for more than 8% of the total assets held by small investors. Apart from actual trading in securities, the Boston Consulting Group predicts that firms with institutional clients will perform increasingly complex analysis and create increasingly complex financial instruments.
A spur to online brokerage has been the proliferation of links between broker-dealers and other Web-based services. For example, the Web site of the newspaper USA Today, from its "Marketplace" page (www.usatoday.com/marketpl/finan.htm), gives viewers direct links to six on-line brokerages such as E*Trade and Accutrade. USA Today receives a flat fee for each order received by the brokerage firms. Because of the fee, USA Today arguably might fall within the definition of a "broker" under the Securities Exchange Act of 1934 ("1934 Act") and be required to be registered as such. However, the SEC issued a no-action position in 1966 which has allowed online access services, such as America Online or CompuServe to connect viewers to broker-dealers without their own registration as broker-dealers, even though the access service receives a flat fee for each order transmitted through an icon on the Website menus to licensed broker-dealers. Certain conditions must be met: viewers may use the access service or link to reach a licensed broker-dealer by clicking an icon and then open a brokerage account, but the access provider must not take any part in the licensed broker-dealer's services other than by routing messages. Moreover, such access providers must not to handle any customer funds or securities, effect clearance of trades or extend credit to any customer in connection with a purchase of securities. The "nominal" flat fee paid by the broker-dealer to the online access service for each order transmitted may not vary depending upon the number of shares, value of the securities involved or the successful execution of the trade. Assuming USA Today follows a similar format, it would also avoid having to register as a broker-dealer.
Charles Schwab and E-Trade have begun expanding their on-line trading outside the U.S. E-Trade has launched an Australian service and signed a licensing agreement to cover expanded services in Germany and Central Europe, partnering with Deutscheland AG and Berliner Freivekehr Group. Schwab is upgrading its United Kingdom electronic system, where E-Trade has yet to sign a deal. Stockhouse, a highly robust site at www.stockhouse.com, is in effect a giant cybersecurities mall that not only links the viewer to brokerage firms with web addresses, but also provides links with 51 stock markets around the world. These include the New York and American Stock exchanges, Nasdaq, and major foreign markets such as the London, Tokyo, Korea, Madrid, Oslo, Paris and Frankfurt exchanges.
B. Full Service Broker-Dealers.
Full-service brokerage firms have been slower to accept on-line trading. Of the top five securities firms as measured by number of brokers, only Morgan Stanley Dean Witter & Co's Discover Brokerage Direct" unit ranks in the top 10 on-line brokers. One of the predecessors had acknowledged the potentialities of the Web in December 1996, when Dean Witter, Discover & Co. acquired a fledgling San Francisco-based Internet discount broker, Lombard Brokerage and changed the name to Dean Witter Lombard's. The Dean Witter deal for Lombard reportedly upset some of Witter's brokers, who were unhappy about going toe-to-toe with an affiliated discounter. Other full-service brokers, who have largely stayed back from online trading, were in 1997 looking at the use of client-broker e-mail as a tool to significantly improve productivity. An officer of Raymond James & Associates has been quoted as saying that while most full-service firms found electronic trading in complete opposition to their mission, "now we're not so sure." At the annual conference of the Securities Industry Association in November, 1997, IBM's chairman challenged the industry to move fully onto to the Internet asserting that firms with well-established names ran a risk of losing their advantage if they waited too long to enter cyberspace. Merrill Lynch had indicated that it expected to offer electronic trading in the fall of 1998. Merrill, however, does not believe that Internet trading is "one of the highest-rates" services by its clients.
Questions of how and when to monitor e-mail between brokers and clients have been a significant concern of the full-service securities firms in exploring the use of the Internet. Prudential Securities announced in 1997 a system of e-mail for its customers to send orders to its brokers, who would then arrange for execution or contact the customer. It also introduced a live internal e-mail network, in order to allow compliance personnel to review and archive e-mail in a paperless environment. New e-mail surveillance products were introduced that aimed at providing a practical way to filter and review e-mail for potential sales practice violations.
Through the end of 1997, the New York Stock Exchange required that all electronic and written correspondence of registered representatives be reviewed before being sent. NASD members had to review such correspondence after it was sent. More liberal e-mail rules were proposed in 1997 by the New York Stock Exchange and the National Association of Securities Dealers. The changes were intended to allow firms like Prudential to review fewer e-mail messages, provided they establish certain compliance guidelines and employee educational programs. The SEC approved the rule proposals on December 31, 1997, effective February 15, 1998. As a result, supervisors at NYSE member firms are no longer compelled to review all e-mail messages by registered representatives before they can be sent to customers. However, some broker-dealers have decided to continue to maintain a close watch over e-mail communication between their registered representatives and their customers.
Security is another key issue in the successful use of the Internet for issuance of securities secondary trading and furnishing of financial information. A perceived impediment to the entry into online trading by full-service brokerages has been concern over security and over the ability of hackers to break into their computers and those of their customers. Software and systems developers as well as major brokerage firms have been making large investments to address security issues. One security system developed for money management clients has been marketed by Tradeware (www.tradeware.com). It is designed to encrypt the FIXlink product discussed earlier (subsection III.B.), using a U.S. Government data encryption standard. Brokers using FIX software will also have available to them a more sophisticated encryption method developed by Morgan Stanley.
C. Banks and Internet Discount Trading.
While most full-service brokers have approached online trading with caution, banks have begun to embrace the new technology for their discount brokerage services. Citigroup in October 1997 announced an online brokerage service with commissions as low as $19.95 per trade. Other banks such as Fleet Financial, Mellon and BancOne acquired or forged alliances with online discounters. Wells Fargo Bank will begin promoting its new online brokerage heavily starting in August 1998. Customers will be able to buy most U.S. stocks, trade about 1,000 mutual funds as well as stock options and obtain news, quotes and research. BankAmerica plans to unveil its own Internet investment services in September 1998. It will allow customers to trade in all U.S. stocks and 1,000 mutual funds and to receive financial news and quotes.
D. "Membership"-Type Trading by Institutions.
Large institutional investors have used electronic trading among themselves since the 1970s. Instinet (www.instinet.com) introduced a closed networked computer system in which a group of institutional members could trade electronically among themselves, thereby avoiding brokers in the middle. As a professional stock trading system used by institutions (mutual funds, broker-dealers, etc.) to trade large blocks of stock with each other outside of the established stock exchanges, Instinet does not use the World Wide Web. Its members use a more limited electronic linking system that is essentially an "extranet." Their trades are made on an anonymous basis, directly between buyer and seller. In the past few years, other closed electronic services have started operating, such as the Island System and the Portfolio System for Institutional Trading ("POSIT"). While Instinet operates simply by electronically "hitting" offers posted in an electronic order book, POSIT uses a crossing system for batches of orders. Despite the fact that these alternative systems are limited to institutions, their volume of trading has greatly escalated; the SEC estimated in 1997 that they handled almost 20% of the orders in Nasdaq securities and almost 4% in New York Stock Exchange-listed securities.
There is no barrier to adapting the private network approach trading from existing extranets to the World Wide Web, provided that security and reliability issues can be successfully resolved. Once these issues are resolved, institutions may move to privately-accessed Web sites that will function similarly to Instinet trading. One software protocol claiming to have sufficient security to allow institutional broker-dealers to trade electronically with one another via the web is Financial Information Exchange ("FIX"), which provides a service called "FIXLink." FIXLink operates on a site (www.tradeware.com) where subscribing money managers can receive brokers' indications of interest, post-trade advertisements and brokers' reports of block-trade fills in FIX protocol over the World Wide Web. Subscribing broker-dealers can send the same kinds of information to targeted institutional customers or all the institutional participants.
Other institutional trading systems using the Web on a password-protected basis include a site operated by Daiwa Securities America for debt instruments: "The Odd-Lot Machine" (www.oddlot.com/). Daiwa's site allows institutions to trade electronically in U.S. Treasury bills (up to $10 million), note and bonds ($3 to $5 million, depending on duration) and strips. Institutional customers can accept the posted prices or enter their own bids by just clicking to the site. Interdealer trading in municipal bonds is also available through a Vermont dealer's web page, using a process of trading similar to the traditional system, except that the offers and bid occur in cyberspace--on the Web site--rather than by telephone and fax machine.
A number of firms have been building electronic
trading capabilities to enable online transactions in fixed-income securities.
As electronic trading in bonds over the Internet becomes increasingly
accessible not just to large institutions but also to high net worth
retail traders, we may anticipate increasing competition in the bond
marketplace. Vincent Catalaneo, President of the New York Society of
Securities Analysts, sees extranets as the next major step in the financial
services industry and believes they will help reduce concerns over security.
As institutions and the brokerage community become more comfortable
with the encryption technologies, it will further spur the increase
in web-based transactions.
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