The SEC, Your Money and On-Line Brokerages
A Special Report from the Securities and Exchange Commission
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Recent advances in information technology – particularly
the Internet – are revolutionizing commerce. The securities industry, most significantly on-line brokerage, is at the forefront of this revolution.
Research reports estimate that last year's $415 billion
in online brokerage assets will grow by more than sevenfold to $3 trillion in 2003. The 3.7 million on-line accounts open in 1997 have almost tripled to reach 9.7 million by the second quarter of this year.
On-line trading volumes have increased dramatically over the last several years. According to one analyst, volume has increased from under 100,000 trades per day in the second quarter of 1996 to over half a
million in the second quarter of 1999. The percentage of equity trades conducted on-line has grown to 15.9 percent of all equity trades in the first quarter of 1999.
On-line brokerage has significantly
changed the dynamics of the marketplace, causing one of the biggest shifts in individual investors' relationships with their brokers since the invention of the telephone. For the first time ever, investors
can – from the comfort of their own homes – access a wealth of financial information on the same terms as market professionals, including breaking news developments and market data. In addition, on-line
brokerage provides investors with tools to analyze this information, such as research reports, calculators, and portfolio analyzers. Finally, on-line brokerage enables investors to act quickly on this
The pace of change and the strength of the securities markets generally has enabled investors to more directly participate in the securities markets. This confluence of events – the
development of technology affordable to investors and increased investor access – has raised a number of questions for the industry and the regulators. The questions addressed in this Report are:
The Report provides a number of statistics to put in context the growth and activities of on-line investors and firms. It also describes the various products and services currently offered on-line.
Finally, the Report describes various trends in the industry, including: (a) the continued growth of on-line investing and the pressure it has put on traditional firms to offer on-line services; (b) how the
growth of on-line brokerage will impact the services firms offer going forward; and (c ) how firms are developing technology to provide automated, but personalized, advice on-line.
A well-established doctrine, suitability refers to a broker-dealer's obligation to recommend only those investments that are suitable for a customer. In order to trigger a suitability obligation, a
registered representative must make an investment recommendation to his or her customer. In the on-line environment, pinpointing what constitutes a recommendation can be difficult. As data mining technology
enables on-line firms to customize information and provide it to customers, this question becomes even more pressing.
3. How has technology impacted on-line firms' performance and evaluation of their best execution obligations?
The duty of best execution requires a broker-dealer to seek the most advantageous terms reasonably available under the circumstances for a customer's transaction. Although this duty evolves with changes
in technology and market structure, the Commission has stated that broker-dealers must carry out regular and rigorous evaluations of execution quality across markets and consider price improvement
opportunities. The combined events over the last three years of : (a) the growth of on-line brokerage, (b) the move to quoting in sixteenths, ( c) implementation of the Order Handling Rules, and (d) advances
in order routing technologies have impacted how firms approach fulfilling their best execution obligations.
4. How have on-line investors' demand for market information impacted the pricing of real-time data?
The federal securities laws grant the Commission broad authority over information about securities quotations and transactions. The Commission must ensure that market participants and the public can
obtain this information on terms that are "fair and reasonable" and "not unreasonably discriminatory." The Internet's ability to broadly disseminate real-time information to the public
and the concomitant rise of on-line brokerage have substantially increased demand for market data. This demand has raised a number of questions, including: (a) whether individual investors pay too much for
the information and (b) how much of that data revenue should be devoted to the operations of self-regulatory organizations.
5. How do firms ensure sufficient capacity to keep up with the systems demands resulting from on-line trading?
Over the past year, many on-line firms have experienced some type of systems delay or outage that affected the ability of their customers to place orders. Despite the industry's efforts to improve
capacity, the Commission's highest number of complaints about on-line trading comes from customers who cannot access their firms' systems. On-line firms vary in their approach to measuring systems capacity
and in their disclosure to customers about the risks of systems delays and outages.
Investor education is critical to investor protection. The decreased personal interaction between an on-line firm and its customers presents interesting challenges to providing investor education.
Investors can now access an unprecedented amount of financial information without the guidance of a broker. Educating on-line investors requires an understanding of how these investors trade and the
appropriate time and place to provide them with educational information. At the same time, the Internet provides a valuable resource for the Commission to more widely disseminate investor education
While on-line discussion forums may educate and provide a sense of community to investors, they also may provide a venue for fraudulent behavior. Many issuers monitor on-line discussions about their
companies but refrain from addressing rumors about them in the marketplace for fear that they may create a continuing duty to correct or update. Instead, issuers oftentimes go to court to unmask the
"anonymous" posters of information.
Broker-dealers have generally refrained from sponsoring on-line discussion forums on their sites although anectdotal evidence indicates that some firms may
consider doing so.
Customers increasingly are concerned about the privacy of their personal information. As on-line firms' data mining capabilities develop and the number of financial conglomerates continues to grow, so do
customers' concerns about what these institutions can and will do with their personal information. Control over customers' personal information was recently the subject of much discussion in the financial
modernization legislation debate. While the Gramm-Leach-Bliley Act requires the Commission and other regulators to adopt specific privacy rules, it appears the discussion is far from over.
Websites known as portals are considered the "on ramp" to the Internet, attracting millions of monthly viewers. Well-known portals include Yahoo! Finance, America Online, Quicken.com, and
Microsoft MoneyCentral. Portals have become broker-dealers' rivals for the attention of on-line investors. In addition, portals have become important intermediaries between broker-dealers and their
customers. A number of broker-dealers have entered into cobranding arrangements with portals, either paying a flat up-front fee or a per order "connection" fee for every order transmitted by an
investor who hyperlinks from a portal to the broker-dealer.
II. Findings and Recommendations
Roundtable participants generally subscribed to the traditional notion of suitability,
but suggested that the obligation did not apply to some, if not all, on-line activities. Although the participants were not unanimous on this point, the majority of them wanted clarification or guidance from
regulators. Resolving this issue will require several considerations. First, how should the regulators interpret the concept of "recommendation" online? Push and pull technologies make this a
difficult question to answer. Regulators need to consider how defining suitability on-line may impact information flow and customer access. Although some would argue that the Internet gives investors (and
consumers generally) too much information, investors may not want this information flow restricted, even at the expense of receiving unsuitable advice.
The Report recommends that the Commission:
obtain information from the industry on: (a) how data mining products would work, (b) what information the products would provide to the firms, and (c) whether customers would understand that the firm
had provided them with customized information;
alternatively, include as part of future Commission or SRO examinations a review of what services firms provide to their customers based on information
derived from data mining; and
work with the SROs to consider the hypothetical scenarios and relevant analysis, found in the Appendix to the Suitability Section of the Report, in providing guidance to
the industry regarding on-line suitability obligations.
Technology is making best execution an especially critical concept in today's market structure, and a significant competitive factor. Indeed, technology provides firms with the
opportunity to adopt a new approach to order routing and to meeting their best execution obligations. In the roundtable discussions, many on-line brokerage participants contended that speed and certainty of
execution are factors that should receive greater emphasis in their best execution evaluations. Moreover, some participants questioned whether on-line customers actually understood how their brokers' order
routing decisions affected their total execution cost.
The Report recommends that the Commission:
encourage the industry to demonstrate the relative importance of factors such as speed and certainty of execution in today's market environment;
consider requiring market centers to make certain
uniform information available on various best execution factors;
consider requiring broker-dealers to regularly provide customers with plain English information about: (a) the execution quality
available on different market centers; (b) the broker-dealer's order handling practices; and (c) inducements for receiving order flow received by the broker-dealer; and
the potential impact of new
order routing technologies on brokers' best execution obligations, investors, and the markets.
The Report briefly outlines the pricing structure for retail users of market data. Roundtable participants generally agreed that the Internet warrants a reevaluation of the pricing
model for delivering real-time market data to individual investors. However, the participants recognized the industry's need to meet the costs of creating and maintaining an infrastructure to collect and
disseminate market data.
The Report concludes that the Commission should encourage the broadest possible dissemination of real-time market data to investors, which requires evaluating whether the current
pricing scheme for market data is consistent with the federal securities laws. Because the Commission currently is involved in such an evaluation, the Report recommends that the Commission's upcoming market
data concept release address the issues raised in this section.
In the roundtable discussions, the participants acknowledged occasional systems failures are inevitable, but
indicated that they have committed significant resources to ensuring that their systems remain operational. The Report concludes that 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:
maintain and periodically test contingency plans;
maintain records of significant systems outages;
conduct regular systems testing and evaluation; and
include plain English disclosure of the
risks of systems delays or outages in new account documentation.
The Report also encourages the Commission to repropose the broker-dealer operational capability rule.
The Report reviews the current status of investor education and makes
certain recommendations for improvements. The Report recognizes that the roundtable firm participants taking into account the roundtable participants' preference for keeping customers on their websites and
that it would be useful to educate investors on their sites. The Report also notes that it would be helpful to understand the behavior of on-line brokerage customers in determining the most effective means
for disseminating investor education material.
The Report recommends that:
firms partner with the Commission in helping to educate investors; and
the Commission study on-line investor behavior to determine the best place and time to educate investors on the Internet.
On-Line Discussion Forums
The Report describes on-line discussion forums on the Internet and the challenges these forums pose to issuers, market participants, and regulators. The roundtable
discussions focused on two separate areas: (1) addressing rumors on on-line discussion forums; and (2) whether broker-dealers should offer this feature on their websites.
The Report recommends that:
the Commission conduct or encourage researchers to conduct a study analyzing the effect of chat room discussions on company's stock prices; and
broker-dealers operating on-line discussion forums
consider adopting certain best practices to prevent investor confusion.
The Report describes: (1) the rising concerns over on-line privacy; (2) how the Gramm-Leach-Bliley Act addresses privacy concerns; and (3) surveys on-line firms' privacy policies. The
roundtable discussions focused on how on-line firms address, if at all, investor privacy.
The Report recommends that the Commission:
evaluate on-line firms' information collection practices; and
2. consider certain factors in conducting its statutorily required study on privacy.
The roundtable discussion focused on how broker-dealers want to change the way they compensate portals for routing investors to them. Specifically, firm participants indicated that they
want to compensate portals based on the number of accounts opened by viewers who hyperlink to a broker-dealer from a portal. Such a "success-based" fee is typically how other commercial partners
pay portals, but the federal securities laws prohibits broker-dealers from paying portals that are not registered broker-dealers in a way that gives them a salesman's stake in the transaction.
federal securities laws generally prohibit entities not registered as broker-dealers from receiving securities transaction-based compensation, the Report recommends that the Commission consider whether
alternative compensation arrangements are appropriate for entities not registered as broker-dealers.
Technology has made this an exciting and challenging time for the industry and the Commission. As discussed in this Report, the Internet is rapidly making on-line
trading ubiquitous. This Report provides the Commission with a comprehensive examination of the critical issues to be addressed in the area of technology. Although it may still be premature for extensive
rulemaking in this area, this Report highlights for the Commission certain key issues facing investors and the industry and recommends how the Commission can resolve some of these issues.
staff is already at work exploring ways to help firms fulfill their duty to ensure effective customer service, best execution, high-quality disclosure, and responsible advertising, whether on-line or off.
Through inspections, surveillance, enforcement, and investor education, the staff is responding swiftly and decisively to the challenges posed by the constantly evolving technology.
This Report continues
our progress in molding securities regulation to fit the age of technology.
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