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online_trading_mar30_v2.doc.doc.doc

  1. 1. Introduction The Internet has lead to the transformation in the way we lead our lives in general and one of the areas in which it has had a dramatic effect is on the online trading of securities. Online trading is defined as buying and selling of securities via the Internet or other electronic means. With a few clicks of the mouse, it is possible for an investor to buy or sell millions of dollars of stock, get up-to-date information on stock prices, evaluate the financial performance of companies and gather data on the performance of thousands of companies and mutual funds. Not only that, he can get all these services for a fraction of the cost that it would have had to pay in the pre- Internet days. The impetus for online trading was largely driven by three major factors: (i) the creation of electronic stock exchanges (ii) the spread of the Internet and (iii) improved electronic communication methods. The spread of online trading has created many opportunities for increasing the volume of trading, but has also presented a number of challenges in regulating this industry and protecting the investor. There are three main parties in the online trading industry: (i) investor (ii) brokerage firm and (iii) stock exchange. This paper looks at how online trading has impacted each of these entities. Exchanges To elaborate on the process and technology of security trading, it is difficult to avoid the question that “why we have security trading in the first place?” This is because capital market were created to fund new expeditions and ideas centuries ago when the sea route to “the New World” was opened and claims on the future benefits of these expeditions and ideas were in turn traded on organized exchanges as a means of providing liquidity to market participants. These
  2. 2. “claims” are in fact equivalent to the modern securities which are known to us as stocks and bonds. Indeed, securities can be traded on the OTC (over the counter) markets, but exchanges are where the majority of trades are carried out. The first security exchange in history was established in Netherlands in 1602 by the Dutch East India Company. The Portuguese Dutch people were the lords of the sea before the British came up with their powerful warships. It is no surprise that the Dutch had the first security exchange in history to sweep in cash for funding the trade ships to Asia. There was only one kind of share with a 3000-Guilder par value, which was traded on the Dutch exchange back then. The trade system was entirely paper-based as you can imagine. Purchases and sales of shares were affected by a new entry in the share register in the presence of two directors, who needed to confirm the share transfer by signature. This system worked very well for the Dutch since the number of transactions was not overwhelming. The trading system of securities has evolved continuously since then. Before we jump into the details of this evolution process, let’s define what a trading system does exactly first. A typical trading system has 4 cores functions: solicitation, pricing, execution, and booking. Solicitation Solicitation, as the name indicates, is the process of having potential buyers become interested in purchasing the securities. Then, a price has to be agreed upon on the underlying security. Most of trades stop right here because the price simply disenchants the buyers. If the buyers actually like
  3. 3. the price, then the trade is executed on the specific terms agreed upon. After that, the trade has to be booked in the registry and security certificates are exchanged (no longer the case after 1972). Pricing and Execution Historical developments of electronic trading technologies have been a significant cross through from the pricing and execution process. Reuters has been a prominent financial information provider for centuries. A couple of hundred years before we are able to connect to their information portal and grab the price of the security we want to trade, Reuters used to use carrier-pigeons to send the price of securities to their customers. __ Using this scheme, Reuters was able to give the most up-to-date prices so that their customers could get the other side of the trade to pay for (or sell at) a not-so-realistic price because those who did not use Reuters’ service had no way to know what the realistic price was. In 1836, Samuel F. B. Morse and Alfred Vail developed an electric telegraph that sent electromagnet signals through wires. While this technology was first adopted by militaries, Wall Street did not overlook it. In its hay days, more than 50% of telegraph traffic was used to send price information and execute trades. Guess who laid the wires for the telegraph technology to be up and running? The New York and Mississippi Valley Printing Telegraph Company, founded in Rochester, New York, completed the first transcontinental telegraph line in America in 1861. Not so familiar with this company? Today it is called Western Union.
  4. 4. As more modern inventions came to life, they were quickly adopted by the exchanges to improve the trading systems. Even better still, Wall Street did not just simply wait to enjoy the fruits of scientific inventions. In 1867, Edward A. Calahan of American Telegraph Company invented a stock price printing device, the ticker machine (see the image below). This machine could transmit price information in text over telegraph signals and print the information as it “ticks”, hence the name “ticker”. In strong resemblance, it could do what a 21st-century printer does! Booking In 1968, a century after the invention of the ticker machine that was designed to facilitate the pricing and execution function, Wall Street unexpectedly stumbled on the “Paper Crunch”. It would not be unreasonable to think that advancement in the four functions should have gone hand in hand, otherwise the trading system would be awkwardly imbalanced. However, in reality the booking function had been left intact as a people-intensive process since the opening of the Dutch security exchange in the 17th century. Trades had to be registered in the registry and stock certificates had to be redistributed. With the advent of electronic message switch boards in the 60s, trades were executed almost real time. This further fueled the growth in trading volumes on
  5. 5. Wall Street. Thanks to the 3-century old paper-based method, the back offices simply could not cope with the work to book all the executed trades. Soon, a significant number of investors became dissatisfied and withdrew from buying and selling activities in 1968. The so-called “Paper Crunch” thus took place. It took 4 years to for a solution to emerge. An organization called The Depository Trust Company was setup in 1972 and effectively solved the problem of the post-trade processing (booking) using IBM’s electronic ownership transfer technology. Since then, booking of security trades has been done electronically. Bad news for the back office employees who lost their jobs dealing with stock certificates, but the trading system could finally go paperless! The year 1971 saw the introduction of National Association of Securities Dealers Automated Quotation System, NASDAQ. Though today it is the largest electronic screen-based equity securities trading market in the United States, it was merely an electronic price bulletin board following its birth. Trades were handled with phones back then until the 1987 Black Monday. Investors furious with traders not answering phones on that day asked the congress to implement a remedy. The consequent policy gave rise to the mandatory use of NASDAQ’s Small Order Execution System (SOES) by stock brokers and dealer. The inauguration of SOES symbols the birth of advanced systems that can single-handedly perform all four trading functions electronically. More such systems have come to existence since then. Today, they are categorized as Electronic Communication Networks (ECN). The history of trading system has changed the way people invest their money and it is also important to understand the underlying technologies that operate and support the system.
  6. 6. Technology Behind Electronic Trading System When dealing with online investment and trading, electronic payment transfer is a necessary step to be involved. The traditional electronic payment system is a simple process where one account is debited and another credited using a direct fund transfer. With the increase in the volume of electronic commerce, several new methods of payment have developed. However, all these new systems have one thing in common, namely, electronic tokens. Tokens can be stored locally on a user’s computers. Using this system, tokens can be used only once to ensure they are being copied. Token has high security protection. Using tokens allows the implementation of untraceable transfer. This means the token itself is anonymous. There is no extra identification is exchanged during the transaction. ECN and SOES As previously mentioned, ECN is an electronic technology that directly makes connection between breakage and individual traders without going through a middle man. People can make a trade within real time after open an account with the broker dealer. Unlike New York Stock Exchange (NYSE), which uses people to make the trade, the ECN system is computer driven and can automaticaly match a buy order and a sell order. Some SCN may order additional features such as negotiation and pegging. Also, the fee is collected from each completed. Sometimes ECN charges a lower fee to attract more traders. Smaller investors use Small Order Execution System (SOES) because it has better liquidity than SCN. There are some restrictions applied to this system: 1) Trades may not be in excess of 1,000 shares for a particular stock. 2) SOES does not allow trades in stocks that are trading at prices greater than $250 per share.
  7. 7. 3) Once a trader places an order through SOES, he or she must wait at least five minutes to place a trade through SOES on the same stock. 4) Short selling through SOES must comply with SEC rules. Internet Payment Protocol: iKP For the internet electronic money transfer, the system goes through a special protocol called iKP. It is invented by Internet EFTOPS facility. iKP is a collection of three protocol that to be used for payments on the Internet. There are three parties involved in the payment: the buyer, the seller, and the acquirer (the seller’s bank). The merit of iKP is that it can be implemented using existing systems. STT: Secure Transaction Technology STT, developed by VISA and Microsoft, is another set of protocols for the implementation of an Internet credit card system. STT was VISA’s first published outline for a virtual credit card system for the internet. Certification in STT is confirmed by “credentials”. A credential is a message that contains a user’s name and his public key. This is used to verify the user’s signature as well as the one used to encrypt messages. Recently, STT adapt to “dual signatures”. This is use by the buyer to make a payment without disclose the information to the bank or to the seller. Electronic Communication networks
  8. 8. ECNs are a form of Alternate Trading Systems or ATS. These are computerized networks that enable investors to place bid/sell prices in an off-exchange market.1 The primary products that are traded on ECNs are stocks and currencies. ECNs came into existence mainly as a result of improvements in information and communication technology as users can place orders on the ECN only through custom computer terminals or network protocols. ECNs connect buyers and sellers through an electronic exchange without any brokers so that trading is cheaper and quicker. One of the other features of an ECN is that it allows after hours trading. The biggest users of these networks used to be institutional investors like mutual fund managers but now individual investors also participate in these networks. Examples of ECNs are Instinct, Archipelago, Island and Tradepoint. Brokerage Firms When an investor places an order to buy or sell a share, this is normally done through a broker such as Ameritrade or Merill Lynch. Before the advent of online trading, brokerage houses, such as Goldman Sachs, were the dominant players in the securities trading industry. Their main task was to offer routing services to their subscribers for a flat fee per transaction.2 The broker could route the order to the exchange or to a market-maker (a person who offers to buy and sell a certain security at a certain price for a continuous period of time) or fill it from his inventory of stock. The firms were able to charge high fees for their services mainly because they had access to information that was not available to the regular investor and also because the NYSE was fixing the commission rates.3 There was a mutually beneficial relationship between the brokerage 1 Electronic Finance – page 61. 2 Electronic Finance – page 64 3 The Bright Side page 47.
  9. 9. firms and the stock exchanges. The exchanges permit trading only between members of the exchange. If an ordinary person wants to place an order, he/she must place an order through stock broker. The stock broker pays the exchange certain fees for the privilege of being a member. In return, the NYSE was allowing the brokerage firms to charge a high commission rates. In essence, the brokerage firms were acting like a cartel because membership was restricted. The advent of online trading changed most of this. The relationship between the exchanges and the brokerage houses is now under threat. The brokerage firms are trying to find alternate avenues instead of the big stock exchanges like NYSE and NASDAQ. They are trying to route their transactions to smaller and regional stock exchanges or through alternate trading systems by avoiding the traditional exchanges entirely.4 Also, a number of online brokerage houses began to offer their customers low-cost or free research and analysis on stocks. They also began to lower the fees on each transaction. Charles Schwab was a pioneer in this type of trading and this was largely due to innovative technology by taking an order from the web browser to its servers so that trading could be done using the internet.5 Also, most brokerage houses started to provide banking facilities as a means of differentiating themselves from traditional brokerage houses. The online trading houses also offer 24-hour service whereas regular brokerage firms take orders normally only during office hours. The entry barriers for a brokerage firm are not very high at present. The average fee for a seat on the NYSE is about $2.6 million, but at times, the cost drops below a million dollars. 6 Thus, the 4 http://www.reuters.com/article/reutersEdge/idUSN0837666020070112?pageNumber=1&virtualBrandChannel=0 5 The Bright Stuff, page 50 6 http://lawprofessors.typepad.com/business_law/2005/week18/index.html
  10. 10. cost of the seat is definitely not a major barrier to entry. However, the risk lies more in the cost is more in terms of actually running the business. The firms have to be able to provide adequate controls against identity theft and safeguarding customer privacies. Also, the industry by nature is very cyclical as the amount of activity increases during a bull run in the stock market but drops during bear trends. These two factors combined form a high barrier to entry, which is why not many companies are present. In terms of entry barriers, there has not been a major change. In the early days of the dot com bubble, there was a mushrooming of online brokerage houses mainly due to the bull run in the stock markets. However, once the bubble burst, the firms began to make losses. There was a significant drop in the income of these companies. For example, earnings had dropped for these firms by thirty to fifty percent in 2001.7 However, once the market started improving, the performance of these companies improved, but there was a consolidation in the sector. Thus, overall, the entry barriers have not really changed due to the internet especially in times when the market is not doing very well. The __ result of this increased competition is definitely beneficial to the individual investor. __ The brokerage firms are lowering their commission charges and people are trying to move away from payment of any type of commission by trading directly with the market-maker and avoiding the brokers totally. The main advantage that internet-based stock trading has is user friendliness, accessibility, speed and low fees. The firm that can offer all of these at the most competitive prices tends to attract the greatest number of customers. Traders 7 Bright Stuff, 62
  11. 11. Based on their time horizons for investment, there are a number of different types of online traders and they can be classified into four main categories: (i) investor, (ii) long-term trader, (iii) swing trader, (iv) day trader. Investor The investor has a time frame of a minimum of one year and his calculations are based on fundamentals (what fundamentals? Possible to listed one or two “fundamentals” just like what you did for long-term investors. I think that’ll be more clear) that affect stock prices. He may hold a diversified portfolio or invest in specific sectors or single issues. Long-Term Investors Long-term investors look at the fundamental rations of a company such as Return on Investment (ROI) and compare it with other companies in the same sector before deciding on investing. This type of trader would have in the earlier days mainly based on advice from his brokers and by obtaining information from various analyst reports. The explosion of the online trading industry has made it much easier for this type of investor to obtain comparative data on the performance of various companies as there are a number of websites like Google Finance and Yahoo Finance that provide this type of information. The easy availability of information makes it convenient for this type of trader to invest using online trading. A long-term trader has a time horizon that may extend between a week to one year. He focuses on the same data as the investor, but in addition, relies on technical indicators to decide on when to enter and exit the market. One such example of a technical indicator is where he buys an
  12. 12. investment because he believes the stock is undervalued. The minute the company reaches the same P/E as other companies in the sector, he will exit and book his profits. The main difference between an investor and a long-term trader is that in a similar scenario, the investor may decide to stay on because they have faith in the company and hence, continue to hold the script even if the targeted price has been reached. The internet has had the same impact on the long-term trader as on the investor as he has also benefitted from the volume of financial information that is available through the Internet, including detailed technical charts. Swing Trader The swing trader has a time horizon of three to five days. He tries to identify pivotal points in the stock’s weekly actions and try to find precise entry and exit points. Risks are well calculated and well-defined. He exploits critical turns in the market or issues that may materialize into larger stock market moves. For example, when the recent crisis in the banking sector was announced, there will be some traders who get into the market knowing that the price of the bank shares are likely to highly fluctuate depending upon the actions taken by the federal reserve. If the Federal Reserve announces a bail-out, such as that announced for Bear Sterns, there is likely to be an initial drop in the price followed by an increase in price when the fed announced the bail-out and then the price could either stabilize or go down. A swing trader may try to get in when the initial bad news is announced and get out after the fed bail-out is declined. Online trading provides such traders with the ability to be able to enter and exit the market as they wish to at the prices at which they want to get in and get out. They can action based upon daily fluctuations in the price and, hence, online trading offers far greater advantages for such traders.
  13. 13. Day Trader Day traders have very limited time horizon and do not carry a position overnight. For example, they buy and sell stocks in the same day and they work on very small price increments hoping to collect enough profit by sheer volume. It is for this type of trader that online trading has the greatest attraction because anybody can get into this business and since they are just looking for minor fluctuations in prices and are not performing any detailed technical analysis, there are no entry barriers. Since they buy and sell within the same day, there is no need for the investor to have a great amount of funds. Also, day traders are most likely to use direct access trading (DAT), a mechanism whereby they deal directly with the market makers of the exchange. This is possible only because of networks as DATs require high-speed computer links to the exchange. Though the fees for the DAT are much higher, but the day trader deals in small fluctuations in price and hence instant communication is very critical for him to make a profit. Furthermore, the rates for the DATs are based on volumes and, since a day trader enters into a large number of trades, this is beneficial for them. On-Line Trading Internet has been widely used in recent years. Many traders have moved their investment process to the on-line platform. On-line trading has competitive pricing and the same faster trading process. In general, all online traders need to log into a website in order to be able to trade and often they are required to install specific software on their machine. Web Trader Platform
  14. 14. Different online trading providers use different platforms. Users are required to install this software on their machine so that they can access their service provider’s platform. The main function of software includes placing multiple orders, setting order time, displaying real time charts and news, and reporting management dialog. Some more advanced software also provides pricing analysis and strategic recommendation. The example of a popular trading software is TD Waterhouse’s Active Trader that is used by a number of investors. Impact of Online Trading on Investors There has been a boom in the number of online traders and it is estimated that the internet accounts for as much as twenty-five percent of all stock trading activities online.8 The first wave of online investors consisted of the young and the affluent. The internet has offered traders a lot of benefits that were not available to them through the traditional brokerage system. Firstly, access to these houses was not available to everybody. The internet has made it possible for almost anyone to get access to detailed information on the financial markets and thus, offers an avenue for them to trade. Secondly, the growth of a number of online trading houses has resulted in substantially lowering the commission rates for executing transactions. Earlier, customers had to pay a price that was much higher than that paid by the brokers. For example, Merrill Lynch used to charge $200 as full-service commission for a single trader.9 This rate today has fallen to as low as nine dollars a trade and this is one of the major reasons why all type of traders are using the internet. It has also made it much easier for traders to place orders and to enter into forward trades. Online trading has resulted in a great deal of power being transferred to the trader and this is a part of the reason for the explosion in the number of online traders. This is 8 Ibid., 6 9 The Bright Stuff, 58
  15. 15. not to say that online trading is without any risks. However, if a person makes decisions based on proper information and detailed analysis of facts, then online trading gives them the ability to create and manage their portfolios successfully and can result in wealth creation. One of the major concerns for online traders has been security. There have been a number of instances where the security at the online trading companies has been breached and this has contributed to reluctance on the part of some traders to switch to the internet. Such traders believe that the traditional trading mechanism offers them greater protection. However, over the years, there has been substantial increase in the level of security provided and, hence, this impediment has also been removed. In order to make online trading attractive to customers, a number of companies have started providing financial data. For example, Yahoo Finance enables customers to access free-of- charge to financial information and tools. Customers can create customized portfolios, track holdings, obtain information on stock prices, earnings and also collate reports from a number of industry analysts. They also provide chat rooms where investors can participate in online discussions. This example of Yahoo has been followed by other companies like Google and MSN. In fact, online trading has become prevalent that it has spread to countries all over the world. In the developing countries, such as India, has a significant increase in the number of online traders. All this is possible only due to the availability of financial information. The customers are now empowered and are no longer dependent on brokers. Brokers are being forced to question the value that they provide to the process and can no longer just act as an intermediary between the customer and the brokerage firm. Internet-based bulletin boards are
  16. 16. rapidly emerging and are challenging the role of the broker and as more and more of these boards grow, traders can share information amongst themselves and thus, make independent informed decisions. Large, institutional investors/traders have used closed electronic networks such as Island System to trade shares amongst themselves.10 These networks will widen to include the smaller traders as security and reliability concerns are addressed and already a number of such sites exist like Real Goods and PerfectData.11 Today, many firms are also making public offers to sell equities directly to the investors through the internet rather than through the traditional underwriter. Several sites for direct public offerings (DPO) have been established and it is estimated that the number of such offerings will increase in the future. The Impact of Electronic Trading System The Efficient Market Hypothesis (EMH) is a financial theory that says stock prices move up and down randomly rather than following any trends. In addition, EMH supports the idea that the stock price at any given point in time is the unbiased indicator of the stock’s future performance; therefore there are no mispricings or opportunities to be taken advantage of in the stock market. Online Privacy and Security The other major problem faced by individual investors is that relating to security and privacy concerns. The online brokerage companies collect a lot of information about an individual before they are permitted to register with them. Investors have to provide detailed personal information such as personal account number and the amount of investment, etc. All this information is stored on the servers of the brokerage companies and it means people can retrieve data more 10 Ibid., 68 11 Ibid.
  17. 17. easily than in the past. In order to provide the secure environment to the investors and other online users, a number of legislative acts have been passed. Personal Information Protection and Electronic Documents Act (PIPEDA) PIPEDA was established in 2001. It applied to all the applications and business that has to do with internet. This act protects personal information that is collected, used or disclosed in circumstances. For example, under law enforcement or threat of one’s life, the information can be disclosed. Otherwise, under the usual condition, the personal information must be strictly kept in private. The organization should clearly state the purpose of collecting information to the individual before implementation. For example, online investor must enter the bank account, home address, and the area of investment such as stocks, funds, or currency. Since the investment is going through the online process that is hosted by the third party, the service provider is accountable keep the personal investment profile in a safe condition and not to share with third party. Electronic Signature The use of electronic signature has been widely accepted in different fields, such as e-business, some governmental documentation, and various internet investment applications. Various laws have been passed internationally to formalize the use of electronic signature. The main purpose is to making electronic communication equivalent to written one. It is a new technology and relevant laws are implemented by many countries. In Canada, Federal government has legislated Personal Information Protection and Electronic Documents Act. In part 2 of the Act, it has fully
  18. 18. defined and describes the chiastic of electronic signature, and demonstrates the specific requirement under provision of federal law. However, in spite of all these regulations, there has been an increasing number of incidents relating to identity theft and loss of other personal information. The sophistication of the hackers is continuously growing and in October 2006, TD Ameritrade and E-Trade reported that hackers had broken into their customer accounts and had resulted in customers losing more than twenty- two million dollars.12 While bank deposits are insured to the extent of $100,000 against such types of fraud, no such protection is offered to brokerage firms.13 This is an area of great concern because a lot more money is placed by customers in brokerage accounts as compared to bank accounts and there is no protection. Quality of Information While the internet has been a boon in terms of providing information, it has also been a source for spreading misinformation and has given rise to a number of fraudulent schemes. One such activity is called pump and dump whereby people hype up a particular script so that price goes up and then they sell their shares and get out. The bulletin boards that are sometimes beneficial in spreading information can also be used for providing misleading data. These activities are also possible in the regular trading environment, but the use of the internet has resulted in speeding up the spread of such information and can also target a larger group of people. This again reinforces the fact that any trading that is done online has to be done after careful research of the 12 http://www.computerworld.com/action/article.do?command=viewArticleBasic&articleId=9004416 1 13 Ibid.
  19. 19. company and cannot be based on information provided on bulletin boards or unrecognized investment newsletters. However, even the quality of the financial data and research reports that are provided on these websites may not be reliable and may also not be timely. For example, if a company reports the guidance figures to the analysts, it may take a day or so before this data is reported on the website. It is because of these shortcomings that Michael Bloomberg believes that the financial information that is available for free on the internet is too unreliable and serves too broad an audience to meet the requirements of the serious investor. This is why organizations like Bloomberg L.P. and Reuters and Bridge Information Systems are able to charge fees for what they believe is exceptional information and unmatched analytics. These organizations provide real-time financial information to security traders and even though these companies have web-based operations, they still concentrate on investors who are willing to pay high fees for these services. It remains to be seen if the Internet-based free services pose a serious threat to the fee-charging organizations. Ultimately, both types of organizations may coexist with the trader deciding on the type of organization he would like to deal with. However, there can be no denying the fact that the Internet has resulted in lowering fees for financial services as evidenced by the fact that even Reuters is charging lower fees and Bloomberg may have to follow suit There have been a number of concerns with online trading mainly relating to questions around privacy issues and also amount of risk that a trader could be exposed to. Online trading has earned a bad reputation mainly due the massive losses that can be incurred by traders. For example, in July 1999, an Atlanta trader lost $150,000 in the stock market and went on a shooting rampage that resulted in the death of nine people.14 These deaths raised questions about 14 Koppel, Robert. The Mentally Tough Online Trader. xi
  20. 20. online traders and if they were equipped to handle the emotional ups and downs that result from dealing with the stock market. However, we believe that this problem was caused not by the mechanism of online trading, but by the type of trading that was being done. A number of people get into online trading for the wrong reasons. Some of the most common reasons for trading online have been identified as excitement, “get rich quick”, entertainment or “it’s cool”. Online trading can be very exciting especially when you make a lot of money and the advertisements from online trading companies tend to reinforce this image. Similarly, others get in because they think it is an easy way to become rich, which is totally flawed. It is possible to make money through trading, but there are no guarantees. Then there are traders who get in for entertainment purposes because it is a novel way of spending time and money. However, this is a business and is not definitely entertainment. The last misguided reason why some people get in is because they think it is the in thing to do and because day traders are looked upon with admiration. Any of the above reasons is definitely not the correct reason for an online trader and if a person gets into this business with the above expectations, they are doomed to failure. Online trading is a business and participants needs to have sufficient knowledge about the risks and rewards before entering it. Conclusion.

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