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Updated 1-24-03

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Online Brokerage Report


I.
Executive Summary


The complex world of trading securities in cyberspace is truly booming. Indeed, the growth rate of the online brokerage industry is astonishing even in the realm of e-commerce. During the first quarter of 1997, online trades comprised just over 7% of total trading volume. By the first quarter of 1999, this percentage had more than doubled. Online trading grew nearly 50% during that quarter alone, with one in six equity trades occurring online. Analysts project that one in every four trades will take place online by the end of 2000. As of January 1999, there were approximately seven million online brokerage accounts open. By July 1999, there were approximately ten million.

Online trading is revolutionizing the securities industry in several critical ways. The advent of the online brokerage industry is fundamentally changing the relationship between broker-dealers and their customers by allowing individuals to manage their own investments in a manner never before possible. Members of the public can now readily access a range of sophisticated research materials and financial data -- once available only to market analysts -- directly from the websites of most online trading firms. Equipped with this information, investors can, if they choose, make an independent evaluation of stock performance. Investors can also place their trades without the assistance of a registered securities representative by entering an order and transmitting it to an online firm for execution by traditional mechanisms.

The easy availability of these online services is also democratizing the securities industry. Per trade costs are dropping dramatically for individuals who use online brokers, both at firms that provide online services exclusively, and at those that provide a mix of traditional full-service trading and online options. As a result, those who might have found the charges of a full-service brokerage firm prohibitive can now be active participants in the securities trading arena.

This migration of trading services to cyberspace holds great potential for investors, as well as for the securities industry as a whole. Yet, the explosive growth of this industry also poses unique risks to the public, and presents tough challenges to regulators charged with ensuring the integrity of the trading environment.

These risks were acutely apparent during a rash of system slowdowns and outages experienced by numerous online brokerage services earlier this year. Within the first quarter of 1999, the New York Attorney General's Office received a dramatic surge in complaints from investors affected by these slowdowns and outages. Investors identified a range of problems, including an inability to access online trading services, delayed executions of trading orders, and inadequate dial-up customer service. These delays resulted in some investors paying tens of thousands of dollars more for stock than they expected to when they placed their trades online.

Pursuant to his authority under New York's securities and consumer protection statutes, Attorney General Eliot Spitzer initiated an inquiry of numerous firms in the online brokerage industry. As part of this inquiry, the Attorney General's Office reviewed over 120,000 pages of documents provided by the firms, spoke with dozens of online brokerage firm representatives and experts regarding information systems and online trading practices, and visited firms at twelve sites located in five different states.

This Report sets forth the results of our extensive nine month inquiry into the practices of seven online brokerage firms and three industry participants. Online brokerage firms are identified in the Report in those circumstances where information was derived from publicly available sources, regardless of whether the firm was part of our inquiry. However, the Office has chosen not to identify firms -- which have had no opportunity to review this Report before its release -- when discussing potentially proprietary information gathered in the course of our confidential inquiry.

The Office identified several factors, each briefly summarized below, which contributed to the online brokerage performance problems and investor dissatisfaction. This Report sets forth these findings, makes recommendations to the industry and investors, and discusses investor education initiatives which the Attorney General and the Securities Industry Association have agreed to put in place. While the Office has not commenced any enforcement actions regarding these events, we will continue to monitor the performance of online brokerage firms.


  1. Investor Expectations and Advertising

The Attorney General's Office identified a significant gap between the expectations of online brokerage firm customers and the services that online brokerage firms provide. Complaints received by this Office indicate that many novice online investors expect unfettered, direct, and immediate market executions. Online brokers, for their part, can provide investors with only a faster mechanism for placing orders -- and, at that, a mechanism vulnerable to occasional failures and slowdowns.

This "expectation gap" is in part being fueled by the aggressive advertising campaigns being waged by online brokerage firms. Many of the advertisements for online brokers -- a common sight on billboards, on television, and in numerous publications -- convey a message of convenience, speed, easy wealth, and the risk of "being left behind" in the online era. These themes ignore several critical facts about online trading, which we discuss in the "Recommendations to Investors" section below.

A better understanding of these constraints, and the resulting periodic system slowdowns and outages, will allow investors to craft their investment strategies with a full understanding of the limitations of online trading. For their part, online brokerage firms should ensure that advertisements do not foster unrealistic expectations about the potential of online trading, and undertake the education initiatives detailed below.

The tremendous surge in advertising also raises another troubling concern: Can the firms adequately service new customers, especially if the increase in accounts exceeds the firms' expectations? Online brokerage advertising budgets have ballooned over the past two years, which has generated a tremendous increase in total trading volume and the number of customer accounts. As the slowdowns and outages of this year indicate, however, many online brokerage firms were not prepared to handle this increased demand. While several firms responded to these difficulties by responsibly decreasing advertising activity, not all firms acted in this manner. In light of the extraordinary increases in advertising dollars budgeted for the coming year, online brokerage firms should consider whether the capacity of their trading systems will permit them to adequately handle the influx of new accounts that will likely result from this additional spending.


  1. Moving Online: Shortcomings in Online Brokerage Disclosures and
    Information Systems Performance

As the slowdowns and outages of this year demonstrate, the migration of trading to an online environment has encountered several significant glitches. These system slowdowns and outages appear to be related to an unprecedented surge in demand. During the period when this Office's complaint volume spiked, total online trading volume was also skyrocketing -- a "blowout," as one analyst described it. The online brokerage industry had not anticipated investors' appetite for online trading of Internet "dot.com" stocks, and the accompanying increase in demand pushed many of the firms' information systems beyond capacity. Another complicating factor was the substantial volatility in certain sectors, particularly high-tech stocks. Prices for numerous stocks fluctuated wildly during this period, compounding the adverse consequences for investors of any delays in accessing an online brokerage firm's website or in executing a trade. A final factor was the unprecedented rate at which individuals signed up for online services, including online brokerage accounts.

A central focus of our inquiry was determining why these failures occurred. It is extremely difficult to identify and assess what makes a particular firm's information systems inadequate. Each system is comprised of numerous complex components, any one of which can become a bottleneck that constrains the firm's overall ability to accommodate customer demand. The firm's operational capacity is therefore inevitably limited by its weakest link, even if virtually every other component operates at a low percentage of available capacity. Furthermore, the percentage of an information system's capacity utilized by customers generally varies throughout the day, reaching "high points" at market open and close. Thus, capacity that may be sufficient to accommodate trading volume during much of the day may not be adequate during these narrow windows of high demand.

Our review also identified potential deficiencies in each "tier," or major component, of online brokerage information systems, and revealed how those deficiencies contributed to the performance slowdowns and outages that occurred earlier this year. The problems we found included:

  • Deficiencies in the "front end" of online brokerage information systems, which provides the web interface used by online brokerage customers. Front-end hardware was in some instances insufficient to handle high-volume traffic. Moreover, some firms used older software to handle their front-end tasks, which is not optimal for high-volume web traffic and can slow system performance. Customer log-in posed particular problems for online brokerage firms. Log-in times were further delayed by capacity constraints on databases that are essential to the log-in process.

  • Deficiencies in the "middleware" component of online brokerage information systems, which routes messages back and forth between the front and back ends of the system. Capacity constraints on the number of messages that could be routed, as well as software bugs, adversely affected customer response times.
  • Deficiencies in the "back end" of online brokerage information systems, which controls order routing, the vetting of trade orders, and maintenance and updating of customer accounts. Of particular concern were deficiencies observed at service bureaus to which online and offline firms outsource back-end processes.
  • Limitations in the back-up systems utilized by online brokerage firms, which could adversely affect their ability to function in the event of system failures.
  • Inadequate access to customer service support, which is particularly critical when online systems are delayed or down.

The Office also identified a number of constraints on firm capacity, including the following:

  • A number of online brokerage firms rely upon mainframe computer systems originally designed for use by brokers employed by the firms themselves, and not intended for 24 hours-a-day, 7 days-a-week high-volume transactions that involve a direct interface with customers.
  • The architecture of online brokerage information systems may limit their "scalability," or ability to grow as customer demand increases.
  • Physical limitations, including adequate space, power, and cooling needs, may also constrain the ability of online brokerage firms to expand their information systems as needed.
  • Online brokerage firms may find it difficult to hire and train highly-skilled technical staff, which is critical to the expansion of information systems capacity.

The delays experienced by online customers were caused not just by these technological deficiencies, but also by the actions taken by online brokerage firms -- without any notice to their customers -- in response to these problems. Some of the deficiencies discovered through our intensive nine month inquiry where disclosure to customers would have been appropriate include the following:

  • Because of capacity bottlenecks which developed as the result of a heavy concentration of trading activity in a small number of securities, one firm "blocked" the placement of online orders for those securities, and instead required orders for those securities to be called in by phone, so as to slow the order flow.


  • Due to heavy trading volumes, and a belief by one firm that some investors were inappropriately using order modifications and cancellations during market hours, that firm disabled the on-screen buttons, thereby preventing all online customers from canceling or modifying their orders.


  • Many firms do not update certain customer account information to reflect the day's transactions until after the market has closed. At those firms, the account buying power, portfolio value and other critical information will be outdated, often reflecting the account information from the previous day's close. We discovered that due to the use of this outdated information, investors were able to make purchases which exceeded their margin buying power and/or other account limitations at the time that those purchases were made. We also found that investors were able to make securities purchases from self-directed IRA accounts which exceeded the value of those accounts, thereby obligating investors to make additional, and often unintended, IRA contributions.


  • Although touch-tone trades offer investors an alternative method for submitting orders when a company's website is inaccessible, because some firms route touch-tone orders through the same system as online orders, an outage which prevents online orders from being executed may likewise prevent touch-tone orders from being executed.


  • We discovered that during times of high trading volume, one firm would utilize system operators to reduce the number of "ports" available for the order entry process, thereby slowing the flow of orders by preventing some customers from completing the order entry process in a timely manner.


Because we believe that better disclosure is vital to ensuring that investors make informed decisions, the "Recommendations to the Industry" section below discusses disclosures that we believe firms should make to online investors.

  1. Moving Forward: Improving Online Brokerage Risk Management

We found that many of the specific technical deficiencies that led to slowdowns and outages earlier this year have, for the most part, been remedied. But our dialogue with the industry also revealed that the risk management procedures utilized by online brokerage firms should be strengthened to avoid recurrence of similar problems in the future, especially as online trading volume continues to expand.

It is worth noting that the observed slowdowns and outages are symptomatic of failures that have been, and in all likelihood will continue to be, experienced generally by e-commerce firms, communication providers, and even the stock exchanges themselves. The susceptibility of "mission critical" information systems to temporary failure has elevated the industry's awareness of the need to adopt risk assessment and mitigation strategies. This process is particularly important for online brokerage firms and other financial institutions, where customers demand extraordinarily high performance because delays may prevent them from taking advantage of market conditions -- or worse, expose them to market harm.

Our review also confirmed the need to improve online brokerage risk assessment and mitigation strategies. The inquiry revealed that mission critical failures generally occurred when online brokerage firms sought to develop and deploy new software applications and hardware upgrades, especially when the firms sought to introduce applications and upgrades amidst a highly pressured environment and without adequate technology development processes. Such a "cowboy mentality," as one academic terms it, seems endemic to the e-commerce world, which frequently directs resources at quick fixes and lightening-fast deployment of new business applications. The focus on speed, however, tends to elevate concerns in the highly-regulated arena of securities trading. Inadequate quality assurance and risk assessment practices in these circumstances may lead to the interruption of online transaction processes which, as we have seen, can have adverse economic consequences for both the online brokerage firm and its customers.

The occurrence of numerous mission critical failures, and the obvious need to minimize the future prospects of such failures, raise several questions that online brokerage firms should consider. Specifically:

  • What are the "best practices" for maintaining a continuous (24 hours-a-day, 7 days-a-week) online transaction processing system, and for moving from an older information systems platform to a newer, more scalable and robust one?


  • What are the "best practices" for identifying and mitigating risks when new mission critical software is continuously being introduced to an enterprise?


  • When a new application is internally developed, what are the "best practices" for ensuring that the software will deliver requisite functionality, with appropriate quality assurance?


  • What are the "best practices" for pre-testing system changes, whether internally developed or purchased from an outside vendor, to evaluate their prospective impact on overall system performance and stability?


  • What should an online brokerage firm disclose about system problems it encounters, and at what point should such disclosure occur?


  • What role should management and the Board of Directors play in this process?


  1. Recommendations To The Industry

The Attorney General's Office is making several recommendations that will facilitate the responsible growth of online investing.

  • Telling the truth about technology and services. At present, current and prospective online brokerage customers have only limited information about available technology and services. Assuring investors that a sound technological foundation supports online brokerage generally, and persuading them that this foundation can successfully accommodate future demand, will require additional disclosure about online brokerage information systems. The public should be able to understand and compare the service quality offered by various online brokerage firms. We believe this goal is best accomplished by mandating disclosure standards which allow for "apples-to-apples" comparisons of technology performance, customer services, and technology development processes, preferably through a combination of standardized self-reporting and independent third party reviews.

  • The firms themselves should assess and improve their quality assurance processes. Online brokerage firms should consider using models widely recognized in the computer industry, such as CMM or ISO 9000, to fully assess their own software development processes.

  • The firms themselves should assess and improve their quality assurance processes. Online brokerage firms should consider using models widely recognized in the computer industry, such as CMM or ISO 9000, to fully assess their own software development processes.

  • Online brokerage firms should improve the disclosure of certain events that may occur in the course of trading. Specifically, firms should disclose slowdowns or outages as they occur, in a prominent and easily-accessible location on the affected firm's homepage. Firms also should notify customers of heightened margin requirements, limitations on customer account buying power, and order cancellation procedures. Furthermore, investors should be informed of market conditions, such as extreme volatility, which might affect customer trading practices. Finally, the industry should seek to dispel, not foster, certain investor misconceptions. For instance, the industry should clearly inform customers that there is no direct access to stock markets; that mere submission of an order does not mean the order has been executed; that account updates are not instantaneous; and that market orders, as opposed to limit orders, may expose investors to significantly greater liability in fast moving markets.

  • While government should avoid placing regulatory "handcuffs" on the online brokerage industry, several specific and narrowly-tailored changes should be considered by the SEC and self-regulatory bodies such as the NYSE and NASD. Specifically, these entities should consider adopting requirements regarding the documentation and retention of system outage information, system performance standards, and customer service data. Regulatory bodies might also consider whether it is appropriate to require an effective and accountable process for online brokerage capacity planning; to provide further guidance regarding disclosure of online brokerage information system capacity and reliability; and to mandate disclosure of online brokerage spending on information systems technology.

  1. Recommendations to Investors

Although online investing is undeniably an excellent opportunity and tool, investors should note the following caveats before they trade:

  • Clicking the mouse is easy, but making sound investment decisions is not. Nothing can substitute for good old fashioned research and education. Investments are not sound just because they are easy to make.

  • "Making a trade" with a click of the mouse is not the same as executing the trade. The technology is not instantaneous -- it still requires navigation of several market layers and can encounter delays before the stock is actually purchased or sold.

  • Cheap, easy, and frequent trading does not equal successful trading. Trading over and over again may be a good strategy for some, but making long-term, sound investments is still the best course for most investors.

  • Speed, access, and reliability of online services is dependent on system availability, and will inevitably be subject to occasional delays. The computer screen an investor sees still has complex functions behind it that may, at times, fail. The technology, while wonderful, is not infallible.

  • Contrary to frequently encountered advertising rhetoric, online investors are not connected "directly to the markets." Online trading simply gives the investor the opportunity to place the trade in the firm's trading system, a function previously performed by a broker.

  • Trading fees may be more complicated and expensive than they appear. Investors need to read the fine print to see the cost of the trades they anticipate making.

  1. Attorney General's Plan of Action and Investor Education Initiatives

Working with the Securities Industry Association ("SIA") during the upcoming year, the Attorney General will pursue certain important industry and educational initiatives. In addition, the Attorney General intends to continue this inquiry in discrete areas, by collecting more information about investor attitudes and needs, as well as by proposing round table discussions on the e-commerce issues raised in this Report. The Attorney General's initiatives include:

  • The formation of an Online Brokers Committee. The SIA, working with the Attorney General, will form a committee dedicated to the particular issues confronting online brokers. The committee will be comprised of senior legal counsel of the top online firms and will meet regularly to discuss these issues and foster improved investor education.

  • In conjunction with the Attorney General's Office, the SIA will publish educational materials for national distribution to assist online investors.

  • The SIA committee and the Attorney General's Office will create and fund full page advertisements to appear in major newspapers, both across the State of New York and the nation. The intended purpose of the advertisements will be to educate present and future online investors regarding the benefits and pitfalls of online trading.

  • The Attorney General's Office and top online firms will post the SIA educational materials on their websites.

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