Pursuant to a congressional request, GAO provided information on on-line
trading, focusing on: (1) the growth in on-line trading; (2) the extent
to which on-line broker-dealers had experienced trading system delays
and outages, including the causes of these problems and their reported
effect on investors; and (3) how on-line broker-dealers address investor
protection issues related to margin, privacy of information, risk
disclosures, best execution, suitability, and advertising.
GAO noted that: (1) from the last quarter of 1997 to mid-1999, the
number of broker-dealers offering on-line trading more than doubled to
about 160 firms; (2) also, the number of on-line trading accounts
established nearly tripled to 10.5 million within this time period, and
the volume of on-line trades increased to about 37 percent of all retail
trading volume in equities and options; (3) this growth in on-line
trading has been accompanied by a series of delays and outages in
broker-dealers' automated trading systems that have caused some
investors to suffer losses or miss investment opportunities; (4) each of
the 12 on-line broker-dealers GAO contacted had experienced trading
system delays or outages; (5) officials from these firms maintained that
several factors caused delays and outages, such as inefficient message
routing by Internet service providers, glitches in vendor-supplied
systems, and computer hardware and software failures often associated
with service upgrades; (6) the officials said that they expect delays
and outages to continue because they must constantly upgrade their
systems' services and capacity to remain competitive and to keep up with
the growth in on-line trading; (7) on-line investors have access to
extensive financial information through the Internet and other sources,
but they are responsible for their own trading decisions in the absence
of solicitations and recommendations by a broker-dealer; (8) to help
investors make informed decisions, the Securities and Exchange
Commission (SEC) and the securities self-regulatory organizations (SRO)
require that broker-dealers furnish investors information relating to
margin trading, have proposed rules concerning privacy of information,
and recommend that broker-dealers also furnish information about trading
risks and best execution of trades; (9) however, the broker-dealers that
GAO contacted did not always provide their customers all such
information, especially on the firms' Web sites where it would be most
useful since this is where investors go to trade on-line; (10) SEC and
the securities SROs are responsible for overseeing the securities
industry and markets for the ultimate benefit and protection of the
investor and each has taken initial steps to monitor the activities of
on-line brokerage firms; and (11) ensuring that investors receive
appropriate information on margin requirements, privacy considerations,
risk disclosures, and trade executions is especially important
considering that an estimated 8 million new on-line trading accounts
could be opened by the year 2001.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-00-43
TITLE: On-Line Trading: Better Investor Protection Information
Needed on Brokers' Web Sites
DATE: 05/09/2000
SUBJECT: Consumer protection
Computer networks
Information disclosure
Securities
Securities regulation
Stock exchanges
Brokerage industry
Risk management
Internal controls
IDENTIFIER: Internet
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GAO/GGD-00-43
United States General Accounting Office
GAO
Report to the Congressional Requesters
May 2000
GAO/GGD-00-43
ON-LINE TRADING
Better Investor Protection Information Needed on
Brokers' Web Sites
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Contents
Page 341GAO/GGD-00-43 Better Investor Protection Information Needed
Letter 1
Appendix I 36
Top Ten On-line Trading
Complaints to SEC,
January 1998 to June
1999
Appendix II 37
Comments From the
Securities and Exchange
Commission
Appendix III 39
Comments From the
National Association of
Securities Dealers
Appendix IV 40
GAO Contacts and Staff
Acknowledgments
Figures Figure 1: Number of Broker-Dealers 8
with On-line Trading Systems From the
Last Quarter of 1997 Through July
1999
Figure 2: Number of On-line Trading 9
Accounts From the Last Quarter of
1997 to May 1999
Figure 3: Number of Average Daily On- 10
line Trades From December 1997
Through March 1999
Abbreviations
IPO Initial Public Offering
NASD National Association of Securities
Dealers
NYSE New York Stock Exchange
SEC Securities and Exchange Commission
SRO self-regulatory organization
B-283098
Page 6GAO/GGD-00-43 Better Investor Protection Inf
ormation Needed
B-283098
May 9, 2000
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
The Honorable Ron Klink
Ranking Minority Member, Subcommittee on Oversight
and Investigations
Committee on Commerce
The Honorable Edward J. Markey
Ranking Minority Member, Subcommittee on
Telecommunications, Trade, and Consumer
Protection
Committee on Commerce
The Honorable Edolphus Towns
Ranking Minority Member, Subcommittee on Finance
and Hazardous Materials
Committee on Commerce
House of Representatives
The Honorable Carl Levin
Ranking Minority Member, Permanent Subcommittee on
Investigations
Committee on Governmental Affairs
United States Senate
This report responds to your requests that we
review various aspects of on-line trading. As
agreed with your offices, our objectives were to
determine: (1) the growth in on-line trading; (2)
the extent to which on-line broker-dealers had
experienced trading system delays and outages,
including the causes of these problems and their
reported effect on investors; and (3) how on-line
broker-dealers address investor protection issues
related to margin, privacy of information, risk
disclosures, best execution, suitability, and
advertising.
Investors who trade on-line submit orders to
broker-dealers electronically through the
Internet. This report summarizes information
collected from 12 on-line broker-dealers. These
firms represented less than 10 percent of the
total estimated number of firms that offer on-line
trading. However, they accounted for about 90
percent of the on-line trading volume during early
1999.
Results in Brief
On-line trading is a rapidly growing segment of
the securities industry. From the last quarter of
1997 to mid-1999, the number of broker-dealers
offering on-line trading more than doubled to
about 160 firms. Also, the number of on-line
trading accounts established nearly tripled to
10.5 million within this time period, and the
volume of on-line trades increased to about 37
percent of all retail trading volume in equities
and options. Industry analysts expect this growth
to continue as more full-service broker-dealers
offer on-line trading services to their customers.
This growth in on-line trading has been
accompanied by a series of delays and outages in
broker-dealers' automated trading systems that
have caused some investors to suffer losses or
miss investment opportunities. Each of the 12 on-
line broker-dealers we contacted had experienced
trading system delays or outages. Officials from
these firms maintained that several factors caused
delays and outages, such as inefficient message
routing by Internet service providers, glitches in
vendor-supplied systems, and computer hardware and
software failures often associated with service
upgrades. The officials said that they expect
delays and outages to continue because they must
constantly upgrade their systems' services and
capacity to remain competitive and to keep up with
the growth in on-line trading.
The on-line trading industry is new and evolving.
Its regulators, the Securities and Exchange
Commission (SEC) and the securities self-
regulatory organizations (SRO), have issued some
guidance on maintaining adequate capacity or
notifying their customers about the potential for
service disruptions. These regulators have also
posted some of this information on their web
sites. However, they have not issued final rules
in these areas. The most frequent complaint SEC
has received concerns investors' difficulty in
accessing on-line trading accounts. Requiring that
consistent records be kept on delays and outages
and investors be informed of the potential for
delays and outages could help investors better
understand the limitations of on-line trading
technology and prepare for delays and outages.
On-line investors have access to extensive
financial information through the Internet and
other sources, but they are responsible for their
own trading decisions in the absence of
solicitations and recommendations by a broker-
dealer. To help investors make informed decisions,
SEC and the SROs require that broker-dealers
furnish investors information relating to margin
trading, have proposed rules concerning privacy of
information, and recommend that broker-dealers
also furnish information about trading risks and
best execution of trades. These actions are all
key investor protections. However, the broker-
dealers that we contacted did not always provide
their customers all such information, especially
on the firms' Web sites where it would be most
useful since this is where investors go to trade
on-line. For example, only 4 of the 12 firms we
contacted posted information about special margin
requirements for volatile stocks on their Web
sites for investors to check before making a
trade. At one firm that did not post this
information, a customer unknowingly placed a trade
on a stock that the firm had determined could not
be bought on margin. After the purchase, the
customer had to pay the total price for the
security, which resulted in him owing the firm an
additional $75,000.
Some customers have complained to SEC that they
lost money or missed financial opportunities
because they did not understand how on-line
trading worked. SEC and the securities SROs are
responsible for overseeing the securities industry
and markets for the ultimate benefit and
protection of the investor and each has taken
initial steps to monitor the activities of on-line
brokerage firms. Ensuring that investors receive
appropriate information on margin requirements,
privacy considerations, risk disclosures, and
trade executions is especially important
considering that an estimated 8 million new on-
line trading accounts could be opened by the year
2001.
This report contains recommendations that would
enhance oversight of on-line broker-dealers in key
areas of system capacity, outages and delays, and
information disclosure. It also contains
information on suitability and advertising issues
associated with on-line trading.
Background
On-line trading is transforming the relationships
that investors have with broker-dealers. Before
1995, investors typically bought and sold stocks
by calling or visiting registered representatives
of broker-dealers who executed their orders.
Today, nearly 6 million investors buy and sell
stocks through the Internet.1 The services on-line
broker-dealers provide their customers have
differed from their full-service counterparts, but
these differences are diminishing, and both are
subject to the same rules and regulations. Their
activities are regulated by the regulatory arm of
the National Association of Securities Dealers,
Inc. (NASD), NASD Regulation (NASDR), and by SEC
for the ultimate benefit and protection of the
investor. They also may be members of and
regulated by the New York Stock Exchange (NYSE).
The terms on-line trading and day trading are
sometimes used interchangeably. Unlike on-line
investors, however, day traders have virtually
direct access to markets and generally trade more
frequently, attempting to profit from short-term
movements in stock prices. Although on-line
trading differs from day trading, the differences
between them are diminishing.
On-line Trading Differs from Full-Service Trading
Trading on-line is typically an experience much
different from trading through a full-service
broker. Instead of talking to a registered
representative about a trade or an investment
strategy, on-line investors primarily access their
broker-dealers' Web sites through the Internet and
order securities trades without assistance from a
registered representative. Automating transactions
and accepting payment for order flow (as discussed
below) allow broker-dealers to charge on-line
investors less for trades. The top 10 on-line
broker-dealers generally charged their customers
commissions that averaged about $15.75 a trade,
for any number of shares less than some specific
amount. They might charge more for larger trades,
such as those exceeding 1,000 shares. In contrast,
full-service broker-dealers generally charge
commissions that are based on the size of the
order and the dollar value of the transactions.
These commission fees can exceed $90 or more but
may be negotiable for customers that have large
accounts. As we discuss later, the total cost to
trade includes not only the commission charge, but
also differences in stock purchase or sale prices
that may result from different methods of
executing trades. Full-service brokers provide
assistance to their customers through registered
representatives. Although on-line investors do not
generally receive such personal assistance, they
do have access to a vast array of financial
information, often at no charge, such as market
data, historical charts, industry reports, and
analyst reports. This information can assist them
in making trading decisions. Full-service brokers
have provided this information routinely only to
high net worth individuals and institutional
investors, such as the firms that manage mutual
funds and state pension funds.
Broker-dealers that offer on-line trading install
an additional layer of computer hardware and
software to their trading systems. This layer,
called the "front-end system," allows customers to
access information on the firms' Web sites and
submit orders to the firm for processing. The
firms also have internal systems that provide
customers the information they request, such as
price quotes, as well as deliver messages that
confirm their orders have been received and
executed. Both on-line and full-service broker-
dealers have "back-end" systems that route trading
orders to be executed.
On-line broker-dealers are beginning to offer
financial services that used to be offered only by
full-service broker-dealers. These services
include opening mutual fund accounts; trading
mutual fund shares, listed options, and fixed-
income securities; and access to initial public
offerings (IPOs). In addition, on-line broker-
dealers now offer new services, such as after-
hours trading and pre-opening trading. Also,
online broker-dealers are developing software that
can provide tailored portfolio and investment
advice. Conversely, some full-service broker-
dealers have begun to offer on-line services that
once only on-line firms provided.
On-line Trading Differs from Day Trading
On-line trading is sometimes confused with day
trading. Although on-line investors and day
traders both place electronic trading orders to
buy or sell stocks, their access to markets and
investment strategies differ. Trading on-line
provides investors a fast way to place orders with
their brokerage firms. On-line investors may use
any number of trading strategies designed to
profit from either short-term or long-term price
movements in the stocks they buy or sell. Day
trading, on the other hand, is a more focused
strategy used by traders who generally submit
trading orders from computers physically located
on the premises of a brokerage firm. These traders
attempt to profit by buying and selling stock
frequently, taking advantage of minute-by-minute
price movements. Day traders prefer to start each
day with no open positions and end the day the
same way, so they do not carry overnight market
risk. Although millions of investors trade on-
line, industry estimates suggest that there are
fewer than 10,000 active day traders.
A significant difference between on-line investors
and day traders is their access to the markets. On-
line investors access the markets through their
Internet service providers and their brokers'
order routing systems. This process can take
several seconds or minutes, exposing trading
orders to fluctuations in stock prices between the
time of order entry until its execution. By
contrast, day traders have virtually direct access
to the markets. Day traders trade at the offices
of day trading firms that have direct connections
to market centers.2 The day trading firms, as on-
line firms have begun to do, also generally
provide day traders in-depth news and information
about the securities markets, including real-time
price quotes for stocks. This enables day traders
to execute trades attempting to capitalize on
anticipated stock price movements. We address day
trading issues in a separate report.3
The differences between on-line trading and day
trading are diminishing as these industries
develop. For example, some on-line broker-dealers
now offer their active traders news and price
quote services similar to those already provided
to day traders; and they offer customized
software, such as that used by day traders, for
their most frequent users. Also, some day trading
firms are providing remote access terminals so
that their day traders can trade from home via the
Internet.
Scope and Methodology
To determine the extent of recent growth of on-
line trading, we obtained and reviewed reports
prepared by an SEC commissioner, Gomez Advisors,
and Credit Suisse First Boston Corporation. We
collected data from the reports on the number of
on-line broker-dealers, trading accounts, and
trading volume from the last quarter of 1997
through July 1999. We did not verify the accuracy
of these reports.
To determine the extent of system delays and
outages experienced by on-line trading firms,
including the circumstances for these problems, we
contacted 12 on-line broker-dealers. We selected
these firms primarily on the basis of their market
share of on-line trading volume.4 Ten of the firms
selected represented about 90 percent of the on-
line trading volume for March 1999, nearly 500,000
trades a day. We also selected two small firms to
determine whether the issues they faced were
different from those experienced by large firms.
These two firms had a combined market share of
less than 1 percent of total on-line trading
volume. We asked officials at each firm to provide
information on the number of system delays and
outages and the reasons for these occurrences. We
interviewed industry system professionals at
Keynote Systems, Inc., an Internet performance
measurement, diagnostic, and consulting firm, to
obtain their views on system delays for 11 of 12
on-line broker-dealers in our review. We also used
Keynote's data to examine the possible effects of
trading system outages and delays. Finally, we
obtained and reviewed investor complaints
submitted to SEC between January 1998 and June
1999 concerning on-line trading system outages and
delays.
To determine how on-line broker-dealers implement
investor protections related to margin, privacy of
information, risk disclosure, best execution,
suitability, and advertising, we discussed these
issues with officials from the 12 selected on-line
trading firms. We obtained and reviewed SEC and
NASD regulations and guidance, and reports. We
interviewed senior agency officials at SEC, NASDR,
NYSE, and the North American Securities
Administrators Association (NASAA) to obtain their
views on the various investor protection issues.
Also, we reviewed the Web sites and customer
account agreements of the on-line broker-dealers.
In addition, we obtained and reviewed 1999 reports
prepared by the Office of the New York State
Attorney General, From Wall Street to Web Street:
A Report on the Problems and Promise of the On-
line Brokerage Industry; and by an SEC
commissioner, On-line Brokerage: Keeping Apace of
Cyberspace. Finally, we obtained on-line trading
complaints submitted to SEC between January 1998
and June 1999 to identify problems experienced by
investors.
We conducted our work in accordance with generally
accepted government auditing standards between
June 1999 and February 2000.
On-line Trading Has Grown Rapidly
According to information we obtained from industry
analysts and SEC, the number of on-line broker-
dealers and trading accounts more than doubled
between the last quarter of 1997 and mid-1999. On-
line trading accounted for about 37 percent of all
retail trading volume in equities and options for
1998. Industry analysts also forecast that the
growth in on-line trading will continue.
Broker-dealers are not required to report to SEC
or NASD when they offer financial services on-
line. As figure 1 shows, however, available
information from industry analysts and SEC
indicates that the number of broker-dealers
offering on-line services grew from 37 in the last
quarter of 1997 to 160 by July 1999.
Figure 1: Number of Broker-Dealers with On-line
Trading Systems From the Last Quarter of 1997
Through July 1999
Sources: Analysis of information from Gomez
Advisors, Inc., and SEC.
Over the same period, the number of trading
accounts at on-line broker-dealers also increased
significantly. As figure 2 shows, the number of
accounts more than doubled from about 4.1 million
accounts in the last quarter of 1997 to nearly
10.5 million by mid-1999.5 We found no
comprehensive statistics to show how many of these
accounts were from investors new to securities
trading. However, estimates from one study suggest
that just over half of 7.5 million new accounts
established in 1998 were from investors who
converted from full-service or discount brokerage
accounts to on-line accounts.6 Industry
projections show that by 2001, on-line trading
accounts could nearly double again to about 18
million accounts.7 By then, some of the largest
U.S. full-service broker-dealers plan to have
implemented on-line trading operations.8
Figure 2: Number of On-line Trading Accounts From
the Last Quarter of 1997 to May 1999
Source: Gomez Advisors, Inc.
The rapid growth in the number of on-line broker-
dealers and trading accounts is reflected in the
increased number of average daily trades by on-
line investors. Figure 3 shows that in the last
quarter of 1997 the number of on-line trades
averaged about 153,000 a day, increasing to about
500,000 trades a day by March 1999. Ten of the 12
on-line broker-dealers in our review processed
about 90 percent of all these trades.
Figure 3: Number of Average Daily On-line Trades
From December 1997 Through March 1999
Source: On-line Trading Quarterly: 1st Quarter
1999, Credit Suisse First Boston Corporation, June
1999.
An industry report stated that on-line trading
orders represented about 37 percent of all retail
trades in equities and options for 1998.9
According to another industry report, future
growth of on-line trades will depend on the
features that make on-line trading attractive to
investors, such as low commission fees and free
company research.10 The report also cited other
factors that could affect future growth, including
more broker-dealers offering on-line trading;
increased Internet access, which is expected to
reach over 225 million people worldwide by the end
of 2000; and increased investment of Individual
Retirement Account and other retirement funds in
the stock market. The report further stated that a
strong market could influence on-line trading
growth. However, a major market disruption or
prolonged downturn could greatly reduce the extent
of future trading.
System Delays and Outages Were Not Reported
Complaints filed with SEC by customers of the on-
line broker-dealers we contacted have stated that
they lost financial opportunities because their on-
line trading systems experienced delays and
outages.11 Although the press reported some of the
more significant trading system outages, we could
not determine their full extent because securities
regulators generally do not require broker-dealers
to record or report delays and outages. Officials
at each of the on-line broker-dealers we contacted
attributed delays and outages to a number of
factors, including heavy Internet traffic and
problems with vendor trading systems. They said
that they expect delays and outages to continue
and are taking actions to minimize their effects
on customers.
On-line Broker-Dealers Had Trading System Delays
or Outages
Officials from each of the on-line broker-dealers
we contacted told us that their trading systems
had experienced either delays or outages or both.
Some said system delays happened more frequently
than outages, but they provided us information
only on outages.
Without records on the number and extent of system
delays, we could not determine the significance of
delays. However, in analyzing data from Keynote
Systems on the performance of on-line firms' Web
sites, we found that delays could adversely affect
on-line investors' ability to get their trades
executed.12 For example, we analyzed data from
Keynote that measured the average time it would
take for investors to enter an order after they
had accessed a Web site. Data for a 17-week period
from June through September 1999 showed a
statistically significant association between
average Web page processing speed and the rate of
success in submitting an order.13 Thus, investors
at firms that took longer to enter a trade had a
greater chance that their orders either would not
be executed or would be executed at an unexpected
price. Officials from a broker-dealer that had
longer processing times told us their speed was
influenced by the type and amount of information
contained on their Web sites. They said Web sites
with more information take longer to process an
order than those with less. However, they said
investors may benefit from the information
provided. NASD officials told us that the amount
of information on a Web site might determine the
length of time it takes an investor to download
Web pages, but it should not affect the speed at
which the on-line broker processes orders.
Officials from 11 of the 12 on-line broker-dealers
we contacted said they monitored trading system
outages that prevented their customers from
entering trading orders or prevented firms from
processing these orders. Officials from the
remaining firm told us about one outage but said
they had so many outages that they did not keep
track of them all. Although this was one of the
small firms, officials from the other small firm
said they had no outages. In total, officials from
11 firms reported 88 outages between January and
September 1999.14 However, this number may not
capture all outages because officials from one
firm explained that they track only outages that
last 25 minutes or more and affect at least 25
percent of their customer base. Of the 88 outages
that firms reported, about 40 percent lasted less
than 25 minutes.
Delays and Outages Attributed to Many Factors
On-line broker-dealer officials told us that
trading system delays were primarily caused by
heavy Internet traffic, especially during times of
high market volatility. The most commonly
identified reason they reported for trading system
outages involved problems with vendor-supplied
trading systems. Nearly all the officials from the
firms we contacted told us they have excess
capacity and that the capacity of their systems
has not been a cause of delays or outages, but
rather to system upgrades implemented to expand
capacity or improve capability.
On-line Trading System Delays Attributed to
Problems With Internet Service Providers,
Investors' Equipment and Market Makers
On-line broker-dealers, market analysts, and
regulators attribute some delays for on-line
investors to problems with Internet service
providers as well as the investors' own equipment.
On-line broker-dealer officials said that they
often do not know when customers served by
Internet service providers located outside their
local area encounter such delays. Keynote Systems
officials provided an example of an Internet
service provider problem. They said they found
delays caused by U.S. Internet service providers
that routed messages intended for U.S. broker-
dealers through Japan. In addition, SEC's Web site
warns investors that they might incur delays
because of problems with their own computer
equipment, such as slow modem speed.
To a lesser extent, on-line broker-dealer
officials attributed system delays to market
makers who switch from automated to manual
processing of trading orders.15 Market-making
officials explained that during periods of
abnormal volatility in stock prices and high
trading volumes, market makers have the option to
suspend automatic electronic execution of trading
orders. They said this generally happens when the
number of shares that customers want to purchase
exceeds shares available in the market makers'
inventory. Market makers subsequently shut down
their automated systems until they can refill
their inventories by buying shares from other
market makers. When this happens, delays in
filling customer orders may occur at the broker-
dealers that originated the customers' orders,
whether on-line or off-line. Sometimes these
delays can last several hours after customers
submit their orders to the broker-dealers.
System Outages Attributed to Vendor Systems and
Firm Hardware and Software Problems
Officials from 5 of the 12 on-line broker-dealers
we contacted said that vendor-operated systems
caused most of their outages. SEC staff stated
that many on-line firms rely on vendor systems for
major parts of order processing; and when these
systems experience problems, system outages can
result for more than one firm.16 Generally, vendor
systems handle the processing, routing, or
execution of trading orders for broker-dealers.
None of the firms in our review could provide
specific information on the causes of their
vendors' system problems. Officials from one firm
told us that their vendor does not disclose the
factors surrounding trading system problems. An
industry report expressed concern about the
technical capabilities of vendors that are being
pressured by on-line broker-dealers to respond to
their demands for faster processing.17 SEC Staff
Legal Bulletin No. 8, issued by the Division of
Market Regulation in 1998, recommends that
brokerage firms oversee vendors' operations to
ensure that vendors adequately address capacity
problems.
Officials from four broker-dealers cited hardware
problems as another reason for system outages.
These problems included failures of new pieces of
system hardware and memory caches and incorrect
coding of hardware products developed by vendors.
To better understand the nature of these problems,
we discussed two outages in detail with on-line
broker-dealer officials. In each of the cases,
human error compounded hardware problems.
For example, officials from one firm told us
that a major outage occurred when they attempted
to implement a significant upgrade to the firm's
trading system to speed the routing of investor
trading orders. The new piece of hardware
functioned properly during simulation testing but
failed after 3 days of operation. The firm
corrected the problem; but shortly thereafter,
another outage occurred when an employee ran a
massive report during regular market hours in
violation of company procedures. Officials told us
that no customer closed a trading account because
of these outages.
Officials from another firm told us of an outage
that stemmed from a failure of a device that
contained customer account information necessary
for processing trades. Although they designed the
system to contain five other similar devices that
would take over should any one of them fail,
efforts to repair the initial failure
inadvertently disabled these devices. This action
prevented customers from accessing 70 percent of
the firm's trading system. Officials explained
that this outage might have been prevented had the
device been installed properly in the first place.
Some broker-dealer officials attributed other
outages to software-related problems. For example,
officials from one firm described a malfunction in
a newly installed software program that was
designed to allow 250,000 customers to log on
simultaneously. This led to a 90-minute outage
shortly after the stock market opened that
prevented customers from either accessing their
trading accounts or obtaining pricing information
on stocks and mutual funds.
Problems Stemming from Upgrades to System Capacity
Are Reported As Causes for Outages
Officials from five broker-dealers said the only
trading system outages related to capacity have
been those that occurred during or soon after
system upgrades to expand capacity or improve
capability. Officials from 11 of the 12 broker-
dealers told us they build excess capacity into
their systems.18 Officials from seven firms told us
they have excess capacity ranging from two to five
times peak trading volume, based generally on
historical or projected trading volume data.
Officials from 3 other firms said their total
system capacity can handle 1 million trading
accounts, or up to 3 times their average daily
trading volume. Officials from the remaining firm
said that their system could handle up to 100,000
trades a day but is only averaging about 40,000
trades a day.
SEC staff stated that daily trading volume does
not provide an adequate gauge of available system
capacity during periods of peak usage. They
explained that surges in trading volume generally
occur during the first minutes after market
opening and before market closing. Thus, although
a system may be able to process a significant
number of trades over the course of a day, it may
have difficulty handling large numbers of trades
over a short period of time. SEC staff stated that
trading system capacity evaluations should
consider all uses of a system, both historical and
projected, and the system's ability to process
such uses.
An SEC staff legal bulletin recommends that broker-
dealers establish comprehensive planning and
assessment programs to determine system capacity.19
In addition, the bulletin emphasizes to broker-
dealers the importance of having adequate capacity
to handle high-volume or high-volatility trading
days and conducting capacity planning on a regular
basis. With few exceptions, officials from the
firms SEC reviewed, as well as the ones we
contacted, said they tested their systems
regularly, although the frequency of testing
varied. Officials from the firms we contacted that
did not regularly test their systems said they had
vendor systems that processed trades, and they
relied on these vendors to ensure adequate
capacity.
Not All On-line Broker-Dealers Warned Their
Customers About the Potential for Systems Delays
and Outages
Securities regulators generally do not require
broker-dealers to report system delays or outages.
NYSE requires firms to report only those outages
that threaten the viability of the firms.20 NASD
recommends that firms inform investors of the
problems resulting from potential trading system
delays and outages.21 SEC has added information to
its Web site informing investors that
technological "choke points" may exist that can
slow or prevent investors' orders from reaching
their on-line firm. The Chairman of SEC has stated
that each on-line broker should completely and
clearly explain to investors the limitations of on-
line trading technology and their effects on
placing and executing orders. He stated that it
would be useful to investors if firms' Web sites
better explained to customers the possibility of
system delays and outages. By better informing
investors of the points at which their orders may
be delayed, investor expectations would be more
consistent with the capabilities of technology. He
added that these disclosures would be useful to
investors only if they are readily visible on
brokers' Web pages. Also, investors might be
better able to minimize or avoid the disruptions
to their trading that delays and outages might
otherwise cause.
Eight of the 12 on-line broker-dealers we
contacted notified their customers of the
potential for delays and outages. These firms
either explained the types of circumstances that
could cause delays or outages and possible
financial loss or provided a link to NASDR's or
SEC's Web sites, which also contained this
information.22 One firm recommended that its
customers open an account with a competitor to
avoid trading disruptions should a delay or outage
occur. The remaining four firms either did not
notify their customers or did not provide clear
notices. For example, two of the firms stated that
system response time may vary due to a variety of
factors, such as trading volume, market
conditions, and system performance.
The most common investor complaint to SEC about on-
line trading concerned difficulty in accessing the
Web sites of broker-dealers. (See app. I.) Many
investors reported lost financial opportunities.
For example, one on-line investor said that he
lost up to $6,000 in his 2-day unsuccessful effort
to submit a sell order through one of the major on-
line firm's Web site. Officials from two on-line
broker-dealers said they made efforts to
compensate their customers for losses due to
outages. These officials told us they reimbursed
some customers over $1 million in commission
credits and trade adjustments. SEC staff said that
many firms have refused to provide compensation
for their customers' losses in this regard.
Firms Expect Delays and Outages to Continue and
Are Making Contingency Plans
Officials from several large on-line broker-
dealers told us they anticipate that trading
system outages and delays will continue as firms
expand or upgrade their systems. According to
these officials, frequent trading system upgrades
have been necessary to compete with other on-line
broker-dealers and to keep up with the growth in
on-line trading. For example, officials from one
firm said they made over 600 changes between
January and June 1999. Officials from each of the
firms said they are providing alternative means of
order entry to reduce the effects of outages on
their customers, including call centers, touch-
tone services, or redundant trading systems.
Officials from 8 of 12 on-line broker-dealers we
contacted said they use call centers as their
primary backups should on-line systems fail. SEC
staff have questioned whether, in the event of a
system outage, broker-dealers' call centers have
sufficient capacity to process normal on-line
trading volumes. Officials from 5 of the 12 firms
reported that they are planning to build new call
centers.
Officials from two broker-dealers said they use
secondary or redundant on-line trading systems as
their primary backups. They explained that should
one system fail, another system would handle all
the transaction processing. Officials from five
other firms told us they were building, or
planning to build, redundant trading systems.
On-line Brokerages' Web Sites Lack Information on
Trading Risks, Rules, and Procedures
To help investors make informed decisions, SEC and
the SROs require that on-line broker-dealers
furnish investors with information relating to
margin trading, have proposed requirements for
privacy of information, and recommend that broker-
dealers also furnish information about trading
risks and best execution of trades. These are key
investor protections. However, the on-line broker-
dealers that we contacted did not always provide
their customers all such information, especially
on the firms' Web sites, where it would be most
useful for investors trading on-line. Most of the
on-line broker-dealers provided some information
on their Web sites to educate investors, but
officials from one firm said they did not want to
overwhelm their customers with information; and
others said they had to work through a burdensome
process with vendors to provide this information.
Some customers have complained to SEC that they
lost money or missed financial opportunities
because they did not understand how on-line
trading worked.
SEC and SROs are also addressing other information
issues that might affect on-line investors. As on-
line broker-dealers provide investors information
tailored to their individual needs, they get
closer to becoming responsible for determining if
these investments are suitable for their
customers. SEC is reviewing which activities might
require suitability determinations. Also, SEC and
SROs require that advertising for on-line broker-
dealers be fair and honest and not mislead
customers. Some broker-dealers have withdrawn
advertisements that the regulators found
misleading.
Investors Are Not Always Provided Margin
Information on Brokerages' Web Sites
The regulations governing the information to be
provided to investors on margin trading-buying
stocks using money borrowed from a broker-are the
same for investors who trade on-line as they are
for investors who trade through full-service
brokers. However, investors who are trading on-
line do not normally use a registered
representative who might help explain the risks or
rules of margin trading. Some on-line broker-
dealers have personnel available to discuss margin
rules by telephone. An SEC commissioner reported,
with many broker-dealers SEC contacted in
agreement, that the most effective means to
educate on-line investors would be on the firms'
Web sites. All the on-line broker-dealers we
contacted provided their customers required
information on margin trading, but many did not
provide all of that information on their Web
sites. SEC has determined from its customer
complaints that many investors who traded on-line
did not understand margin requirements.
Margin regulations for securities trading specify
the maximum amount of borrowing, or leverage,
allowed by investors (usually 50 percent). For
example, an investor with $5,000 cash in a
brokerage margin account would be allowed to
borrow a maximum of an additional $5,000 from the
brokerage firm for total stock purchasing power of
$10,000. In return, the investor would pay
interest on the amount loaned from the brokerage
firm. Although margin trading allows investors
additional purchasing power, it also has
additional risks because of the leverage it
provides. For example, investors who borrow on
margin and buy twice as many shares can suffer
twice the losses if stock prices fall. Also,
margin regulations allow brokerage firms to sell
investors' stocks the firms hold as collateral for
margin loans should the value of the stocks fall
below a certain level. Consequently, investors
must provide additional collateral quickly or risk
having the firm sell the investors' stocks to pay
back the loan. Margin regulations also require
broker-dealers to disclose their policies and
procedures regarding margin trading that might
affect investors' accounts.
The lack of sufficient disclosure on when firms
would sell securities in a margin account to cover
margin loans was among the leading margin-related
complaints that SEC received.23 All of the on-line
broker-dealers we contacted provided their
customers some type of information on margin
trading, such as requirements for account opening,
procedures for selling securities to cover account
losses, or special requirements for volatile
stocks. However, nearly half of the firms
automatically opened margin accounts for new
customers without informing them of the risks and
benefits of margin trading. Those that provided
clear indications of the type of account to be
opened offered their customers the option to
choose either cash or margin accounts, or both, on
the Web site. The other firms offered only the
choices of ownership, such as a joint or
individual account, that all the firms offered.
These broker-dealers automatically opened margin
accounts; at three firms, customers would find out
about their account type only if they read and
understood their account agreements, which SEC
staff stated are written in legal language and may
be too difficult for investors to understand.
Three of the 12 on-line broker-dealers we
contacted took extra measures to ensure that their
customers understood that stocks could be sold to
cover outstanding loans in a margin account. The
three firms included information on their Web
sites that explained accounts could be liquidated
in fast-moving markets before the customary 3-day
period given to investors to replenish their
margin account collateral. At one firm that did
not take extra measures to inform its customers, a
customer complained to SEC that the firm sold
stock in his account without his knowledge before
the 3 days he thought he had to cover his margin
obligation.
Each of the 12 on-line broker-dealers we contacted
had margin requirements higher than 50 percent for
volatile stocks, and nearly all of them considered
some stocks too volatile to be traded on margin.
However, only 4 of the 12 firms we contacted
posted information about special margin
requirements on their Web sites for investors to
check before making a trade. The remaining eight
firms did not post this information. Officials
from two of these firms said that investors could
telephone the firms to obtain this information
before making a trade. Officials from the other
six firms said that customers would find out about
these special requirements when the firms asked
them for money after the trades were made. One
investor complained to SEC that he received a call
from his firm that he owed the firm $75,000 after
he unknowingly placed a trade on a stock that the
firm did not allow to be bought on margin.
Officials at one firm told us that they were
trying to improve their customer service in this
area.
On-line Brokerages Did Not Generally Inform
Investors About the Privacy of Their Data
Under the Gramm-Leach-Bliley Act adopted in
November 1999, SEC has proposed rules to require
broker-dealers to provide investors with a notice
of their privacy policies and practices. The rules
also describe the conditions under which broker-
dealers may disclose nonpublic personal
information about a consumer to nonaffiliated
third parties.24 The act also requires broker-
dealers to implement procedures to protect the
privacy of nonpublic customer information. SEC's
examination of 38 on-line firms found that these
broker-dealers implemented a variety of measures
to address customer privacy and confidentiality.
However, on-line investors have complained to SEC
that their broker-dealers inappropriately released
personal account information.
Nine of the 12 on-line broker-dealers we contacted
included information about the firms' privacy
policies on their Web sites.25 However, at the time
of our review, the privacy policies generally
stated only that the firms do not rent or sell
customer information to independent vendors.
Officials from four of these firms said they might
share this information with affiliated vendors
offering related financial services that might be
of interest to their customers, such as mortgage
companies, banks, and mutual funds.
Also, three of the on-line broker-dealers
generally provided their customers information on
how the firms internally use customer data, on
whether customers have a choice about how the firm
uses their data, and on what procedures firms use
to protect the confidentiality of the data. The
remaining nine firms had not yet provided such
information to their customers.
To determine how well on-line broker-dealers
protected customer information, SEC reviewed the
adequacy of password protections adopted by on-
line broker-dealers.26 It found that all of the
firms used at least one level of password
protection to restrict access to their on-line
trading systems. This level of password protection
requires a customer on a firm's Web site to enter
a password before gaining access to the trading
site. Few firms required customers to periodically
change their passwords. SEC also found that five
on-line broker-dealers used a second level of
password protection that requires the customer to
enter another password to submit a trading order.
SEC staff concluded that double-layer password
protection can reduce the likelihood that trades
will be either accidentally or intentionally
entered without the customer's consent. However,
they said even these protections can be overcome
by computer hackers.
In addition, SEC found that 22 of the 38 on-line
broker-dealers it examined tested the efficacy of
their security systems on preventing unauthorized
access. The firms either conducted their own tests
or contracted with outside security consultants.
Some tested their systems daily or when system
changes occurred. SEC staff stated that without
regular and comprehensive testing, broker-dealers
could not ensure the integrity of their on-line
trading systems for use by the public. However,
recent events showed that even testing may not
make brokers' systems immune from outside
disruption. In February 2000, some of the major on-
line broker-dealers' systems were targets of
attacks by hackers on a number of popular Web
sites. These attacks, called denial of service
attacks, made the on-line brokers' trading systems
unavailable to their customers for as much as an
hour or more.
SEC and NASDR are addressing investor complaints
involving inappropriate securities trading, misuse
of personal information, and unauthorized access
to trading accounts. Some of these complaints
involved four on-line broker-dealers in our
review. For example, one customer reported that
his firm gave him a user identification number and
password to gain access to his trading account.
However, the account accessed using this
information belonged to another customer and
contained over $400,000. In their customer
agreements, some on-line broker-dealers specify
that should theft or other financial loss occur
due to breaches in security or confidentiality,
they may not be held liable regardless of who the
responsible party is. SEC staff told us that
arbitrators or the courts would ultimately
determine the validity of such disclaimers.
On-line Brokerages Did Not Always Disclose Risks
Related to On-line Trading on Web Sites.
NASD and SEC recommend that on-line broker-dealers
inform their customers about the various risks of
securities trading, such as the differences
between limit and market orders,27 the effect of
these different orders on trade executions, and
the effects of trading volume on trade executions.
SEC staff stated that investors need this
information to fully understand the risks of on-
line trading or of securities trading in general.
The firms we contacted provided some of these
disclosures, but they disseminated the information
in various ways and did not always include it on
their Web sites.
Seven of the 12 on-line broker-dealers we
contacted generally disclosed information to their
customers in each of the recommended categories,
either on their own Web sites or by providing a
link to the Web sites of securities regulators,
which also contained this information. Three firms
provided their customers some, but not all, of the
recommended disclosures; and two-one small and one
major firm-provided no disclosures to their
customers on their Web sites. Officials from one
of these two firms told us that because they had
to work with a vendor, it was too burdensome to
have this information placed on their Web site.
Officials from the other firm told us that they
mail this information to their customers.
All of the 12 on-line broker-dealers we contacted
provided customers other information about
securities trading on their Web sites. For
example, some firms offered a glossary of
investment terms, answers to frequently asked
questions, letters and speeches by regulators, and
links to guides on personal investing. Other firms
provided more extensive education programs for
their customers. One established an "institution
for higher learning" on its Web site and offered a
free on-line curriculum about securities
investing. Another provided simulated trading
accounts for practice in on-line trading.
Despite these efforts, SEC staff told us many on-
line trading complaints came from investors who
lacked knowledge about securities trading. For
example, SEC staff said that they received many
complaints from investors who wanted to know more
about initial public offerings (IPO), especially
how firms allocated IPO shares and the total
amount of shares available.28 SEC staff stated they
are planning to offer guidance to on-line broker-
dealers on disclosure of IPO allocation and on-
line distribution methods. SEC staff also stated
that broker-dealers offering IPO shares to on-line
investors should provide clear and meaningful
disclosure about the on-line distribution of IPO
shares, including their allocation methods and any
restrictions on share distributions. The eight on-
line broker-dealers that offered IPOs did not
generally provide information on their allocation
methods, the probability of any one customer
receiving shares, or the number of shares to be
allocated to the firms. Instead, some of these
broker-dealers informed investors that a limited
number of shares were available or presented data
on the total number of shares offered to the
industry as a whole. SEC staff have stated that
investors, especially those new to trading, could
mistakenly assume that the on-line brokerage firm
had sufficient IPO shares available for purchase.
Some On-line Brokerages Had Problems Ensuring
Quality Execution of Trading Orders
The 12 on-line broker-dealers we contacted
generally routed their customers' orders to third-
party broker-dealers who guaranteed to fill the
orders at the best prices available at the time
they were received or at least the national best
bid or offer (NBBO) price.29 As a result, the
quality of the execution of their trades was
dependent on the third-party broker-dealer.
Determining whether investors were getting the
best possible executions of their orders was
difficult because the quality depended on a number
of factors, such as price, speed, and the
likelihood of execution. SEC, NYSE, and NASD
require broker-dealers to obtain the best
execution reasonably available under the
circumstances for their customer orders, and SEC's
review of the execution practices at 29 on-line
broker-dealers indicated that over half were not
meeting their duty to ensure best executions. SEC
sent deficiency letters to those firms that failed
to meet their best execution obligations to get
the firms to take corrective actions. On-line
investors can take steps to ensure quality trade
executions, such as specifying where they want
their trade to be executed, but eight firms we
contacted did not provide this information to
their customers. SEC staff said that this may
require customers to call the firm to specify
where they want their order executed. They also
said that this is a very complex issue, and a
typical investor may not currently know how to
make this decision. Officials from one firm said
they did not want to overwhelm their on-line
customers with information on the Web site. Those
from another firm said this issue is complicated,
and if customers needed more information they
could call the firm.
On-line Broker-Dealer Customers Do Not Have Direct
Access to the Markets
When customers submit orders to on-line broker-
dealers, the firms decide where to send the
orders. They can send the orders to exchanges,
such as NYSE, Chicago, or Philadelphia; Electronic
Communications Networks (ECN), which
electronically link buy and sell orders; or over-
the-counter market makers. The on-line firm itself
could also act as a market maker and execute the
orders out of the firms' own inventory-known as
internalizing order flow. The on-line firm could
also route orders to its clearing firm, which
would generally execute orders from the clearing
firm's own inventory or through other firms that
quote prices to buy and sell particular stocks.
Ten of the 12 on-line broker-dealers we contacted
said they routed the majority of their customer
orders for Nasdaq-listed stocks to market makers.
Officials from five firms said they used a single
market maker, the rest used as many as nine market
makers. The particular market maker chosen
depended on parameters programmed into the firms'
trading system software, such as the type or size
of the order or payment for order flow. Three
firms routed Nasdaq orders to ECNs. The 12 firms
generally routed NYSE-listed orders to either the
Chicago or Philadelphia Exchanges, or both.
When third-party firms or exchanges receive orders
from an on-line brokerage firm, they generally
fill the orders from their own inventories at NBBO
prices. Although this price is the best price
displayed at the time of the order, it may not be
the best price available at the time of the trade.
Because the orders are filled internally, other
market participants, such as market makers or
specialists, do not see them and, thus, do not
have a chance to better the NBBO price. SEC staff
stated that routing order flow for execution at
the NBBO does not necessarily satisfy a brokerage
firm's duty of best execution for retail-sized
orders.30
SEC Has Found Problems With Broker-Dealers Meeting
Best Execution Requirements
SEC requires broker-dealers to seek the most
advantageous terms reasonably available under the
circumstances for a customer's trading order.
These circumstances include price, speed, and the
likelihood of execution, among others. SEC has not
promulgated a separate best execution rule or
explicitly defined best execution. Traditionally,
price has been the predominant factor in
determining whether a brokerage firm has satisfied
its best execution obligations. This position was
reiterated in 1994.31
In 1999, in its examinations of the trade
execution practices of 29 on-line broker-dealers,
SEC found that 17 firms improperly emphasized
"payment for order flow" in deciding where to send
orders, rather than considering factors that could
benefit trade executions, such as the best price.
Payment for order flow occurs when a market maker,
ECN, or an exchange pays an on-line brokerage firm
for its orders. The payments could include rebates
of up to 1 or 2 cents a share and credits or
discounts against fees charged for executing the
order. Broker-dealers might also receive a portion
of the profits made by the market maker.32 Thus,
SEC found that the 17 firms, including 6 that we
contacted, were not ensuring that their customers'
trades received the best execution possible. The
firms did not evaluate execution quality available
from other competing market makers in making order
routing decisions.33 Instead, most of them routed
orders to market centers whose execution quality,
or percentage of trading orders that received
price improvement, were well below industry
averages. In response to SEC's findings, 7 of the
17 firms claimed the data used by SEC to identify
these problems were flawed, or that their clearing
firms were responsible for ensuring execution
quality. However, the firms supplied the data SEC
used to make its determinations; and according to
SEC, the firms are ultimately responsible for
ensuring that their customers receive best
execution. SEC staff sent each firm a deficiency
letter and plan to focus future examinations on
broker-dealers' best execution obligations.
Officials from five of the on-line broker-dealers
we contacted told us they emphasized speed and
liquidity-the ease with which the market can
accommodate large volumes of securities trading
without significant price changes-over price
improvement in providing their customers the best
trade executions. According to SEC officials,
these factors can be considered as long as the
brokerage firm conducts a regular and rigorous
evaluation of the quality of the different market
makers trading in a particular security.34 However,
SEC found that 17 broker-dealers were not taking
the steps necessary to determine whether other
market centers offered faster execution or
executions that were just as fast but had a
greater likelihood for price improvement. SEC also
identified these problems in its deficiency
letters and plans to focus future examinations on
broker-dealers' best execution obligations.
Officials from 3 of the 5 on-line broker-dealers
that emphasize speed of execution explained that
many investors were not willing to wait to get an
opportunity for a price improvement of 1/8 or 1/16
on a specific stock in order to save a few pennies
on a trade. However, the Chairman of SEC said in a
November 1999 speech that retail investors might
be willing to give up a few seconds if it meant
receiving more money on the sale of a stock or
saving money on the purchase of stock. He
explained that if a brokerage firm receives
payment for order flow from a market maker at the
rate of a penny a share on a 1,000-share order,
the brokerage firm gives up the possibility of
obtaining price improvement from another market
maker. A price improvement of 1/16th on a 1,000-
share order would mean that the customer has
overpaid by $62.50.
Firms Are Addressing Best Execution Problems
In its examination of on-line broker-dealers, SEC
found that six brokerage firms we contacted were
not fulfilling their best execution duty.
Officials from five of the six firms told us that
they have implemented improvements to help ensure
that investors receive the best price for a stock.
These improvements included establishing execution
quality committees to monitor trade executions on
a weekly basis, implementing software programs
that automatically flagged trading orders executed
outside of the bid and ask price of stocks, and
requesting price improvement data from other
market centers. Officials from one major firm that
did not implement any specific measures told us
that execution quality was the responsibility of
the broker-dealer executing the trades, which was
contrary to SEC's view. They also said that they
respond to complaints made by individual investors
on execution quality.
On-line investors can also take steps to help
ensure quality trade executions. In its on-line
trading examinations, SEC found that many on-line
broker-dealers would accommodate a customer's
request to route an order to a specific market
center, although the customer would likely be
charged higher commission fees. Investors may be
able to offset the higher fees by getting better
prices for their trades. Eight of the 12 firms in
our review did not provide this information on
their Web sites or customer account agreements.
The Chairman of SEC said investors would benefit
greatly from more information about execution
quality. SEC staff said they are considering what
additional information on trade execution could
benefit investors and in what form that
information should be provided.
Suitability Considerations Are Not Clear in the On-
line Trading Environment
When broker-dealers or registered representatives
recommend specific securities to investors,
securities rules make them responsible for
determining whether the potential investment is
suitable for those investors. Officials from the
on-line broker-dealers we contacted reported that
they do not provide their customers the type of
specific stock recommendations that would trigger
the suitability requirements. However, the
suitability rules may begin to apply as these
firms develop information tailored to individual
investors.
NASD first adopted suitability rules in 1939 as
part of its Rules of Fair Practice. Currently,
NASD's suitability rules require member broker-
dealers to make reasonable efforts to obtain and
document the data they use or consider in
determining whether their recommendations are
suitable for their customers. The data are to
include customers' financial and tax status and
investment objectives. Other SROs have similar
rules that are grounded in concepts of
professionalism, fair dealing, and just and
equitable principles of trade. For instance,
NYSE's "Know Your Customer Rule" requires members
to use due diligence to learn the essential facts
relative to every order, cash or margin account
accepted, and every person holding a power of
attorney over any account.35 In addition to
customer-specific suitability, firms must have a
reasonable basis for believing that a particular
security being recommended is appropriate for any
investor. To have such a reasonable basis, firms
must perform due diligence on the security to be
in a position to recommend the security to a
customer.36
Each of the 12 on-line broker-dealers in our
review either displayed disclaimers on their Web
sites or told us that they do not offer advice on
the suitability of particular investments or
"recommend" specific stocks to individual
customers. However, suitability determinations
depend on the facts and circumstances relative to
every customer, and these broker-dealers provided
a wide range of information to their customers.
They offered their customers investment and
research reports prepared by unaffiliated
companies that contained recommendations for
thousands of stocks, and they linked these reports
to their Web sites. In addition, some firms we
contacted charged their customers for general
stock recommendations by specific industry or risk
category. Officials from several firms told us
their investment research services are the same
tools used by professional brokers. An SEC
commissioner expressed concern about whether this
research raises suitability issues because
investors might assume that information posted on
firms' Web sites is a recommendation by the
brokers.
In addition to research from unaffiliated
companies, 2 of the 12 on-line broker-dealers we
contacted offered their customers research
information from the firm's analysts. An SEC
official told us that suitability requirements
typically have not applied to analysts'
recommendations unless the recommendations are
brought specifically to the attention of
individual investors. However, a legal expert on
securities trading told us that some type of
suitability obligation might apply when broker-
dealer analysts prepared the research provided to
on-line investors. Officials from four on-line
broker-dealers generally agreed, especially, as
one official said, when a firm's own research is
the only information provided on the Web site. All
of the on-line broker-dealers we contacted used
disclaimers on their Web sites or in customer
account agreements that the research service they
offered should not be used or considered as a
recommendation to buy or sell a particular
security. Such a recommendation might trigger
suitability requirements. SEC staff told us that
broker-dealers could not use such disclaimers to
make their customers waive their rights under
federal securities laws.
Further, two on-line broker-dealers offered their
customers access to personalized messages about
particular stocks through chat rooms and bulletin
boards. Chat rooms and bulletin boards include
participants' opinions about specific stocks.
These firms also sponsor "live events" in their
chat rooms that present financial analysts who
sometimes recommend specific stocks in response to
customer questions. SEC staff expressed concern
that investors may believe that the on-line firms
had endorsed the recommendations. In a series of
roundtable discussions SEC held with broker-
dealers in 1999, many participants favored
additional guidance from SEC on what types of
information and what delivery mechanisms might
trigger suitability responsibilities. SEC staff
told us they are reviewing which on-line trading
activities might require suitability
determinations.
Regulators Plan More Extensive Oversight of
Advertising for On-line Trading
NASD regulations on advertising require firms to
portray the risks and rewards of investing on-line
in an honest, fair, and balanced manner. Eleven of
the 12 on-line broker-dealers we contacted plan to
collectively spend about $1 billion on advertising
to attract new on-line customers during 2000.
Because of the volume of advertising for
securities trading in general, overseeing the
quality of on-line trading advertising has been
difficult. In early 1999, NASDR found that firms
engaged in extensive and aggressive advertising
campaigns had minimally complied with advertising
regulations. Later in 1999, SEC found improvements
in the quality of advertising by on-line broker-
dealers. However, NASDR reported that it plans to
monitor advertising by on-line broker-dealers more
aggressively.
An NASDR official told us that NASD's review of
television advertising by on-line broker-dealers
in early 1999 found that firms' use of expensive
material goods in advertisements or suggestions
about investment returns portrayed unrealistic
expectations about opportunities to profit through
on-line trading. For example, in its advertising
campaign one firm showed a person trading on-line
in a mansion. Another firm's ad had "Al the tow
truck driver" telling a passenger about the island
that he now owned due to trading through his on-
line broker-dealer. In another ad, a jogger
sheepishly admits that she still invests in mutual
funds in response to a friend who boasted that she
had just made $1,700 in an on-line trade. This ad
may be demeaning to those who would invest in
mutual funds. Rather than taking formal
enforcement actions against these firms, NASDR
negotiated the voluntary withdrawal of certain
misleading advertising campaigns. NASDR also
sponsored three advertising roundtables between
June and July 1999, at which the legal and ethical
responsibilities of broker-dealers who promote on-
line trading were discussed.
SEC's mid-1999 review of on-line broker-dealer
advertising found that firms have begun to modify
their advertisements. For example, two on-line
broker-dealers had televised ads that communicated
the risks associated with on-line trading in a
volatile market. One of these firms instructed
investors not to view on-line trading as playing
the lottery, and the other firm suggested that
investor education was important in on-line
trading.
To prevent misleading advertisements, NASD rules
require compliance personnel at member firms to
approve advertisements before they are used and to
submit certain marketing material and sales
literature to NASDR. NASDR rules do not require
that firms submit all advertisements. Officials
from many of the firms told us they sent
advertising materials for NASDR review only when
they were concerned about the content of the
advertising. NASDR officials told us that they
review all of the advertising submissions.
In September 1999, NASDR announced plans to adopt
more aggressive oversight and investigation of
possible rule violations for television
advertising. NASDR monitors advertisements for on-
line trading and works with other regulators and
NASD members to educate the investing public. If
firms are required to file advertisements, NASDR
also plans to require members to file a final
filmed version of a television or videotape
advertisement within 10 days of its first use or
broadcast.
Conclusions
The on-line trading segment of the securities
industry is growing and evolving rapidly. What
began as primarily an order entry system has
evolved into a myriad of on-line services and
programs to help investors independently plan and
track their investments, including allowing them
to engage in more risky strategies, such as margin
trading and IPOs. Industry analysts expect the
growth in on-line trading to continue.
On-line trading has generated many benefits to
individual investors, such as reduced commission
costs to trade securities and free research and
other investment tools that had previously been
available only to professional brokers and
institutional investors. However, on-line
investors have also experienced problems, such as
trading system delays and outages. On-line broker-
dealers neither consistently monitor these
disruptions nor disclose that such disruptions
could occur. Maintaining consistent records about
delays and outages could provide the broker-
dealers information that could be used to better
inform investors about the potential for, and
adverse effects of, delays and outages. The
information could also assist securities
regulators in assessing whether these broker-
dealers comply with SEC guidance on maintaining
adequate system capacity.
Investors might be able to find all the
information they need about how to trade on-line
and the risks of doing so from a combination of
sources, including their broker-dealers' Web sites
or written material, regulators' Web sites, or
other Internet sources. However, on-line investors
make their trades on the Web sites of their broker-
dealers, and regulators and industry members agree
that this is the best place to provide the
information on-line investors need. Some Web sites
of on-line broker-dealers were incomplete or
missing key pieces of information in the investor
protection areas of margin requirements, privacy
considerations, risk disclosures, and trade
executions. As SEC complaints have shown, many on-
line investors may not understand the risks they
are taking or the rules and procedures for
trading. Providing complete information on the Web
sites of on-line broker-dealers could help
investors make more informed investment decisions.
Recommendations
We recommend that the Chairman, SEC, require
broker-dealers with on-line trading systems to
maintain consistent records on systems delays and
outages and their related causes and to disclose
the potential for service disruptions on their Web
sites. We also recommend that the Chairman monitor
these records to ensure that firms have adequate
capacity to serve their customers.
We also recommend that the Chairman, SEC, ensure
that broker-dealers with on-line trading systems
include accurate and complete information on their
Web sites in the key investor protection areas of
risk disclosure, margin requirements, privacy
considerations, and trade executions.
Agency Comments and Our Evaluation
SEC provided oral technical comments on a draft of
this report, which we have incorporated where
appropriate. In addition, SEC provided written
comments (see app. II) in which it said it
appreciated our thoughtful recommendations in this
new and evolving area. SEC highlighted the actions
it has taken, or plans to take, in each of the
areas we discuss in our report, and said it
believed these efforts were responsive to our
recommendations. For example, it said the
Chairman has actively encouraged on-line brokers
to use their web sites to better inform customers
and SEC would continue to focus broker-dealer
examinations on best execution. SEC also plans to
closely monitor adherence by the firms to privacy
rules when they go into effect. These examples
show that SEC is working to increase the
information available to investors in the areas we
identified. However, we continue to believe that
on-line investors need to be able to access this
information directly on their brokers' Web sites.
We also believe that SEC, through its
examinations, recommendations, and rule proposals,
can help ensure that on-line brokers provide such
information.
SEC noted that it has published recommendations
and proposed rules addressing on-line systems'
capacity, vulnerability, and operational
capability. SEC also said it often includes an
assessment of system capacity and reliability in
its examinations of both on-line and traditional
brokers, including reviewing records on system
delays and outages and their causes. However,
these activities do not address variations in the
methods firms use to track delays and outages, or
the disclosure of the potential for disruptions on
firms' Web sites. This makes it difficult for
investors to understand the potential limitations
of on-line trading systems or compare system
performance for various on-line brokers.
Therefore, we believe SEC should have broker-
dealers with on-line trading systems maintain
consistent records on delays and outages, which
includes defining at what point a trading system
disruption is considered an outage. We also
believe that SEC should have broker-dealers inform
customers of their track record for trading system
disruptions, and the potential for these
occurrences.
NASD and NYSE provided oral technical comments on
a draft of this report, which we have incorporated
where appropriate. NASD also provided written
comments (see app. III) in which it said our
report provides insight into the public policy
issues relating to on-line trading that will be
helpful in illuminating several important on-line
trading issues. NASD also mentioned it created a
new page on its Web site directed to on-line
investors.
As we agreed with your offices, we plan no further
distribution of this report until 30 days from its
issuance date unless you publicly release its
contents sooner. We will then send copies of this
report to Representative Tom Bliley, Chairman,
House Committee on Commerce; Representative Fred
Upton, Chairman, Subcommittee on Oversight and
Investigations, Representative W.J. "Billy"
Tauzin, Chairman, Subcommittee on
Telecommunications, Trade, and Consumer
Protection, and Representative Michael G. Oxley,
Chairman, Subcommittee on Finance and Hazardous
Materials, House Committee on Commerce; Senator
Susan M. Collins, Chairwoman, Permanent
Subcommittee on Investigations, Senate Committee
on Governmental Affairs; the Honorable Arthur
Levitt, Chairman, SEC; Mr. Frank Zarb, President
and CEO, NASD; and other interested committees and
organizations. Copies will be made available to
others upon request.
Major contributors to this report are acknowledged
in appendix IV. Please call me or Michael Burnett
on (202) 512-8678 if you or your staffs have any
questions about the report.
Richard J. Hillman
Associate Director, Financial Institutions
and Markets Issues
_______________________________
1On-line Financial Services Update, U.S. Bancorp
Piper Jaffray, September 1999.
2Market centers include exchanges, Nasdaq, and
electronic communication networks (ECNs).
3Securities Operations: Day Trading Requires
Continued Oversight (GAO/GGD-00-61, Feb. 24,
2000).
4Six of the 12 broker-dealers began on-line
trading after 1995 and represented 56 percent of
the market share of daily on-line trades. The
other six firms are subsidiaries of well-
established full-service or discount broker-
dealers and represented 35 percent of the market
share of daily on-line trades. Before 1995, some
of these firms offered on-line trading using
proprietary software.
5These accounts include only active on-line
trading accounts.
6Securities Industry Trend, Securities Industry
Association, May 1999.
7Ibid.
8We did not identify how many of the estimated
7,785 broker-dealers nationwide are planning to
offer on-line trading to their customers.
9Online Financial Services Update, U.S. Bancorp
Piper Jaffray, March 1999.
10Online Brokerage: Industry at a Critical
Inflection Point, U.S. Bancorp Piper Jaffray,
October 1988.
11Delays occur when customers' access to firms' Web
sites or firms' ability to process trading orders
is slowed. Outages occur when customers can not
access the firms' Web sites or when the firms
cannot process trading orders.
12Keynote Systems had data for 11 of the 12 broker-
dealers in our review. It did not have data for
the remaining firm during the time period we
reviewed.
13Keynote Systems allows each page necessary for
order entry to take 12 seconds. For example, if an
on-line broker-dealer requires customers to
download five pages to enter an order, then
Keynote allows a total of 60 seconds for
processing. Therefore, an attempt is considered
successful if it is processed within the 12
seconds per page time limit.
14The number of outages the firms reported ranged
from 1 to 25.
15Market makers are NASD member broker-dealers who
quote prices at which they are willing to buy (bid
quote) or sell (ask quote) securities for their
own accounts or for their customers.
16SEC identified at least 31 on-line broker-dealers
that were electronically linked to a single
vendor's trading system.
17eBrokerage Quarterly, BancBoston Robertson
Stephens, June 1999.
18Officials from one remaining firm told us they do
not know their total system capacity because the
firm relies on its vendor to process its trading
transactions.
19In 1989 and 1991 respectively, SEC issued two
Automation Review Policies. Automation Review
Policy I states that self-regulatory
organizations, on a voluntary basis, should
establish comprehensive planning and assessment
programs to determine system capacity and
vulnerability of trading systems. Automation
Review Policy II provides guidance on the type of
independent review that should occur in overseeing
capacity planning.
20NYSE Rule 401 states that members must report
system problems if they could lead to capital,
liquidity, operating problems, or impairments in
recordkeeping, clearance, or control functions. To
help track system outages, NYSE recently added an
"on-line trading" category to reports of customer
complaints that member firms are to file
quarterly.
21NASD Notice to Members 99-11 and 99-12.
22In its comments on a draft of this report, NASDR
indicated that it has just completed development
of a new Web page directed to on-line investors
that includes information about the mechanics of
on-line investing and margin, among other matters.
23This situation could occur when the value of cash
and securities in an investor's margin account
falls below brokerage firm maintenance margin
requirements (usually 30 to 50 percent at on-line
brokerage firms). Broker-dealers have the legal
right to sell the investor's securities to bring
the account back to the maintenance margin
requirement at any time without consulting the
investor, although firms generally inform
investors of an immediate need to replenish their
accounts, called a margin call.
24Financial data can be gathered on-line from
customers or from potential customers, which then
could be used for possible marketing purposes. For
example, financial information obtained by broker-
dealers may provide allied businesses
opportunities to solicit customers for potential
banking services.
25Officials from the three remaining broker-dealers
told us they did not yet have written policies in
place, but were using informal internal policies.
26SEC also reviewed other security measures, such
as the use of firewalls and encryption.
27With a limit order, investors can establish the
maximum price they are willing to pay for a stock
or the minimum price at which to sell the stock.
With a market order, the trade is executed as fast
as possible without regard to price.
28An IPO is a firm's first offering of stock to the
public. IPOs appeal to investors because in recent
years the prices of some IPOs have risen rapidly
on the first day of trading.
29The best bid is the highest priced buy order, and
the best offer is the lowest priced sell order in
the market at a point in time. Although NYSE and
Nasdaq are the primary market centers for stock
trades, trades can also occur in other
marketplaces. For example, Electronic
Communication Networks (ECNs) traded nearly 10
percent of the volume of Nasdaq-listed stocks as
of March 1999. The best buy and sell prices listed
on any of these marketplaces would be the NBBO.
30Retail size trading orders can vary up to 10,000.
31SEC Exchange Act Release No. 37619A (Sept 6,
1996), 61 Fed Reg. 48,290.
32Six of the 12 firms in our review disclosed in
their customer account agreements that they could
receive payment for order flow.
33Some of these problems may be mitigated as
changes in market structure occur, such as
centralizing securities prices and orders or
changing to decimal trading with the prospect of
penny differences between offers to buy or sell
stock.
34Exchange Act Release No. 26870 (May 26, 1989) 54
Fed. Reg. 23,963 (1989); Exchange Act Release No.
34,902 (Oct. 27, 1994), 59 Fed Reg. 55,006 (1994).
35All of the 12 on-line broker-dealers we contacted
were members of NASD, and 4 were also NYSE
members.
36Hanley v. SEC, 415 F. 2d 589, 596 (2d. Cir.
1969).
Appendix I
Top Ten On-line Trading Complaints to SEC, January
1998 to June 1999
Page 36GAO/GGD-00-43 Better Investor Protection In
formation Needed
Source: SEC Office of Investor Education and
Assistance.
Appendix II
Comments From the Securities and Exchange
Commission
Page 38GAO/GGD-00-43 Better Investor Protection In
formation Needed
Appendix III
Comments From the National Association of
Securities Dealers
Page 39GAO/GGD-00-43 Better Investor Protection In
formation Needed
Appendix IV
GAO Contacts and Staff Acknowledgments
Page 40GAO/GGD-00-43 Better Investor Protection In
formation Needed
GAO Contacts
Richard J. Hillman, (202) 512-8678
Michael A. Burnett, (202) 512-8678
Acknowledgments
In addition to those named above, Denise
Callahan, Robert Pollard, Kate Mannen, and Don
Yamada contributed to this report.
*** End of Document ***
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