Transcript INTERNET BASED SECURITIES TRANSACTIONS

THE INTERNET BASED
SECURITIES TRANSACTIONS
MEHMET FAHRİ ERCAN
Securities industry has been affected significantly by technologica
developments during recent years.
One of the most important changes stems from the way which brokerag
firms use the Internet to communicate with their customers.
Using the Internet provides lower cost and range services to customers.
Broker/dealers have used the Internet to provide investors with tools to
obtain access to important analytical information conduct their own
research and place their own orders.
Capabilities of the Internet
The Internet began in the 1960's as a network of computers funded by
the Department of Defense, intended to facilitate communication in the
United States in the event of a nuclear attack.
In the 1970's, universities and other nongovernmental entities started
linking with this net.
PC revolution of the 1990s has incrased information processing
capability of the Internet enourmously.
The Internet decreases the importance of physical distance as an
obstacle to market access.
It lowers the costs of obtaining and exchanging information.
Use of the Internet for Securities Transactions
Web sites, bulletin boards, e-mail and push technology can all be used
in advertising, offering and selling securities and for delivering
investment advices.
They permit communication instantaneously with millions of people
worldwide at low cost.
They allow matching proposed trades and circulating information in
broad-based markets. They also permit individuals to access vast
amounts of information far more quickly and directly than any other
mean.
The Internet is an efficient mean;
(1) for issuance of new securities;
(2) for secondary trading in already-issued securities;
(3) as a powerful new information tool.
The Internet As A Mean To Trade New Securities
The Internet causes two main changes in the issuance of new securities.
1) investment bankers can post new underwritings of stock issues on
the World Wide Web and thereby expose them to vast numbers of
prospective investors at very low cost.
2) Issuers can bypass traditional underwriters and make direct public
offerings of securities using the Web bulletin boards and push
technology.
The Regulatory Framework For Cybersecurities
1. Federal Regulations
The issuance of new securities in the United States is primarily ruled
by the Securities Act of 1933. The 1933 Act generally requires
registration with the SEC of securities that are publicly offered.
The Securities Act of 1934 generally requires registration of brokerdealers and national securities exchanges with the SEC.
Both of these Acts regulate securities fraud, the 1933 Act focuses on
securities issuance while the 1934 Act deals broadly with both issuance
and after-market trading.
The Investment Advisers Act of 1940 governs both open and closedend investment companies that offer their securities to the public.
In October 1995 interpretive releases and a 1996 concept release,
reflect an SEC effort to encourage electronic delivery of information to
investors.
The SEC also published in 1998 an interpretive release on the
application of U.S. federal securities laws to offshore offering and sales
of securities and investment services over the World Wide Web.
Electronic Transmission of Information.
The SEC has stated that electronic distribution of information through
electronic means as satisfying the delivery or transmission requirements
of the federal securities laws if such distribution results in the delivery to
the intended recipients of substantially equivalent information as these
recipients would have had if the information were delivered to them in
paper form.
However, unlike information transmitted in paper form, an issuer must
obtain the investor's informed consent to the receipt of information
through the Internet.
Secondary Trading of Securities in Cyberspace
Discount Broker-Dealers
Contrary to a common misconception, the Internet does not cause
disintermediation. By increasing the availability of information, lowering
transaction costs and enlarging the span of the potential relationships, it
creates a strong demand for new forms of intermediation. And the
Internet technology provides both a network infrastructure and a flexible
set of tools to develop and deploy new transaction systems.
Even before it was used for offerings of securities, the Internet had
begun developing a new dimension for secondary trading in alreadyissued securities. Small discount brokerage firms were the first to offer
full online trading services and research to account holders in 1995.
The online firms allowed it was estimated that in 1966, there were 1.5
million online accounts.
In 1997, the number had grown to almost three million, and
the number is about 20 million today. Internet-based trading
accounted for 17% of total retail sales in 1997.
In US 76 brokers were offering some form of electronic
trading in mid-1998.
The most prominent are Charles Schwab & Co., and E-Trade.
As of March 1997, Schwab had 700,000 active on-line
accounts and $50 billion in on-line customer assets, and by
December 1997, Schwab's sales by means of electronic
trading for the month for the first time were more than half
the firm's total retail sales.
Assets managed by on-line investors are predicted to grow
from over $100 billion today to $524 billion in 2001 and
account for more than 8% of the total assets held by small
investors.
The explosive growth of the Internet-based retail brokerage has been the
most obvious sign of the Internet impact on securities markets.
In the late 1990s, superior market performance of technology stocks
attracted technology-savvy investors, who used Internet brokers for their
trades. In turn, Internet brokers focused their marketing on technology
stocks.
However the sharp technology market downfall of 2000 has changed the
picture.Technology distressed investors reduced their trading activities
and in many cases left the market altogether. The trading activity and
assets under management of Internet brokers dropped significantly.
Revenue growth slowed sharply and in many cases turned into a revenue
drop, leading to heavy losses. Market expectations have been revised
downwards. The market capitalisation of the global market leader,
Charles Schwab has dropped over 60% between January 2000 and
January 2002.
Table: Leading on-line brokers: summary data
Revenues
(M $)
Profit
(M$)
Customer
assets (B$)
1999
2000
2001
1999
2000
2001
1999
2000
2001
Schwab
4486.0
0
5788.00
4353.00
666.00
718.00
199.00
846.00
871.70
845.90
Etrade
670.00
1370.00
1275.36
-56.70
19.10
241.50
30.85
65.88
52.85
Ameritrad
e
314.45
654.45
498.6
18.108
-20.26
-146.4
22.90
36.00
26.10
ECNs
In the US, alternative trading systems such as the Electronic
Communication Networks (ECN)s are not a new phenomenon. They
were launched in the 1980s in response to three requirements, to which
the established stock exchanges were unable to respond in satisfactory
manner:
· After-hours trading,
· Order matching for institutional investors (crossing networks),
· Support for market-makers for position management.
The ECNs remained relatively marginal as their access was restricted and
prices were not widely disseminated.
The situation changed in the late 1990s, when the advent of Internet
broking created a strong demand for rapid execution of a large flow of
retail orders.
These orders were heavily concentrated in technology stocks, traded on
NASDAQ via market makers, whose models depended on spreads
between sell and buy prices.
Some online brokers wanted to eliminate the spread by matching orders
directly. Their development was supported by the SEC, which saw the
ECNs as a means of enhancing price discovery process.
In January 1997 the SEC adopted the Order Handling Rules - requiring
market makers and specialists to reflect in their quote the price of any
orders they placed with an ECN if this price was better than what they
were displaying to the public.
The SEC’s regulatory support caused a rapid growth of the ECNs. By
mid-2000, the ECNs have captured over a quarter of trades on NASDAQ
listed stocks.
However with NYSE-listed equities, the figure is only slightly more than
The Effect of Online Discount Trading on Suitability and Other
Obligations of Broker-Dealers
Technological innovations have presented new regulatory problems,
including the application of the suitability rule to online activities.
The NASD’s suitability rule states that in recommending to a customer
the purchase, sale or exchange of any security, a member shall have
reasonable grounds for believing that the recommendation is suitable for
such customer.
Because online discount trading is essentially impersonal and
customer-based, online firms have less of certain broker-dealer
obligations, such as those of suitability and a reasonable basis for
recommendations.
Applicability Of The Suitability Rule To Electronic
Communications
There has been ongoing debate about the application of the
suitability rule to online activities.
Two major questions have arisen;
1) whether the current suitability rule should apply to online activities,
2) If so, what types of online communications constitute
recommendations for purposes of the rule.
NASD Regulation believes that the suitability rule applies to all
recommendations made by members to customers –including those made
via electronic means- to purchase, sell or exchange a security. Electronic
communications from broker/dealers to their customers clearly can
constitute recommendations. The suitability rule, therefore, remains fully
applicable to online activities in those cases where the member
recommends securities to its customer.
For the second question, NASD Regulation does not seek to identify
in this Policy Statement all of the types of electronic communications
that may constitute recommendations.
As NASD Regulation has emphasized, “whether a particular
transaction is in fact recommended depends on an analysis of all the
relevant facts and circumstances.” That is, the test for determining
whether any communication constitutes a recommendation remains a
facts and circumstances inquiry to be conducted case-by-case basis.
Bulletin Boards and Message Groups as Secondary Trading Tools on
the Web
Assuming a small issuer successfully completes an online DPO, its
securities may not become eligible for trading on NASDAQ or even in
the over-the-counter ("OTC") market maintained by broker-dealers.
Registration under the 1934 Act is only required when an issuer has at
least 500 recordholders of a class of its securities and at least $10 million
in assets.
Because of the small size of DPOs and the issuers that use them, 1934
Act registration of the issuers is therefore generally not mandated.
Newly-issued securities will not qualify for listing on NASDAQ
unless the issuer meets NASDAQ requirements, such as minimum per
share bid price, minimum proportion of shares owned by the public
minimum market value, total assets, total equity and number of
shareholders.
For a DPO issuer, the World Wide Web offers bulletin board trading as
an alternative to trading on NASDAQ or in the OTC market. On a Web
bulletin board, potential buyers and sellers can post bids and offers and
contact each other to facilitate transactions.
Real Goods Case
One of the early boards was that of "Real Goods Trading System,"
which issued the stock traded on the board, markets environmentallyoriented consumer goods such as energy-saving appliances.
The SEC stated that Real Goods could operate the site without
registering as a broker-dealer or investment adviser, on the condition that
Real Goods would play no role in effecting any transaction, receive no
compensation for creating and maintaining the system, not receive,
transfer or hold funds or securities in connection with operating the
system, put disclaimers on the site regarding any registered status, keep
records of all quotes entered, and inform users of the applicability of
securities laws to offers and sale.
Effects of Electronic Trading on Stock Exchanges
As electronic trading of all kinds has expanded, the prices of seats on
major stock exchanges have decreased.
In the first half of 1998, prices of seats on major exchanges in New
York, Chicago, Philadelphia and London dropped between 10 to 40
percent.
While other factors have played a role, the largest concern is the rise
of electronic trading.
The growing competition from the extranets such as Instinet and Island
has raised concerns over the existence of the auction markets conducted
on exchange floors.
The Internet As an Information Services Tool
The wide availability of information is certainly a major factor of the
impressive success of Internet securities trading.
Portals, such as Yahoo Finance and CBS Market Watch or MSN Money
Central offer retail investors a wide range of pricing information,
company analysis and research previously available, at a very high cost,
only to professional traders.
They also offer linkages to online brokers. Financial portals have
captured market shares from traditional financial press as well as from
specialised data suppliers such as Reuters and Bloomberg and have
become the preferred financial information source for many investors.
Internet also stimulated the emergence of new types of financial data
services.
NYSE and NASDAQ have created sophisticated Web sites, which
provide a wide variety of current and historical information.
SEC, between 1999 and 2001, moved its database of listed companies’
financial information and regulatory filings, EDGAR, to the Internet:
today, all company filings are done through the Internet. Investors can
access all 500 000 EDGAR documents on-line for free.
The growth of financial information industry has not been limited to the
Internet.
The on-line trading boom also stimulated the growth of specialised cable
television financial channels.
These channels, each of which has a supporting web site have
transformed online trading into a mass media phenomenon.
However, The on-line financial information explosion has been highly
controversial.
On the one hand, it clearly increased and democratised the availability of
data, thus lowering the information asymmetry between market
professionals and market users.
On the other hand, many specialists have argued that the increase in the
quantity of information has not lead to the improvement in its quality,
quite to the contrary.
Forceful arguments have been made recently about the negative
influence of the widespread financial information availability, made
possible through Internet technology.
After the adoption of the Fair Disclosure Regulation (FD Reg) by the
SEC in 2000, some parties claimed that the FD Reg has increased market
volatility by eliminating a necessary filtering process between the
companies and the general public.
The widespread access to market information has created illusion of easy
gains among retail investors and led them to make hazardous investment
decisions.
Particularly high-tech companies took the advantage of this “information
illusion” to enhance their ability to manipulate markets. Thus,
information explosion played a major role in the market bubble and
subsequent fall.
It is paradoxical to accuse Internet of weakening financial markets, when
its most important impact has been to increase the availability and to
facilitate access to market information.
Jurisdiction of Blue-Sky Laws Over Internet Transactions.
In order to reconcile technology the North American Securities
Administrators Association (NASAA) adopted a model rule to clarify
jurisdiction over Web-based securities offerings.
Under the NASAA policy, states will generally not attempt to assert
jurisdiction over an offering if the Web site contains a disclaimer
essentially stating that no offers or sales are being made to any resident
of that state, the site excludes such residents from access to the
purchasing screens and in fact no sales are made to residents of that state.
As of January 1998, 32 states had adopted the NASAA safe-harbor.
Summary and Conclusion.
Digital communication and electronic commerce are still in their way
of advance.
The ultimate impacts they will cause on public offerings, secondary
trading and capital formation are impossible to predict.
A few facts can be drew.
Big and small issuers can reach more potential investors faster,
reducing the advantages of intermediaries.
Smaller financial institutions have instant access to vast amounts of
complex financial data, creating a leveling influence.
Despite a more level field in terms of information access and
outreach to viewers, data on the World Wide Web may ultimately
confuse some operators to combine.
It remains to be seen whether the cost to build software systems that
will allow for larger and more sophisticated securities offerings in the
future will be so substantial that it will limit the number of players.
Because of the global and instantaneous nature of the World Wide
Web, jurisdictional barriers are more vulnerable than ever.
Finally, the individual investor will be increasingly empowered by
access to types of information previously available to only large
institutions.