Communications of the ACM
Communications of the ACM
The Implications of Online Investing
The number of do-it-yourself online investors has grown at a remarkable rate since the first electronic brokerage opened its virtual doors in 1994. These e-brokerages have attracted 12 million investors in less than five years, now accounting for over 33% of retail stock trades. While the number of online trading accounts represents just 12.5% of all accounts, that proportion is expected to increase to 29.2% by 2002, as reported in Fortune magazine (October 11, 1999). The number of e-brokerages has also grownfrom only 12 in 1994 to more than 120 in 1999, according to Gomez Advisors (www.gomez.com). With increased competition, the commissions investors pay per trade have fallen dramatically during this period, dropping on average over 50% in 1997 and leveling off in 1998, according to Forrester Research, Inc. These developments are commonly attributed to the efficiency of "friction-free" electronic markets that lower transaction and information processing costs by reducing human intermediation [1, 6, 7].
Some financial management periodicals and reporting services have evaluated e-brokerages on a number of dimensions, including ease of use, quality of research, reliability, commission rates, customer service, and reporting. But they have given insufficient attention to some less-obvious factors, including the timeliness of transaction execution and the ability of investors to obtain the "best" prices. These factors play a key role in determining investors' total transaction costs (see the sidebar).
A closer analysis of the online trading process reveals that, in many cases, the only thing that has changed as far as the investor is concerned is the interface, which now involves Web-based interaction. Despite proposed changes in the securities trading process and the introduction of electronic trading systems (such as OptiMark, www.optimark.com), other processes determining market efficiency, including order flow, price discovery, and order execution, remain largely unchanged. In this context, we have to separate the efficiency perceived by investors from the real efficiency of the transactions and the patterns of information flows beyond the interface.
To understand perceived efficiency, we propose a framework that describes the choice process investors use in choosing an e-broker [9]. We've examined the structure of the trading processoften invisible to the investorto understand real efficiency. We've combined the choice framework (see Figure 1) and the structure of the online trading process to explore the difference between the two views of efficiency and to derive policy implications. Perceived efficiency is determined largely by verifiable information provided by e-brokerages, including commission rates and research, and is moderated by the investors' risk attitudes and the degree of trust investors assign to e-brokerages. In contrast, real efficiency is influenced by market structure and the related transactional arrangements, neither of which are transparent to the investor. For example, we've identified how the coordination of activities among intermediaries (such as e-brokerages, exchanges, and market-makers who buy or sell stocks from their own inventories) [57, 11] can lead to different overall cost structures for the investor. E-brokerages might use the information asymmetry implicit in the various coordination mechanisms to support opportunistic behavior. Our discussion of costs relies on the existing classifications and discussions of intermediaries and value-chains in electronic markets [6, 10, 11].
Our analysis finds that for efficiency to move beyond the user interface into the actual trading process, investors need a transparent window to observe the actual flow of orders, the time of execution, and the commission structure at various points in the trading process. When the entire trading process is transparent, consumer choice related to brokerage selection and use patterns is more discriminating. In the long run, informed investor choice itself fosters real efficiency. Some researchers have argued that institutional rules, regulations, and monitoring functions would play a significant role in promoting efficiency and transparency along the value chain in electronic markets, as in the AUCNET auction network in Japan, a popular Web site for car auctions [2, 5, 6]. Our analysis also finds the compelling need for such oversight in the context of online investing. The U.S. Securities and Exchange Commission (SEC) can play an important role in creating the required transparency by implementing new rules related to providing information to investors.
How Investors Choose E-brokerages
The process in Figure 1 investors follow in choosing an e-brokerage reflects consumer search patterns described in the economics and consumer-behavior literature [9]. This process is influenced by four sets of characteristics under the headings: investor, external, e-brokerage, and transaction. The attributes of each characteristic are included in the figure. In the initial stage, investors assign weights to the e-brokerage's attributes (such as timeliness, product range, ease of use, and value-added services). They then engage in a search for information about the e-brokerages, leading to the selection of one or more of them. The following paragraphs describe the various selection stages in sequence:
Study verifiable signals and information from the e-brokerages. These signals reflect the terms e-brokerages are contractually obligated to extend, including bundled research, order transaction fees, and online advice. The required information may be derived from e-brokerage Web sites, word of mouth, and independent consumer reports.
Compute the value of these verifiable attributes. Investors value verifiable attributes. Since individual investors may apply different weights to each attribute, this value can vary by investor. For instance, investors who value research may assign greater weight to that attribute while giving relatively less weight to, say, commission costs. Similarly, some investors may value ease of use more than commission costs.
Form expectations of values for unverifiable attributes. Verifiable attributes can serve as signals for certain unverifiable attributes. The trust investors extend to a particular e-brokerage influences the formation of these expectations. For example, a low up-front trading cost can signal operational efficiencies to investors who trust that e-brokerage. But for investors who lack trust, the same low costs may signal low operational effectiveness; low costs may support the view that the e-brokerage is not pursuing the best "deal." We define trust as the factor that moderates the use of verifiable attributes to form beliefs about unverifiable attributes.
Adjust expectations about unverifiable attributes to accommodate investors' risk attitudes. Since the values of the unverifiable attributes are estimated, rather than known, these values are associated with uncertainty. Investor attitudes about risk help adjust expectations to accommodate uncertainty. For example, risk-averse investors may effectively lower their expectations of online help provided by a particular e-brokerage if they are uncertain as to whether that e-brokerage can provide timely advice of good quality.
Determine the overall value for each e-brokerage, choosing the one delivering maximum value. The investor determines overall value by adding together the value derived from verifiable attributes and the value derived from unverifiable attributes.
Modify the knowledge structure with information obtained during use. Some unverifiable attributes become clear for investors only when they're actually using the e-brokerage's services and products. For example, timeliness of transaction execution and reporting are experiential attributes "discovered" by an investor only through use.
Search for a different e-brokerage if the overall value is unsatisfactory and switching costs are low. If investors' experience with their current e-brokerage is unsatisfactory and if switching costs are low, they will, through a process of trial and error, align themselves with other e-brokerages (or traditional full-service or discount brokers) matching their needs.
A number of insights follow from this selection framework. For example, the assumption of different weights for various attributes allows for segmentation in the e-brokerage market. No single e-brokerage is likely to satisfy all investors. Investors may use a similar selection process even when investigating the appropriate channel, including whether it should be full-service, discount, or e-broker. Investors who learn experientially can distinguish between attributes that are verifiable before use (such as the up-front payment structure); unverifiable before use but revealed after use (such as timeliness); and usually unverifiable (such as the precise execution route for a particular trade). The framework also explains why some investors choose e-brokerages with higher commissions (observable costs) over e-brokerages with lower commissions. For example, some investors may believe that e-brokerages with higher direct costs minimize unobservable costs and increase benefits by way of such value-added services as year-end reporting and research. Investors oblivious to unobservable costs may think direct costs are more important and decide to use e-brokerages charging low commissions.
Structure of the Trading Process
Investors using e-brokerages initiate their transactions through Web browsers. The front-end tasks of the process are performed electronically. However, once an order is received, each e-brokerage may process the request differently [8]. Some e-brokerages employ automated approval processes and order-routing decision systems with built-in rules. The approval process includes verification of the authorization to trade in certain products (such as stocks and options), as well as margin requirements. These e-brokerages are electronically connected to enormous electronic trading systems, including Nasdaq, or to their agents at various exchanges, including the New York Stock Exchange, the American Stock Exchange, and their regional counterparts. That is, transactions are routed to these main market centers based on where the stocks are listed. In contrast, order processing in other e-brokerages offers little improvement over the traditional human-mediated process, except that the order is transmitted electronically over the Internet. Many of the processes are largely manualafter the orders are received electronically. Moreover, because of such incentives as payment for order flow and low transaction-execution costs, some e-brokerages may not trade in the market centers at all, working instead through contracted market-makers (such as dealers, third-party vendors, and the over-the-counter markets) away from the main market centers.
The Four Types of E-brokerages
In 1997, we conducted an exploratory survey of the trading structures of 40 e-brokerages, looking at their Web sites, sending email surveys, and conducting phone interviews [8]. More than 50% of the surveyed firms routed their orders directly to exchanges, and almost 50% channeled their orders to market-makers.1 A few e-brokerages routed their orders either to exchanges or to external market-makers, depending on the liquidity situation at the exchange or marker maker and how quickly the trade can be executed. Some e-brokerages also seemed to function as dealers, executing transactions against their own accounts. The following four-fold classification, which reveals some of these differences, is consistent with the generic taxonomy of market intermediaries in terms of brokers, dealers, and broker-dealer hybrids [5, 6]:
- Type 1. E-brokerages trading exclusively on exchanges or other main market centers;
- Type 2. Those trading with one or more third-party vendors under contract but not on exchanges; they may trade on exchanges using a differential pricing schedule;
- Type 3. Those trading with market-makers or on exchanges, depending on the liquidity context; and
- Type 4. Those trading either on exchanges or with (external) market-makers or functioning as principals or broker-dealers when executing orders.
To explore the implications of these e-brokerage trading strategies on real efficiency, we supplement our description of market structure with an analysis of revenue flows and corresponding costs incurred by market participants and agents.
Figure 2 shows the revenues and incurred costs in the trading context. When investors place orders with e-brokers, they incur direct costs by way of commissions. These costs constitute a revenue source for e-brokerages and representfrom the investor's viewpointthe most visible, or observable, cost of a trade. All other revenue flows and incurred costs usually cannot be observed by the investor. For example, e-brokerages can trade directly on exchanges, incurring costs by way of commissions to the representatives on the exchanges. They may also complete transactions directly with market-makers and receive a fraction of the bid-ask spread, or a fixed commission per transaction, as a "kickback," or payment for order flow, from the market-makers for steering orders toward them. However, this arrangement may conflict with investors' own personal interests.
Note that revenue to an e-brokerage can flow from both the individual investor and the market-maker. When investors lack knowledge of the trading process, e-brokerages can extract larger commissions from market-makers to compensate for low direct commission-based revenue from each trade. Market-makers themselves can recover the cost of these commissions by operating on a larger bid-ask spread [3], passing along unobservable transaction costs to investors, as in Figure 2. If investors are aware of this spread, the market would correct itself to a more efficient structure. The problem is that the spread quoted by market-makers is often unobservable.
The order flow from e-brokerages to specific market-makers is often based on their existing contracts. Some e-brokerages even engage a single market-maker for executing all their trades. In such cases, there is limited competition to obtain the best price for each order, and it is highly likely that the bid-ask spread would increase. For instance, the lack of competition from market-makers in Nasdaq often results in a larger bid-ask spread [3]. Some of this larger spread is justified on the grounds that market-makers need to cover the risks associated with holding an inventory of stocks. However, in the absence of competition for executing transactions, there is little incentive for market-makers or e-brokerages to assure investors of the best prices.
New e-investors may be overly influenced by the low observable costs and oblivious to potentially large unobservable costs.
Some e-brokerages claim that the prices they obtain from market-makers are equal to or better than those set by the exchanges. This claim is difficult for individual investors to verify. In fact, these market-makers rely on prices set by the exchanges but execute trades differently. In exchanges, the specialist functions as a market-maker only when there are no immediate matching orders. That is, when there is no liquidity, specialists step in to buy or sell from their own inventories. However, market-makers quote a bid-ask spread that allows them to buy low and sell high. This arrangement exists even when customer orders might cross, that is, the price at which one investor wishes to buy is greater than or equal to the price at which another investor wishes to sell. Efforts are under way to provide investor-to-investor trading as well.
With an increasing number of e-brokerages charging minimal or even zero commissions, e-brokerages are more likely to seek revenue, including payments for order flow, from other sources. In such cases, investors should be sensitive to the unobservable costs they may incur as the result of the potential for opportunistic behavior by e-brokerages as well as by market-makers.
Implications for Online Investing
Online trading also engenders some changes in the traditional investing scenario. First, the wide variation in investor knowledge of the stock market and of trading is crucial in the online setting. The costs to investors of bad judgment are likely to be borne by new entrants to the world of individual investing; these investors are pleased with the simplicity of the interactive user-friendly formats of e-brokerages but are seldom proficient in the mechanisms and arrangements beyond the interface. Moreover, they may be overly influenced by the low observable costs and oblivious to potentially large unobservable costs, thereby relying on perceived, rather than real, efficiency. Experienced investors can better identify the benefits and costs of choosing specific e-brokerages.
Second, the frequency of online investor trading deserves special attention. Many market analysts suggest that the rapidly expanding U.S. economy and the low commissions charged by e-brokerages influence investors to trade more often. For example, in 1998, an average Merrill Lynch (a full-service broker) customer made four to five trades per year as against an average of 5.4 trades per quarter for the core investors using E*Trade Group, Inc. and other e-brokerages. Frequent trading is generally contrary to the recommendations of standard financial theory. The role of the low per-trade cost in motivating frequent trading cannot be ruled out. Ultimately, an e-brokerage can allow investors to trade frequently at very low or zero cost per trade, earning large profits on the fraction of the increasingly large bid-ask spread that is pushed back by the market-maker, as described in Figure 2. At the same time, investors may be unaware of the indirect costs they incur with each trade.
Third, the evolution of electronic trading may increase market fragmentation in the short run. E-brokerages may increasingly channel trades away from exchanges and toward market-makers to compensate for lost revenue resulting from low direct commissions. Similarly, institutional investors may also trade in off-exchange settings using electronic trading systems (such as Instinet and POSIT) to minimize transaction costs. These developments may fragment the financial market in the short run, thereby reducing market efficiency and increasing the bid-ask spread. Note that this scenario runs contrary to the common belief that electronic markets ultimately lead to centralization and increase liquidity.
In the long run, Informed investor choice itself fosters real efficiency.
Fourth, traditional channels are finding ways to reduce their own operational costs by using the Internet to provide routine services (such as information dissemination, order placement, and account verification), while continuing to provide high-level research and advice through face-to-face or telephone communication. Several brokers will likely maintain multiple channels, producing a complex scenario of competition among brokers within and across channels. In addition, a menu of pricing schedules is likely to evolve; for example, the competition among online brokers "commoditizes" trading transactions, forcing traditional brokers to abandon commissions and charge asset-based annual fees. This strategy can reduce e-brokerages' up-front price competition. Likewise, the National Association of Securities Dealers (NASD), which owns and operates the Nasdaq exchange, is weighing proposals that would move Nasdaq dealers (market-makers) to charging fixed commissions, instead of using spreads to cover their risks. Fixed commissions can affect the e-brokerages that depend on payment for order flow as a source of revenue. It is likely that the loss of revenue from order payment would force e-brokerages to increase their commissions (observable costs). Today, because the execution price is controlled, all e-brokerages charge higher commissions for limit orders.2
Oversight of Online Trading
Electronic trading will likely evolve into a competitive and self-disciplined operation in which investors punish inefficiency and dishonesty (invisible as well as visible). But in the shorter term, the movement toward such a market may require regulatory oversight. An ideal oversight process would simply nudge the market toward full information exchange and free competitionrather than foster unnatural controls over the way the market functions. A number of themes are relevant in this context:
Transaction transparency. We define transparency as the degree of openness about how, where, and when individual investors' transactions are executed. Openness reduces uncertainty about the difference in price at the time orders are placed (the price in the market) and at the time the order is executed (the actual price). These prices may differ depending on when and where an e-brokerage executes a transaction. Transparency will bring about the convergence of perceived and real efficiencies. Although some current institutional regulations protect investors, monitoring each and every transaction is difficult for regulatory bodies, including the SEC. Transparency would ensure that investors are able to monitor transactions themselves and decide when to switch e-brokerages in a more informed manner.
Practice of payment for orders. The dual sources of e-brokerage revenuefrom the investor and from the market-makerrepresent a clash of interests. This arrangement can allow an e-brokerage to project a very low direct transaction fee and supplement these fees with payments for order flows from the market-maker. A clearer alignment between an e-brokerage and investors' interests seems appropriate in light of this dual-fee arrangement.
Pitfalls of frequent trading. Decisions regarding when and how often to tradeeven in electronic tradingwill always belong to the investor. But statutory regulations can impose certain minimum information standards on e-brokerages regarding the pitfalls of frequent trading as well as the structure of the payments they receive for channeling orders. Some investors have sued e-brokerages for allegedly enticing them to trade frequently, thus causing their financial ruin. Such regulated standards for providing information are already in place in some industries, including pharmaceuticals and tobacco.
High levels of system availability. Failure in traditional products is accommodated through repair or replacement warranties. However, when investors are unable to trade due to failures in an e-broker's systems, the ensuring costs are difficult to quantify, often costly when aggregated across investors, and practically impossible to cover in explicit contractual terms, like those in typical product warranties. In spite of these difficulties, and paraphrasing eBay's president and CEO Meg Whitman, online intermediaries need to provide "utility-like stability" to their customers. While an absolute guarantee of service availability is difficult to implement, SEC regulations could, at least, require the reporting of past system outages, service redundancy built into the system, and contingency planning in the event of system failure. More proactively, the SEC could require online brokers to conform to certain statistical standards of system availability over time.
Conclusion
Our analysis of online investing has identified verifiable (observable) and unverifiable (unobservable) costs implicit in online trading. The investors' ability to distinguish among these costs is crucial for determining real market efficiency. When this ability to distinguish is inadequate, e-brokerages have the incentive to charge low up-front costs. Investors, in turn, would view these low payments as representing their low overall trading cost.
Sophisticated online investors are likely to be more discriminating in their choice of e-brokerages. They understand that real efficiencies are determined by factors other than interface features. For example, they have a keen perception of the appropriate degree of trust they should accord to a particular e-brokerage. Trust reflects the investor's belief that the actions and efficiencies of the e-brokerage are consistent with the observed, verifiable signals. When the gap between perceived and real efficiencies is greatso perceived efficiency is much greater than real efficiencyinvestors can systematically make costly order placement decisions. This scenario is different from the one in which the investors are aware of the inefficiencies, but the e-brokerage remains their choice, winning their business through low transaction fees. This situation represents informed and rational self-selection and is not objectionable.
Debate abounds as to whether e-brokerages have increased market efficiency and enhanced the social welfare. E-brokerages provide convenience, encourage increased investor participation, and lead to lower up-front costs. In the long run, they will likely reflect the market's increased efficiency as well. But in the short run, a number of questions remain unansweredabout transparency, investors' misplaced trust, poorly aligned investing incentives and irrational investing behavior. The result may be that e-brokerages and market-makers impede true market efficiency in the short run.
References
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Footnotes
1This information reflects the market at the time of the survey in 1997.
2Investors may lose out if the true market price is higher than the suggested execution.
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