Evolution of Online Financial Trading Systems: Assessing Critical End-User Requirements

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1 Evolution of Online Financial Trading Systems: Assessing Critical End-User Requirements Alexander Y. Yap, Ph.D. Martha and Spencer Love School of Business Campus Box 2075, Elon University, Elon, North Carolina, USA Tel. (1) ABSTRACT Over the past few years, different online stock brokers have developed a wide variety of web-enabled financial trading systems. End-users of the systems, the stock investors and traders, have been given a choice what online trading system they prefer using, weighing in commission cost and the online research capabilities they pay for when analyzing stocks and mutual funds. After years of assessing online trading systems, it appears that end-user requirements have substantially changed with the evolution of financial markets. Low commission cost and research capabilities are now standard packages available across different online trading systems and are not the competitive features they once were. This research initiative intends to find out evolving end-user requirements for online trading systems and what has been done by systems developers to improve financial trading systems. This research involves the testing and use of three different online trading systems to assess how these systems are addressing end-user requirements. Categories and Subject Descriptors H.4 [Information Systems Applications] H.5 [Information Interfaces and Presentation] General Terms Design, Performance Keywords Electronic Trading Systems, Electronic Markets 1. RESEARCH OBJECTIVES There are several issues that online systems developers need to reflect on to make them more functional and pragmatic to users, considering that instantaneous transaction speed and basic research functions are already standard systems features in most online trading systems (Yap and Lin, 2001). User needs have changed due to the dynamics of the investing landscape and regulatory environment. The following are important issues to consider: Permission to make digital or hard copies of all or part of this work for personal or classroom use is granted without fee provided that copies are not made or distributed for profit or commercial advantage and that copies bear this notice and the full citation on the first page. To copy otherwise, or republish, to post on servers or to redistribute to lists, requires prior specific permission and/or a fee. ACM SE 06, March, 10-12, 2006, Melbourne, Florida, USA Copyright /06/0004 $ Order Process Flow - Firstly, there is the issue of how orders are channeled to different electronic trading systems and whether traders are getting the best price for their bid/ask orders. The question is to what extent are online trading systems linked to different electronic trading markets? Are these trading systems facilitating the order flows in favor of their clients, or do brokers internalize their orders? Tabb (2004) defines internalization as an event that occurs when brokers' match orders against internally offsetting trading flow [buy/sell orders] without exposing the order to the public. Macey and Ohara (1997) criticize that order-flow payments compromise brokers duty to provide customers the best trade execution. With advancements in financial trading systems, is it possible that the process of internalization is minimized or eliminated? The ideal objective of having an electronic market is to provide traders accessibility to as many financial market segments; however, the fragmentation of electronic markets leads to problems on how orders are channeled to different electronic markets. Some systems may have limitations in this respect. Electronic Communication Systems (ECNs) are electronic systems that attempt to eliminate the role of a third party in the execution of orders. ECNs form an electronic market segment by themselves. Island (Island.com) and Archipelago (Arcabook.com) are examples of ECNs. In 2001, for example, Business Wire reported that Island ECN surpassed the American Stock Exchange (AMEX) as the largest marketplace for the NASDAQ100. Figure 1 illustrates that buyers (B) and sellers (S) may not be properly matched within a single electronic market (such as ECN1 or ECN2). Some electronic markets may have more buyers than sellers or vice versa, so they may need to balance the orders by channeling them to another market. While some online trading systems may attempt to channel orders to as many ECNs, some do not. They just execute orders within an ECN they are affiliated with (internalization). In this research, the first objective is to find out which online trading systems are more likely to internalize order executions, given the number of ECNs they are connected with and how transparent their order process is Targeting Niche Markets - Secondly, most traders have access to similar basic services, such as streaming quotes, stock research, and Wall Street analysts ratings. What system features differentiate one from the other? And in what ways do different systems cater to different types of traders? There are several financial information systems that online brokers employ to attract different clients (end-users). 440

2 Figure 1. Multiple E-Markets (ECNs) vs. a Singular Market Brokers need to take advantage of market segmentation that caters to different types of clients. The following are some examples of different groups of traders/investors: 1) Buy and Hold Investors these clients can hold stocks for years without selling, 2) Swing Traders they buy and hold stocks only for a couple of days or weeks, and then sell, 3) Daytraders buy and sell stocks on the same day. 4) Institutional Traders, such as hedge funds and mutual fund managers, are those that transact bulk trading in large volumes. The second objective of this research is to discover systems features that add real value and functionality to different end-users Security and Exchange Commissions (SEC) Regulations Thirdly, there have been several changes in SEC regulations that could penalize online brokerage firms if traders violate the SEC rules. The third research objective of this paper is to discover if online trading systems allow traders to break certain SEC trading rules or not. The research attempts to determine whether there are some loopholes to the financial trading system that can be disadvantageous to end-users or traders. For example, stock traders have two strategic paths when profiting from stocks. One path is to buy low and sell high, while another path is to sell high and buy low (short selling). Selling high and buying low is the processing of shorting a stock. Technically, the trader does not own the stock but borrows it from his/her broker. Upon borrowing the stock, a trader sells it at a high price and waits for the stock price to go down. If the stock price goes down, the trader then buys the stock at a lower price to return what he/she borrowed from his/her broker (This is known as buy to cover ). The trader then gains profit from selling a stock at a high price first and buying it at a low price later. For a trader to borrow stocks from his/her broker, the broker must have an inventory of that stock. If the broker does not have an inventory of that particular stock and still lets the individual trader execute a sell order, then the broker is violating SEC rules by practicing naked shorting or creating phantom stocks. While naked shorting is illegal, brokers are known to violate this SEC rule often. SEC has a number of trading rules that brokers must follow or force its clients to follow. SEC can penalize brokers for naked short selling. Data shows that brokers still allow traders to do naked shorting. There are websites, such as that collect data and track the naked short selling of different stocks. Another SEC rule that online systems may have a problem tracking is the daytrading rule. SEC has already limited day trading activities to control the volatility of electronic financial markets. Pattern daytraders need to have at least $25,000 in their account to meet SEC requirements for daytrading. This took effect in Cadway (2001) summarizes these new rulings: The NASD has come out with some new margin rules for daytrading accounts effective Sept. 28, Among these rules is the requirement for all pattern daytrading accounts to have a minimum equity of $25,000. If the account has not been brought up to the minimum equity of $25,000 after three days, the account will be considered frozen and limited to liquidating transactions. This means that the broker needs to restrict violators from doing any trades. 441

3 1.4 Systems Integrity - Fourthly, there may be an increasing risk of system failure, security break, and unreliability of data content. Are trading systems as reliable now as they were a few years back? Or are they getting worst? The fourth research objective is to find out the loopholes in the trading systems that are costly to investors and traders. Dogsofthedow.com posts certain feedback from users of online systems. Some of the feedback cited costly technical problems: After 2 months of technical issues I have closed my account today. I have lost several thousands of dollars in one day because the price of a particular stock that I shorted over and over within 2 hours was not a current price but the day before. I called the manager he could not care any less. He knew exactly that the price was not current I have filed a fraud complaint on April 20, 2004 with the SEC and I intend to file a Class Action Law Suit against them. I ve had an account with a broker and have seen a steady decrease in online reliability. ed complains are answered with a form letter response The problem seems to stem from poor technology implementation and overwhelming the system with new subscribers before adequately architecting for heavier load. 2. RESEARCH METHODOLOGY This research employed the action research approach. To be able to do an in-depth analysis, the researcher opened three separate online brokerage accounts (Scottrade, Ameritrade, and Interactive Brokers) so that different online trading systems can be explored, evaluated, tested and compared in a real-world trading scenario. The researcher was involved in the actual use of the financial trading system and so data was acquired on a first-hand basis. The research uses the interpretive approach, which is essentially based on the unique experience of the enduser. The researcher gathered the findings from direct experience and day-to-day interaction with the trading system, its inherent technological features, and the customer support provided by the online brokers when the system was not working properly. Three online trading systems were used between six months to one year of trading, with one to three trades executed every week from 2004 to There are more than thirty respectable online trading systems aside from the ones chosen for this study. E-trade and Fidelity, for example, are other trading systems that are worth looking at. The limitation of this study is that the researcher has limited funds to open more than three trading accounts. The choice of using Scottrade, Ameritrade, and Interactive Broker was based on initial perceptions that they provided better value in terms of commissions and advertised systems features. 3. COMPARATIVE ANALYSIS Online trading accounts were opened separately with Scottrade, Ameritrade and Interactive Brokers. After using their trading systems extensively, the observation showed that these three different systems cater to distinct user needs. The discussion in this section will focus on their unique strengths and weaknesses Order Routing - In terms of order routing, Interactive Broker has the best system because it channels orders to more ECNs than Ameritrade and Scottrade. This means that traders have a better chance of selling and buying at a better price with more ECNs networked to the Interactive Broker system. This also means that there is less chance for internalization. In fact, end-users can choose which ECN they want to channel their orders to (see figure 2). If preferred by the user, Interactive Broker also has a smart system that can redirect orders to get the best price for the trader. Once the order is redirected, the order is immediately displayed in the particular ECN the order was sent to, and the Interactive Broker s system also displays what ECN the order was sent to. The spreadsheet interface of Interactive Broker s system coupled with the various ECN choices also makes it ideal for scalping and daytrading stocks. Ameritrade also allows traders two choices for routing orders (excluding the Market Maker). Ameritrade has an auto route that is similar to InteractiveBroker s smart routing; however, once it is set to auto routing, traders are left in the dark as to where the order has been redirected. Interactive has a more transparent system than Ameritrade. By choosing Market Maker in Ameritrade s system, internalization of order may actually happen as the market maker controls certain stock inventories. At the time of this research, Scottrade has no routing choice and no order flow transparency at all. In other words, traders are left in the dark as to where Scottrade is channeling their orders Catering to Niche End-Users - In terms of catering to different types of traders, Scottrade was the most attractive for first-time traders. Scottrade s set up was ideal for investors who do not trade frequently and who occasionally need a real person to talk to. Ameritrade has the best tools for Swing traders. Ameritrade has a programmable trade trigger system that is ideal for a swing trader because it can help guard trader s from shortterm losses while maximizing short term gains. The trade triggers can be used to ride the ups and downs of major indices and therefore good for swing trading. Since most of the big cap stocks follow the Dow Jones or NASDAQ indices, the Ameritrade provides an excellent programmed trading system for large-cap stocks (see Figure 3). Interactive broker s spreadsheet interface that combines real time quotes and one click trading platform is ideal for the speed needed by day traders that are scalping to make some quick gains. However, Interactive is not attuned to some penny stocks and small cap stocks that are sold over-the-counter (OTC) or with a pink slip (PK) status. Interactive broker does not have real-time trades for many OTC and PK stocks. Neither is the system useful for trading bankrupt companies that are being restructured. Interactive Broker has taken lengths to set up its system for Institutional and Professional traders. It is only with Interactive Brokers that Advisor Accounts are available. Advisor accounts are tailor- made for professional traders who manage separate client accounts. The clients can electronically transfer money to their accounts but may not do any trading. It is the professional financial advisor that does the trading for clients. (See Table 1 for more comparison between the different trading systems) 442

4 Figure 2. Interactive Broker is connected to five ECNs while Ameritrade has only two (INET and Supermontage) Table 1. Comparing Online Trading Systems Features SCOTTRADE AMERITRADE INTER. BROKER ROUTING ORDERS Routing Choices None - INET (Island) - SuperMontage - INET - ARCA - SuperSoes - BRUT - BTRADE Automatic Routing No Yes Yes For best price Transparency of Order Flow No Not clear unless user-defined Very Clear Process Routing for None Good System to Use Best System for end-users Scalping/Daytrading ADDRESSING NICHE MARKETS (DIFFERENT END-USERS) Buy and Hold Investors GOOD GOOD GOOD Swing Traders AVERAGE BEST GOOD Daytraders AVERAGE GOOD BEST Large & Middle Cap Investors GOOD BEST GOOD Small Cap & Penny Traders GOOD GOOD AVERAGE Institutional Traders AVERAGE AVERAGE BEST FOLLOWING SEC REGULATIONS Good Warnings on SEC Violation System Stops Traders from Violating Daytrader Rule System Tracks Daytrading Activity Before SEC Violation Occurs System Stops Traders from Naked Shorting SYSTEMS INTEGRITY System Down (Cannot Trade) Systems Down (Data Not Unavailable) Internet Intrusion Below Average Average Very Good No No Yes No Yes Yes No No Yes (when stock appears on SHO list) Hours None experienced None experienced Yes, all systems Yes, Java-based tools Yes, data feed SSL-Enabled (SAFE) SSL-Enabled (SAFE) Non-browser Based (SAFER) 443

5 Figure 3. Trade Triggers for Programmed Trading 3.3. System Preventing SEC Violations - It appears that Interactive Broker has a system that has broken grounds in areas that other brokers systems have not. An example of its system s capability is the feature that helps prevent traders from violating SEC regulation. Interactive broker s system automatically does not allow trader s to day trade more than three times in five consecutive days if they do not have $ The system just stops a user from buying long, selling short, or taking any new position once the daytrading requirement hits its limits. More importantly, Interactive Broker s system tracks how many daytrades have been executed over a five consecutive trading day period. Scottrade s system does not have any features like this, and therefore can cause traders to violating SEC rules. heavily shorted naked for more than half a year. Yet, Ameritrade allowed an order to sell short DSTI without prohibition. Interactive Broker s system would not allow the order to be transmitted if it is listed as a naked short. Figure 5. Interactive Broker s system prevents naked shorting Figure 4. System Tracks Daytrading Activities Of all three brokerage firms, the Interactive Broker s system is the one that mostly adheres to SEC rules on illegal naked shorting. As long as a stock is listed on the SHO List (a SEC list that confirms a stock is being naked shorted), then Interactive Broker will not allow that stock to be shorted. Ameritrade and Scottrade do not seem to follow those rules strictly. For example, Daystar Technologies (DSTI) is a stock that has been 3.4. Systems Integrity - The least reliable system during the period of data gathering was Scottrade. When the Scottrade system was down, the system could not be used for trading. When Ameritrade and Interactive Broker had some problems with their real-time data feed, their respective systems still had basic trading functions that allowed the buying and selling of stocks. During the times when Ameritrade and Interactive Broker had no real-time data feed, the alternative solution was to go directly to INET or ARCA s websites to get real-time buy/sell order data. The web-based applications of Scottrade and Ameritrade used the socket layer (SSL), which is what most online banks use. So 444

6 it is generally safe. Interactive Broker s software is not dependent on a web browser. That renders it least susceptible to browser attacks. The researcher also noticed that Trade Workstation, Interactive Broker s software, used a different port to connect to the Internet, or to a different channel from that used by Internet browsers. It is, therefore, less likely to be attacked or hacked. 4. CONCLUSION Overall, Interactive Broker seems to have the most advanced trading system considering that it provides a choice for order process flows, and also shows transparency to where buy and sell orders are being directed across financial electronic markets. Their system seemed to have the best deterrent against internalization. Interactive Broker s system also made sure that end-users will not violate SEC regulations. Ameritrade s system was relatively more advanced in some areas with tools such as Trade Triggers which helps daytraders and swing traders program their trades. Scottrade s system is appropriate for new investors and traders. However, for advance and more active traders, there are better online systems and tools out in the market than what Scottrade can offer. [More detailed features of online trading systems will be presented at the conference.] 5. REFERENCES [1] Business Wire, Island ECN Surpasses American Stock Exchange to Become Largest Marketplace in QQQs, Oct. 22, 2001 [2] Cadway, R. P., New Daytrading Rules, html [3] Macey, J., and M. O'Hara, 1997, The Law and Economics of Best Execution," Journal of Financial Intermediation 6, [4] Tabb, L. Perspective: Time for Brokers, Investors, and Regulators to Align, Wall Street and Technology, published by InformationWeek Media Network, 2004 [5] Yap, A. and Lin, X., Entering the Arena of Wall Street Wizards, Euro-brokers, and Cyber-trading Samurais: A Strategic Imperative for Online Stock Trading, Electronics Market Journal, Vol. 11 No. 3, Switzerland, [6] [7] 445