Electronic Brokerages for Online Investing

Transcription

1 Electronic Brokerages for Online Investing PRABHUDEV KONANA, NIRUP M. MENON AND DAVE ABRAMOWITZ Although the fundamental principles of financial trading have not changed, the Internet is dramatically changing how investors gather information, and how transactions are submitted, executed and cleared in financial markets. While direct exchange of trades between two individual investors appears theoretically feasible, various pre-trade, price discovery, and post-trade functions still require many levels of intermediaries electronic and human in the marketplace. Contrary to the reduced role of intermediaries and the potential for centralization in other electronic markets (Bakos 1998), the financial market is experiencing an increasing presence of electronic as well as traditional intermediaries. Electronic intermediaries seem to provide significant benefits to investors such as low commission costs, increased convenience, and immediate access to market information (Tyson 1998). The number of Internet-based electronic brokerages (e-brokerages) facilitating online trading is growing at an unprecedented rate, attracting over 4.5 million customers in less than four years (Gomez 1998). Currently there are over 80 e-brokerages executing approximately 25% of the retail stock trades. E-brokerages claim timely order execution and guarantee execution prices at a very low commission cost to investors. Popular wisdom holds that low commissions are charged by e- brokerages to influence investors adoption of e-brokerages, owing largely to the lower reservation price of consumers when using the electronic medium (Lee 1998). However, it is still not clear if the perceived total cost to investors commissions plus the unobservable costs caused by the agency problem inherent in this information asymmetry situation (Aitken, Garvey and Swan 1995) is actually lower than the traditional method since the transaction execution is not completely transparent. In the trading context, information asymmetry exists between the investor (principal) and the e-brokerage (agent). Furthermore, the quality of transaction execution (e.g. timeliness) a result of the e- brokerage infrastructure and of the location of transaction completion may influence the perceived total cost for investors. The proliferation of e- brokerages also gives rise to important questions regarding market fragmentation that, in turn, can impact transaction In this paper, we explore how electronic brokerages coordinate with other market participants (i.e. market structure) such as exchanges and market makers, and how that impacts total transaction THE BROKERAGE SERVICE The traditional process of financial trading, described in Figure 1, is self- SPECIAL SECTION: AIS MINI-TRACK ON ELECTRONIC COMMERCE A b s t r a c t Electronic brokerages provide do-it-yourself investors with ready access to information and financial markets, changing how orders are submitted and reported. Although commissions have reduced dramatically, there is little evidence that the total cost to consumers has also lowered dramatically. This paper explores some aspects of the use of electronic brokerages (e-brokerages) that may not be obvious at a first glance. The role of costs during online trading, such as the expectation of costs prior to trading and the observable and unobservable costs after trading, is discussed from the investors perspective. Despite changes to the order submission process, many of the processes critical for market efficiency remain unaltered. The lack of transparency in how electronic brokerages execute transactions may hide unobservable There are numerous ways by which electronic brokerages coordinate with market-makers with different cost implications for market participants. Some of the arrangements may not be in the best interest of the investors. Issues such as lack of advice and valueadded services (e.g. year-end reporting services), market fragmentation and institutional regulations also impact investors A u t h o r s Prabhudev Konana (pkonana@mail. utexas.edu) is Assistant Professor of Management Information Systems at the University of Texas at Austin. He received his PhD in MIS from the University of Arizona. His research focuses on design and use of electronic brokerages, component-based architecture, and transaction management in active and real-time databases. Nirup Menon (menon@ba.ttu. edu) is Assistant Professor of Management Information Systems at Texas Tech University. He received his PhD in MIS from the University of Arizona. His research focuses on IT impacts and economics of information systems. Dave Abramowitz (davea@mail.utexas. edu) is an MBA student at the University of Texas at Austin. Prior to joining the MBA program he worked in Chicago Board Option Exchange. Keywords: online trading, transaction costs, electronic brokerages Copyright 1999 Electronic Markets Volume 9 (1/2):

2 Human Process Traditional Brokerage Houses Manager Checks Orders Trade Report Individual Investor Approval Exchange Phone Clerk Floor Broker Trader Pit Exchange Report Electronic Process E-Broker Human Process Automatic Order Execution System Trade Report Clearing house Figure 1. Trading Process Downloaded By: [German National Licence 2007] At: 14:06 11 March 2010 Electronic Markets Vol. 9 No 1/2 33 explanatory. When a trade is executed, the filled order is printed by the exchange and the brokerage house alerts the customer. This execution process can take as long as 5 minutes. There are chances of errors by the phone-clerk and time is wasted as the order is walked to the trading pit. There are many ways to improve this process, and online trading attempts to do so by improving these processes, thereby lowering the transaction Approximately half of the services offered are really no improvement over the traditional process. We found that nearly all firms process the incoming order similar to the traditional process. The difference is that instead of the order being transmitted over the phone, it is transmitted via the Internet. Once the order is received by the e-broker, a manager checks the order and routes it depending on the class, price, size, etc. More than half the firms route these orders to an exchange, such as the NYSE, AMEX or NASDAQ, where the trade takes place much as a traditional order is traded (see Figure 1). Several firms (nearly 45% of those polled) do not send their orders to an exchange. After the manager checks the order that was received online, the order is routed to a third-party and contracted by the e-broker, where it is traded. E-brokers claim that the order is traded at current exchange prices. They claim that the whole process takes no more than 3 minutes, often less than 1.5 minutes. As a pilot study, we contacted 40 brokerage firms and conducted interviews and obtained data from their websites regarding prices of their services. Specifically, we determined the brokerage fees, average time to execution (timeliness), the number of e- brokerages trading on exchanges, and the number trading with third-parties. Some e-brokerages trade with thirdparties or at exchanges depending on the liquidity conditions. Brokerage fee figures are based on the cost to execute a market order for a minimum of 1000 shares. Timeliness is the firm s own printed or quoted times (or delays) for the trade to be completed. Brokerage fees indicate the pricing structure of transactions and the Table 1. Brokerage Fees and Execution Time Brokerage Fees ($) No. of Firms Average Claimed Execution Time (mins) transaction Timeliness measures the quality of the transaction. The distribution of trading between the firm and the Exchange and between the firm and third-parties is an indicator of the importance of coordination costs of transactions and quality. If a firm chooses a higher percentage of trading with the Exchange (and a lower percentage of trading with third-party transactions), transactions in that firm have a higher coordination cost. Table 1 presents a preliminary descriptive statistics of commissions, time to execution and percentage of firms trading on exchanges and with third-parties. Higher commission fees correlate with timeliness. E-brokers are electronically connected to their broker representatives at the exchanges (e.g. NYSE) and are able to No. Trading on Exchange a Less than Greater than a some e-brokers send orders to either exchanges or third-parties No. Trading with Third-Parties a

3 get the best prices for their consumers at the earliest since the prices are set at the exchanges. This is contrary to trading with third-parties that may have much higher bid-ask spreads to cover the risks of holding inventory. E-brokerages who trade with thirdparties offset their reduced direct revenues from customers by receiving part of the spread from the thirdparties (Fortune 1998). Also note that as timeliness increases, the percentage of trading on Exchange increases. However, this pattern does not continue indefinitely. For we find that a large percentage of firms with the best timeliness (1.14 minutes) were those that traded with third-parties, compared to e-brokerages with a timeliness of 1.64 and 2.56 minutes. We expected that all firms charging high commission would trade directly with exchanges, but we found that a high percentage of these firms do use third-parties. That is, the high commission charged by these firms is not necessarily for the timeliness, but also for factors such as research and service quality, which investors value and are willing to pay for. These firms also seem to provide better cues and signals to indicate their high quality to investors. We plan to explore these issues in future research by proposing a more rigorous model for transaction costs and their constituents (Konana, Menon and Balasubramanian 1998). Contrary to expectations that the role of intermediaries will decline with electronic markets, another stronger intermediary (i.e. third-parties or market-makers) is growing and so the electronic brokering process has to be studied in greater detail. TRANSACTION COSTS Transaction costs are used to explain the existence of hierarchically organized firms in place of markets (Williamson 1986; Malone, Yates and Benjamin 1987). We posit that, to aid the choice between particular brokerages, or between using electronic versus traditional brokerages, investors use belief-processing cognitive mechanisms that primarily use ex-ante transaction costs (Chiles and McMackin 1996). These ex-ante transaction costs consist of two major components: (1) observable (direct) costs and (2) unobservable (indirect) 1. Observable costs are the commissions that e-brokerages charge while unobservable costs are those resulting from transaction execution inefficiency (e.g. lack of timeliness) and information asymmetry. Observable costs or commissions for e-brokerages have declined rapidly due to intense competition to attract investors. However, it is not clear if unobservable costs have declined in perception or reality. 2. Unobservable costs are determined by where e-brokerages choose to complete transactions. It is true that investors will vary over a range of values on their expectation of these unobservable Nevertheless, unobservable costs while using the electronic medium will be higher than traditional channels because it seems that the electronic medium has made investors more sensitive to agency problems and possibility of fraud. Based on our study and that reported in recent popular press, thirdparties, including some exchanges (e.g. Philadelphia Stock Exchange), provide e-brokerages with certain commissions for the order flow. This may be a fixed commission (e.g. $10 per transaction) or a percentage of bid-ask spread. On the contrary, e- brokerages that trade at exchanges, such as NYSE, incur costs for sending their orders. Based on the claims of e- brokerages, executing with marketmakers or at exchanges should not matter since they guarantee investors the best deal by shopping around. If this is true then e-brokerages (or even traditional brokerages) have no incentive to channel the orders to exchanges where the prices are set. Furthermore, some e-brokerages claim that their prices are lower than the prices at exchanges. This seems counter-intuitive because price differences between market-makers and exchanges present arbitrage opportunities! This means that there is no incentive for e-brokerages to trade on behalf of investors, but rather to trade on their own accounts to exploit the price differences. Indeed, the revenues of market-makers depend on the difference between trading with uninformed and informed traders (Aitken et al. 1995). Securities Exchange Commission (SEC) regulations require e- brokerages to find the best deal for investors. However, it is not at all clear how SEC would monitor any price differences between the executed price and the best offer. It is also particularly troubling why marketmakers would pay e-brokerages commissions when their prices are the same or better than those in NYSE. From our analyses, there are no strong reasons for market-makers to provide such incentives. This raises the possibility of opportunistic behavior by agents. The degree of opportunistic behavior may increase when e-brokerages contract with only one or a few market-makers. If marketmakers do increase bid-ask spreads (to cover their risks of holding inventory) then even an eighth of a dollar differential between the true price and the market-makers quote may impose an unobservable cost of $125 for 1000 shares! This unobservable cost is significantly more than commissions charged by traditional full-service brokers. Another issue that has been recently discussed is the effect of e- brokerages on investors trading habit. Many reports seem to suggest that e-brokerages have resulted in increasing the frequency of trading by investors. This attitude change may be a result of low commissions (some e-brokerages even waive commissions for their preferred customers) and a perception of costless transactions. Another issue that seems to influence trading habits is the use of on-line chat rooms or bulletin boards that hype-up stocks and influence stock price movements. While it is difficult Konana, Menon and Abramowitz Electronic Brokerages for Online Investing 34

4 Electronic Markets Vol. 9 No 1/2 35 to monitor the role of e-brokerages in hyping-up certain stocks, e-brokerages provide opportunities for impacting investors decision-making for good or for bad. When investors trade based on such biased information, unobservable costs may further increase. Therefore, unobservable costs can add up quickly. Thus, one cannot conclude whether e-brokerages provide lower costs than traditional channels when unobservable costs are considered. Potential for Market Fragmentation Electronic trading has opened up many opportunities for many (proprietary) trading systems. One can argue that large e-brokerages may themselves operate as a trading system in the future. The potential market fragmentation, in the short run, is contrary to the belief in an eventual consolidation or centralization of trading activities in the electronic marketplace. Market fragmentation may cause liquidity to be adversely affected, leading to higher bid-ask spreads. Under such circumstances, unobservable costs may increase further. Also, if e-brokerages operate as a trading system, then there is a potential for e-brokerages to trade with their own accounts (certain SEC regulations forbid such trading). This may further increase agency cost if proper monitoring facilities are not in place. Therefore, there is a need for SEC regulations that protect investors from agents opportunistic behavior. TRUST IN E-BROKERAGE USAGE E-brokerages will have to pursue different strategies and business processes from those of traditional brokerages to influence further adoption. Risk-averse investors may postpone adoption for various reasons, such as trust in online trading. For example, trust is influenced by the signals that e-brokerages provide for investors to observe (Konana et al. 1998). We identify four broad characteristics that influence trust and usage: transaction; investor; e-brokerage; and the business environment characteristics. Each broad characteristic has many different issues that collectively determine its impact. For example, the transaction characteristic includes transparency, complexity, dollar amount, semantics, security, privacy and exception resolution. A complete analysis of all the characteristics is outside the scope of this paper; however, we discuss some critical issues that influence trust and usage. In particular, we discuss the issues of transaction transparency, online advice, value-added reporting services and the regulatory implications that will increase the adoption of riskaverse investors. Transaction Transparency E-brokerages must make it explicit how user transactions are executed. The information concerning when, where and with whom a transaction is executed influences investors unobservable If an e-brokerage receives any payback for bringing an order flow to a market-maker, such information should be disclosed to investors. Such institutional transparency will also have a positive impact on e-brokerage trustworthiness. Advice and Value-added Services This issue is related to e-brokerage characteristics. The role of e- brokerages does not stop at taking orders from investors and executing orders on behalf of investors. Investment advice and value-added reporting services are equally important. A majority of the early adopters are aggressive do-it-yourself investors who need little advice for decisionmaking. However, a large number of late adopters rely on brokerage advice on investment strategies. If e-brokerage use must grow, online advice is a critical component. Customer service and the ability to talk to a human broker, as in traditional brokerages, positively impact investors trust. As already experienced by many online investors, year-end reporting services for tax purposes are virtually nonexistent. Investors are charged significantly for such services while traditional brokerages provide them as part of the contract. Regulations Stronger regulations are needed to ensure the honesty of e-brokerages and to protect the interests of investors (consumers). These regulations must require e-brokerages to be transparent in their order routing, execution prices and any special interests with trading partners. The SEC regulations must put in place monitoring facilities to insure that investors receive the best price prices set in exchanges in the market. This involves providing audit trail information on transaction details that could be verified. The SEC also has a role in ensuring fault-tolerant, highly available e-brokerages. This issue is becoming critical since many e-brokerages could not handle the load during the market crash of October The regulations should stipulate procedures for e-brokerages to provide adequate system capacity and availability. With the distinction blurring between markets and intermediaries, regulations must stipulate the role of e-brokerages in making markets. CONCLUSION The investigation and analysis of intermediaries or e-brokerages in financial markets can be fruitful in predicting the dynamics of future financial trading for consumers and policy-makers in the information era. In this paper, we argue that investors evaluate ex-ante transaction costs, part of which are subjective and vary over a range of values across the set of investors. Since the reservation price of consumers for electronic commerce

5 activities is lower, e-brokerages have been lowering commission fees. We argue that they must also lower the ex-ante unobservable costs by focusing on characteristics of information presentation on their web page (e.g. increased transaction transparency and research information) in order to attract different segments of the market. We also point to the ex-post unobservable costs that investors may incur due to the difference in the price they paid for a trade and the price at the exchange. The electronic medium is making investors more sensitive to subjective costs than ever before. Our future work will focus on validating our position regarding the heightened sensitivity of netizens to subjective costs and on the role of policy and firm strategy in affecting these subjective References Aitken, M.J., Garvey, G.T. and Swan, P.L. (1995) How Brokers Facilitate Trade for Long-Term Clients in Competitive Markets, Journal of Business 68(1): Bakos, Yannis (1998) The Emerging Role of Electronic Marketplace on the Internet. Communications of the ACM 41(8): Chiles, T.H. and McMackin, J.F. (1998) Integrating Variable Risk Preferences, Trust, and Transaction Cost Economics, Academy of Management Review 21(1): Fortune (1998) Trade Fast, Trade Cheap, 2 February. Gomez, J. (1998) Testimony before the U.S. House of Representatives, Committee on Commerce, Subcommittee on Finance and Hazardous Materials, 6/18/98, June. Testimony is no longer available on the World Wide Web. Konana, P., Menon, N. and Balasubramanian, S. (1998) Exploring the Implications of Online Investing, Communications of the ACM, forthcoming. Lee, H.G. (1998) Do Electronic Marketplaces Lower the Price of Goods?, Communications of the ACM 41(1): Malone, T., Yates, J. and Benjamin, R. (1987) Electronic Markets and Hierarchies, Communications of the ACM 30(6): Tyson, E. (1998) Trading Places, Worth (Special Issue): Williamson, O.E. (1986) Economic Organization, New York: New York University Press. Konana, Menon and Abramowitz Electronic Brokerages for Online Investing 36