Online trading: problems and challenges.

Maniam, Balasundram ; Mehta, Sanjay S. ; Leipnik, Mark R. 等

INTRODUCTION

Online trading is a practice that has exploded in growth and popularity. Currently, there are approximately 150 brokerage firms offering online trading (Future Banker, 2000). Societies use of the Internet has changed the entire concept of securities trading. In fact, Minkoff (2000) termed society=s use of online trading as "mainstream". In further support of this notion, he went on to add that by the year 2005, it is predicted that 81 percent of the households that own stocks will have an online account. Currently, 25 percent of the households that own stocks have an online account. Another study estimated that by the year 2003 approximately 9.7 million American households will manage more than $3 trillion in assets spread among some 20.4 million online accounts (Drummer, 1999). These are mind-boggling statistics compared to just three years ago when electronic trading was regarded a fad (Carroll, Lux, and Schack, 2000). Presently, in the U.S. one out of every six stock trades occurs over the Internet (Kassenaar, 1999). In 1999 online brokerage firms raised $1.76 billion in capital markets due to approximately five million online investors (Economist, 1999, and Registered Representative, 1999). Despite all of its growth and popularity, online investing possesses a host of problems and challenges for everyone involved. "You can make money fast and lose it faster," concluded Drummer's (1999, p.1).

LITERATURE REVIEW

There are several studies in the literature that attempt to discuss some of the problems and challenges associated with online trading. The first problem discussed in the literature is hidden costs and deceptive advertising associated with online trading. Atkinson (2000) supported this contention that buried in all the online trading hype resides the fine print. This obscure data translates into a venture that is more costly than one was lead to believe. Another topic of discussion was that of the independence one comes to face when it comes to online trading. The fact that one must solely bear the overwhelming duties of research and investment decisions was supported through the studies conducted by Opdyke (2000) and Brackey (2000). Reliability was yet another area of concern discussed in these studies. The studies conducted by Patel (1999) and Opdyke (2000) confirmed that factors such as Internet congestion and erroneous data sites could prove costly to investors.

Delayed and varied execution speeds and self serving market makers were among the items responsible for this pitfall of online trading as was collaborated in the studies by McNamee (2000) and Patel (1999). Internet security is also a major concern to investors. Computer hackers and viruses plague every sector of the computer community and with certainty will continue to do so.

Finally, the long-term ill effect of online trading in regards to earnings was also discussed in the literature. McMillan's (1999) study found investors who outperformed the market by three percentage points before they began online trading, typically lag it by two points afterwards.

PROBLEMS AND CHALLENGES

Internet applications are endless and e-commerce companies are developing innovative business models and making advancements everyday. One of the fastest growing internet ventures is online trading. The first internet securities trading occurred in 1994. By 1997, it has been estimated that 17 percent of all trades occurred online via the internet (Goldberg, 1998). Online brokerage firms emerged and the wealth of information available to many investors have promoted the practice of investing through the internet. The opportunity that online investing present to investors is intriguing and returns often seem very promising. Within these opportunities lie many problems and challenges that are potential obstacles for the online investor. There are a variety of issues that online investors will face today and continue to do so in the future.

Hidden Costs and Deceptive Advertising

Since the mid 1990s, investors have been seeing advertisements by a multitudes of online brokerage firms bidding for customers. There are the endless stories and portrayals of the average person making thousands at the click of a mouse. Teaser advertisements boast of inexpensive or even free trades -"teaser rates"- in relation to the high dollar commissions one would pay a broker at a traditional full service firm (Atkinson, 2000). Now, even the traditional firms are offering online trading at discounted rates, whereas in 1998, none offered online trading (Bielski, 2000; Orr, 1999; Economist. 1999). So, why would anyone want to spend an exorbitant amount of money to trade securities using traditional off-line full service brokers when they can start an online account and do it themselves for a fraction of the cost (Brackey, 2000)? The choice appears clear-cut, or does it? For example, compare a trade costing $104 through a traditional full service firm versus $5 through an online brokerage. How can one go wrong? Well, buried in all this online trading hype is the fine print that Atkinson(2000) discussed in his study.

Unfortunately, the advertisements leave out a great deal of very important information regarding what all is involved in these accounts. As Morgenson (2000, p.1) stated, "Online investing is far costlier than most investors think." Nothing is ever mentioned about the large minimum balance one must maintain or initially deposit in order to qualify for these low advertised trading commissions (Kassenaar, 1999, and Financial Service Online, 1999). For example, Merrill Lynch, a traditional full service firm that recently began offering the online trading option through its Merrill Lynch Direct Account, offers trades for $29.95. However, the account requires a minimum account balance of $20,000 or $250 if the funds are applied to an Individual Retirement Account. American Express Brokerage, an Internet discount brokerage, has the following pricing guidelines: Investors who have account balances less than $25,000 must pay $14.95 for each buy and sell. Online buys cost nothing and sells cost $14.95 if investors have a minimum account balance of $25,000. Investors with account balances over $100,000 are entitled to free buys and sells. Brown and Co., a deep-discount online brokerage firm, offers trades for $5 each. It has the following guidelines: An investor must have at least five years= investment experience and have a minimum of $15,000 to open an account. Atkinson (2000) further warns that some firms even require that an investor make a certain amount of trades in order to qualify for the discounted trading fees. There are also the added costs of placing particular types of orders, such as limit, stop, or telephone orders (Atkinson, 2000). For example, Schwab, who requires an initial deposit of $5000, charges $29.95 if the trade is placed over the Internet, $49.50 if placed over the telephone using an automated service, and $55.00 if he or she personally gets a broker to place the trade. As one can see, an investor must possess a sizable sum of cash in order to qualify for some of the low trading fees offered by brokerages. In addition there are additional obscure fees that investors are required to pay when trading online.

In order for this area of concern to improve, everyone involved must do his or her part in facilitating change. Brokerages must strive to keep potential customers informed of the costs associated with this venture. Investors need to take it upon themselves to become educated on all the aspects of online trading (Gordon, 2000). They must investigate each brokerage in order to find out which one best suits his or her needs. Lastly, reading the fine print is imperative. As the old adage states, "if it is too good to be true, then it probably is." The Securities and Exchange Commission (SEC) and other pertinent Governmental entities play a role in online trading. Not only must they continue to monitor the industry, but they also need to increase regulation as well as step up enforcement efforts on the brokerages that facilitate inept marketing practices. As one can see there is much room for improvement in this area of concern in regards to online trading. Everyone must, especially the investor, must be cognizant of what he or she is getting into when it comes to trading online.

Independence

The term "do it yourself" is very much applicable in the case of online trading. Many investors who start online trading have no idea what this endeavor requires and the problems and challenges associated with it. The main problem and challenge that one must tackle is that of research. Without a broker to do this task, one is left to rummage through the endless and complicated amounts of data and information. This would include data sources such as financial statements, stock reports, company profiles, and the like. This is a very time consuming, necessary and prudent task. One must possess the knowledge to understand the data and be able to ascertain its reliability and validity. (Research reliability is another topic in and of itself; that will be discussed later in this study).

The second dilemma faced by the "do-it-yourself" investor is that of investment advice. Without a broker, the decision to buy, sell, or hold a security is left up to the investor (Brackey, 2000). Also, investors who possess a portfolio must bear the responsibility of managing it on their own. Diversification issues and the like are matters that must be dealt with. They require extensive research, knowledge, and time. Therefore, one must truly understand the risk and return characteristics of the securities that they are buying and also have sufficient time to handle various issues involved with this task.

Unfortunately, very few people possess the time and knowledge required to handle this task responsibly and wisely, and therefore, it would be in his or her best interest to go through a full service broker. Online brokerages can improve this situation by offering more tools to assist their customers with investment decisions. Many brokerages are doing this and it appears to be a sign of the times (Fraser, 2000). However, one should not expect too many services to be offered because the lack thereof is the reason their trade commissions are low. It stands to reason that the more services available, the higher the trading fees.

Therefore investors get what they pay for. In order to be profitable, they must have ample time and knowledge to fill the gap that would ordinarily be filled by the duties of a full service broker. With the passage of time, hopefully the online brokerage community will provide investors with more account management tools.

Reliability

One is totally dependent on digital technology when it comes to online trading. After all, one cannot trade online if they are unable to establish a "connection" with the firm. There are a number of problems and challenges that can and do arise in association with computers and the Internet. The results can be devastating should a problem arise at the most inopportune moment. As investors are aware.... time is money. Computer crashes are inevitable, on the part of the firm as well as the investor. Heavy internet traffic or volume is another factor that one must eventually deal with (Patel, 1999). Connections and downloads can be delayed or stopped all together due to Internet or web site congestion. Online firms vary in their computer hardware just as investors. One can bet that there are brokerages that do not possess adequate backup servers or properly maintain them. On the same note, there is the potential of brokerages having faulty "backups" or the lack thereof. Some firms may not have an alternate means available for investors to conduct trades. Should investors be unable to conduct an online trade for any reason, he or she should also be able to place the order via the telephone or personally. Online investing requires that firms and the investors possess reliable computer equipment and measures in order to fulfill their intended purpose.

Another aspect of reliability is that of research materials. There are a number of sources available on the Internet that one can obtain free information regarding an array of investment topics. However, Opdyke (2000, p.1) warned in his study, "that the words, 'good' and 'free' usually don't go together in the same sentence." Opdyke further asserted that within this plethora of information resides data that is stale, incorrect, and in some instances fraudulent (Hirschey, Richardson, and Scholz, 2000). Stale information includes out of date material and lagging stock quotes. Chat rooms, bulletin boards, and other like forums cannot be relied on as credible information sources. Opdyke's study stated that the information one really needs to effectively trade online is restricted largely to brokerage firm customers, institutional investors or those willing to pay handsomely for the research material. Of course this aspect relates back to the issue of "hidden costs". In short, unreliable data sources can provide devastating consequences.

Everyone involved in the online trading process can help improve reliability. Brokerages and investors must strive to improve their computer capabilities as well as keep their computer systems operating in an efficient manner (Nikkei Weekly, 1999). It is imperative that brokerages possess current as well as frequent backups of all data. They too must have a functional backup system available to investors, should the primary system fail or encounter problems. At the very least the firm should have an alternate server. A telephone system is another very beneficial backup alternative, where investors can phone in their orders should they be unable to place their orders via a computer. Investors must also keep up with their brokerages' computer capabilities as well as their own and make changes accordingly. Technology is constantly changing and it is up to both parties to ensure their systems are operating at optimum performance.

There are also steps that can be taken to improve the acquisition of reliable information. The Internet will always contain information that is inaccurate and sometimes criminal in nature. Sponsors of sites that contain securities data must monitor them frequently to ensure that only accurate and up to date material is provided. Disclaimers should be posted on every site that does not or cannot provide accurate information (Gordon, 2000). Online brokerage firms should provide enough data for investors to make sound decisions or provide a list of sites where one can go to obtain said data. Also, the SEC and other governmental bodies must continue to scan the Internet and step up enforcement efforts on those sites and sponsors who mislead its readers. Investors must educate themselves in regards to obtaining information from sites of this nature and be cognizant of the dangers involved in doing so. Hence, online trading can be very unreliable. Education, monitoring, regulation, and enforcement efforts can help reduce this stigma of online trading.

Execution of Trades

Many people are under the impression that a trade is executed the moment the mouse is "clicked" and at the amount expected. This is far from correct, as illustrated in Table 1. To understand how transactions occur, one must come to understand the online trading process (Hamilton, 1999 and McNamee, 2000). The process begins with the placement of an order. Once that order is placed with a brokerage firm, the firm then forwards the order to a Wall Street "market making" firm that actually executes the order. Brokerages often receive payments from market makers to get their business. This payment system is referred to as "payment for order flow" and is very controversial due to the potential of abuse. For instance, brokers may route orders where he or she is receiving the highest payments as opposed to where investors get the best execution. Routing and rerouting orders is inherently slow and result in poor executions. The market maker will match, but not necessarily beat the market's prevailing rate. A group of market makers may control 30 percent or more of the market's volume. They in turn can use this information for their own gain.

Online brokerages vary in their trade execution speeds as well as their trade execution success (Patel, 1999). As volatile as the market is, an online brokerage that takes twenty seconds to execute a market order can result in drastic expenses and losses. (A market order is simply an order to buy or sell a specified amount of a security(s) at the prevailing market rate, whatever that may be at the time the order is 'filled' or executed). What compounds this dilemma is when an online broker or another source contains lagging stock quotes, as opposed to "real time" stock quotes (Patel, 1999). (Lagging stock quotes are quotes or prices that are not current with the actual market price. Real time quotes are those that follow the market second for second and change accordingly). For example, an investor places a market order to buy 1000 shares of a "tech" stock. The stock is quoted at $5 a share from a source that has a twenty-second lag time. Unbeknownst to the investor, the actual value of the stock has increased to $6 at the time the order was placed. Now the online brokerage takes an additional thirty seconds to execute the order at which time the stock's price has escalated to $7 a share. This fifty-second time span--or "slippage" as Patel terms it--has ended up costing the investor an additional $2000. It is the risks and problems such as these that online investors experience everyday, but are seldom mentioned.

In the scenario discussed above, the investor could have placed a limit order on the buy; but there is no guarantee that his or her order would have been executed (McNamee, 2000). Recall that a limit order specifies that the investor will buy or sell shares at the price they specify. If their limit price beats the order offered by the dealer who gets their order, the dealer has to post their order where it will have a chance to be filled/executed. McNamee (2000) addressed this problem through a SEC report. The SEC report found "serious neglect" of these rules by many firms, including three mid-tier NASDAQ market makers that mishandled 46% to 92% of the orders examined. This translated into thousands of customers losing the chance to buy or sell stock at favorable prices. The "execution" issue is a problem and challenge that plagues investors and brokerages with serious negative implications.

There are a number of ways in which everyone involved in the online trading process may address this concern. The SEC must continue to increase and improve regulation and enforcement efforts surrounding this dilemma (Economist, 2000). Brokerages must adhere to these various regulations and laws and make certain their affiliates are doing so as well. They must also remember that the customer is the main priority. Their actions must always be in the customers' best interest. Again, investors must educate themselves on the intricacies of online trading. From the results of time lags to the details of limit orders, investors must be cognizant of the business in order to protect themselves. Everyone involved can improve the process of trade execution if the correct steps are taken.

Security

Another area of major concern is security, which not only plagues online trading but the entire e-commerce industry. But, some argue that online investing is safe and secure. For instance, according to Anderson (1998), president of Ameritrade, online investing is secure mainly due to the fact that the only information being transferred over the internet are orders to buy or sell. Others disagree, because hackers or viruses are infiltrating investors' accounts. These accounts contain very pertinent as well as private information. However, there are times when very personal information is transferred over the Internet. Many online brokerages allow customers to apply for an account via the Internet. The information called for in these applications is very personal in nature (e.g., social security number, bank account(s) information, and credit card(s) numbers). While many firms have increased their security efforts by implementing complicated encryption techniques and various up to date anti-virus software applications, there are still online firms that are lacking in this area. Should these precautions be overlooked by a brokerage, the ramifications can be devastating to its customers. One can only imagine the damage that could occur should his or her personal information end up in the wrong hands.

Hence internet security is a serious problem that plagues the entire E-commerce community. Computer viruses and hackers are always going to be a threat in our society. It is up to online brokerages to maintain and strive to ensure that their computer systems are up to date in regards to anti-virus software and encryption techniques. It is also up to investors to investigate their brokerage firm to see what measures they are taking against this problem. Additionally, they need to see what can be done on their behalf to guard against breeches of security. This is a topic in which everyone needs to be abreast of and counter measures implemented. Failure to do so can result in devastating consequences.

Long Term Outcome

Over time, aggressive online trading can have a negative impact on investors= earnings. The studies by Minkoff (2000), Future Banker (2000) and Chidley (1999) supported this contention. They found that online investors make close to 10 trades a year, and by the year 2005 it is estimated that each investing household will possess an average of 4.5 accounts. On the same note, it is stated that people with Internet accounts trade more often, as well as, trade more on margin. Furthermore, the Securities Industry Association (SIA) estimates that the average number of online trades per day now exceeds 500,000 (partly because of day-traders).

With all this excessive trades, one must contend with excessive trading fees, and lower earnings. McMillan (1999) and Levinsohn (1999) studies supports that excessive trading have resulted in investors's earnings to decrease. They found that investors increase their trading activity when they open an online account. Through aggressive trading, people get roughly two percentage points below what they would have achieved with a traditional "buy and hold" strategy. Levinsohn (1999) concurred with this argument in by stating that online investors are dismissing the rational strategy of buy-and-hold. McMillan's strongest point in his study was that investors, who outperformed the market by three percentage points before they began online trading, typically lag it by two points afterwards. Atkinson (2000) echoed the sentiments of this argument by stating that poor performance of a portfolio is directly attributed to active trading( i.e., it eats away at its gains). An investor that practices aggressive trading and is unwise to its long-range effects will undoubtedly suffer the financial consequences of such behavior.

Investors must be informed and educated regarding the online trading of securities. Securities trading simulation games which are offered through various sites, are excellent ways for investors to achieve this (Saunders, 1999). When it comes to the volatility of the market or the cumulative fees associated with aggressive trading, the investor must be cognizant of the ramifications of said factors (Economist, 1999). Patience and having an investment plan, such as a buy and hold strategy, are key to profitability. In conclusion, the typical investor who practices "buy and hold" stands to make more money than someone who ends up trading aggressively in an uncalculated manner.

SUMMARY AND CONCLUSION

The problems and challenges of online trading are deeply entrenched as discussed. There is no doubt that this practice can be very costly to an uneducated and uninformed investor. However, there are steps that must be taken to improve this dilemma. Investors must strive to better educate themselves through such mediums as investment simulation games in order to fully recognize the intricacies of online trading. To prosper from this endeavor, they must read the fine print in everything and posses the time and other requirements called for in this venture. Maintaining and keeping computers technologically up-to-date is imperative on everyone=s behalf. Brokerages must focus on the customer and keep them fully informed on all aspects of the business. Brokerage firms must ensure that their clients are capable of participating in this form of trading. The SEC and other governmental agencies must continue to increase its efforts in regulating and monitoring this sector of the market to insure that the customer=s best interest are being fulfilled. Online trading presents numerous problems and challenges to everyone involved. Investors must be prepared to work on this if they plan on reaping any benefits. With time, knowledge and continued effort the dangers of online trading can be minimized. Being informed and educated are the best safeguards in this ever-growing field of land mines.

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Balasundram Maniam, Sam Houston State University

Sanjay S. Mehta, Sam Houston State University

Mark R. Leipnik, Sam Houston State University

Table 1: Comparison of Transaction Performance and Success Rate

 Week of June 12-16, 2000

 Transaction Transaction
 Performance Rate
 (in seconds) (Rank)

Market Index 13.87 91.3%
DLJdirect 4.10 99.4%
E*Trade 15.78 96.1%
Charles Schwab 8.29 99.3%
Merrill Lynch 18.69 98.5%

 Week of July 17-21, 2000

 Transaction Transaction
 Performance Rate
 (in seconds) (Rank)

Market Index 11.93 97.0%
DLJdirect 4.5 99.9%
E*Trade NA * NA *
Charles Schwab 9.24 99.3%
Merrill Lynch 22.24 91.7%

Source: www.keynote.com

Note: NA *: Not available