In response to complaints received from constituents, the New York State Attorney General (the "AG") began an inquiry into the online brokerage industry in February 1999 (the "Inquiry"). As part of the Inquiry, the AG asked a number of online broker dealers to provide the AG with documents regarding their advertising, capacity and technology and disclosures. Those requests ultimately led to the submission of a "white paper" by a number of firms. The AG also visited the sites of certain firms where representatives of the AG's office met with the firms' information technology, compliance, and customer service personnel. The end result of this investigation was a report titled "From Wall Street to Web Street: A Report on the Problems and Promise of the Online Brokerage Industry," which was released by the AG on November 22, 1999 (the "Report"). In the Report, the AG discussed the "problems" that led to the inquiry, the advertising campaigns of online brokerage firms, and the systems limitations and risks associated with online trading and made recommendations to the industry and investors alike. The following is an executive summary of the Report.
Background
Since its inception, the online trading industry has experienced rapid growth. This rapid growth led to certain systems outages and slowdowns in the fourth quarter of 1998 and the first quarter of 1999. These problems were especially prevalent during January 1999, when an unexpected surge in the market led to a "rash of outages." Not surprisingly, the AG received a number of complaints from New York State residents regarding long delays, outages, failures to provide the best execution, inadequate staffing of the customer service and dial-up lines, and execution of orders beyond the customers' buying power. As a result of these complaints, the AG posted a survey on his website asking people with online brokerage accounts to provide information regarding their experiences. Approximately 400 people filled out the survey and nearly three-quarters of those who responded expressed dissatisfaction with order processing and execution speeds.
Advertising and Public Perception
In an effort to understand the causes of these outages and the expressed dissatisfaction, the AG reviewed the advertising of the online brokerage industry. The AG found that the advertising of many firms contributed to the customer dissatisfaction in two ways. First, the advertising did not dispel, and in many cases actively encouraged, the misperception that trading online is equal to instantaneous order execution. Second, the amount of advertising led to an increase in the number of customers at a time when these firms could not handle the number of customers that they were currently servicing. The Report focuses on a number of specific ads that allegedly fail to properly set the expectations of the customers and do not "educate the customers about how the market works as well as the limitations of online trading." Report, p. 31. The Report first focuses on those ads that convey the message to customers that online trading will make them rich. The AG stated that while these ads are hyperbolic, they leave a "residual impression of easy wealth when you trade online." Report, p. 33. The Report then quotes SEC Chairman Arthur Levitt who has stated that "when firms, again and again, tell investors that on-line trading can make them rich, it creates unrealistic expectations. And when firms sow those grandiose and unrealistic expectations, they stand a good chance of reaping adverse results when many of them go unmet." Id.
The Report then discusses ads that encourage specific misconceptions about online trading that the AG found to be troubling. These include ads that promote the idea that making a trade is as easy as a "click of a mouse." The Report points out that these ads fail to caution customers that while placing a trade may be easy, investment decisions are not. The Report also focuses on ads that blur the distinction between placing a trade, which can be done instantaneously by clicking the mouse, and the execution of that trade, which is not an instantaneous process. The Report suggests that these ads add to customers' misperceptions by failing to distinguish properly between these two activities and failing to inform customers that the service does not link the customer directly to the marketplace. The Report further suggests that these ads do not provide adequate disclosure regarding the delays that can be experienced during periods of high volume. The Report suggests that a more accurate advertisement would inform customers that a "click of a mouse" represents merely a request for a trade and not the execution of that trade.
The Report similarly criticizes ads that promote "easy and cheap" trading, which has encouraged a new online trading strategy defined by Arthur Levitt as "day-trading light." Report, p. 36. The Report cites ads of E*Trade, which advise the public that the commissions charged are as low as $4.95 per trade. The Report criticizes the practice of advertising such a low commission for active traders without disclosing the risks of "day-trading light" for novice investors. Report, pp. 36-37. These ads are further criticized by the AG for misleading potential customers by advertising this low rate in bold text while revealing only in fine print that such rates only apply to "platinum" customers who execute more that 75 trades per quarter. The Report concludes that online brokers should take care to make sure that investors opening accounts are informed of the applicable fees in a clear and concise manner.
The second focus of the advertising section of the Report is on the failure of certain firms to curtail advertising at times when the customers they currently have are taxing their systems' capacity. The Report lauded those firms that ceased or substantially cut back their advertising campaigns during the relevant period and sternly criticized those firms which either kept their advertising at a constant level or, in some instances, expanded their advertising efforts. The Report recognizes that there is a strong incentive for a firm to obtain brand awareness and establish dominance, however, it advises that firms should not do so if it results in a decrease in the reliability of their systems. In short, the Report advises online brokers to make certain that they have the capacity to handle the new accounts that their advertising are campaigns designed to attract.
Capacity and Technology
After providing a general overview of the systems utilized by the online brokerage industry, the Report anonymously discusses specific limitations in the systems utilized by the online brokerage firms. These limitations include a variety of constraints ranging from scalability to retention of qualified information technology personnel.
The Report noted that there are generally two types of systems utilized by online brokerage firms--the mainframe system and the server system. The Report notes that the mainframe systems were initially designed for the performance of back office functions and were not designed to be used 24 hours a day, 7 days a week. While firms have adapted these systems to accommodate the demands of online trading, the Report notes that by their nature mainframe systems require planned downtimes and outages in order to update the database. The Report also notes that many mainframe systems are limited in terms of messaging and processing capacity. These limitations can be addressed, however, by adding additional partitions to the mainframe.
The Report addresses other limitations experienced by the firms and notes the importance of scalability. Scalability allows a firm to increase its capacity by simply adding additional equipment to the system already in place. Apparently, not all firms are able to increase capacity easily due to the architecture of the systems that are being utilized. Another potential limitation identified is with the size of the physical plant and the power capacity limitations. In some cases, this constraint can only be addressed by opening an additional technology center. The Report also notes that many firms are having difficulty hiring and training the highly skilled information technology personnel needed to operate and monitor the systems that are being utilized.
Front End Systems
In addressing the limitations of the front-end systems utilized by the firms, the Report notes that virtually every firm relies on some type of webserver technology to handle the front-end interface with its customers. Problems with these servers manifest themselves in a variety of ways, including: slowed customer response time, the inability to log on to a website, and being involuntarily logged off a website. The Report identifies several likely causes of the "problems" associated with front end hardware. One such culprit is reported to be old software. Although the Report acknowledges that many firms have already transitioned to updated webserver software, allegedly not all have done so. Another likely cause of the front-end delays is reported to be the use of a single server to authenticate the customers' information, which results in a bottleneck and can slow the system down. Certain firms have addressed this bottleneck by either adding a server dedicated to the authentication process or by load-balancing the work across both the mainframe and the database. The Report also identifies the problems experienced by one firm due to capacity constraints. In one case, the problem resulted in the inability of customers with a certain function associated with their account to log on. This problem was corrected by the adding additional database servers. The front-end systems have also been slowed down by the increase in the number of options available to customers. The Report suggests that firms balance the benefits of the additional options with the strain they place on front-end systems.
Middleware
The Report also identifies certain capacity-related problems caused by the middleware. One such problem was caused by the messaging limitation of one firm's mainframe. In January 1999, this firm had only one partition in its mainframe and thus experienced problems when the messaging capacity was taxed by the upsurge in online trading. The firm, however, has reportedly addressed this problem by adding additional partitions to the mainframe.
Similarly, certain software applications can cause problems with the middleware. While one firm reportedly experienced such a software problem on a number of occasions; the Report does not provide any additional information.
Back-End Systems
The Report identifies three general areas of capacity constraints associated with the back-end systems of online brokerage firms, which resulted in numerous outages and slowdowns. During the relevant period, at least one firm is reported to have resorted to degrading its system availability in order to avoid an outage. This procedure entailed the manual reduction of the number of ports available for trading. With fewer ports available, fewer trades were in the queue. While this procedure may have averted an outage, it allegedly resulted in long delays for the customers of that firm.
The first area of capacity constraint discussed is system limitations in reading and writing data. These problems manifest themselves in a variety of ways. One firm's system design made it difficult to handle the requests of those customers with more than one account. Another firm experienced problems when the number of transactions per day significantly exceeded the maximum number of transactions the database server was designed to handle. The most severe problem identified occurred at a firm which stored its open orders in an "open order file." The problem arose when the number of open orders for particular stocks exceeded the capacity of the back office provider causing severe bottlenecks. Although the firm had plans for a long-term solution of this problem, the firm was forced to address the problem in the interim by blocking orders for certain high volume securities. Now, customers wishing to purchase these securities must do so over the telephone.
The Report also discusses delays in reporting executions to investors. While some delays are not caused by the online brokerage firms, the Report states that some of the delays are caused by the pre-set limitations imposed by the firms on market makers. Additionally, the Report suggests that the bandwidth of the communications lines of many of the firms is less than 10% of the bandwidth of the lines used by the market makers. The result of this difference in bandwidth is that the executions can not be sent to the firms as quickly as the market makers' systems would allow. Also, some firms are reportedly still utilizing lines that run on antiquated communication protocols. The Report further notes that certain firms place a priority on the placement of trades and, therefore, execution reports are allowed to queue up during periods of high volume.
Lastly, some of the delays are allegedly caused by the back office provider to which the firm has outsourced its back-end tasks.
Miscellaneous
With regard to back-up systems, the Report states that it is ideal for a firm to operate more than one facility. Spreading the day to day functions across multiple facilities avoids the over-loading of any one facility and eliminates the need for a back-up facility.
The Report states that customer service is also impacted by high volatility. During such high volume periods the average response times often jump from one minute to 10 or more minutes. The Report acknowledges that the number of call centers and staff size is subject to NASD approval and, as such, the hiring of additional personnel is not solely within the control of the firm.
Knight Securities, L.P.
The Report addresses the role of Knight as the leading market maker and attempts to educate the reader with regard to its role in the delays in the execution of trades. The Report concludes that a solution will not be forthcoming unless the NASDAQ creates "a tool that will permit market makers to auto-ex each other at size levels much above the current firm quote rule." Report, p. 123.
Risk Management Procedures
After describing how the e-commerce issues affecting the online brokerage business are not unique to that industry, the Report discusses the need for risk management procedures. The Reports suggests that the greatest risks to the relevant systems are caused by software upgrades that do not go as planned. The Report recommends the firms adopt quality assurance benchmarks such as CMM and the ISO 9000. Becoming certified as ISO 9000 compliant or CMM compliant has rapidly become a benchmark for those in the e-commerce business. Currently, it is reported that none of the online firms are either CMM or ISO 9000 certified and that while firms have adopted similar standards, none are believed to be operating at the higher levels of CMM certification. While some firms believe that CMM gets in the way of the rapid development necessary, the Report favors such certification.
The Report recommends that firms employ periodic independent third party reviews to access their systems and criticizes the view that an internal review is sufficient. The Report rejects the view that the subjective reviews of the systems by various magazines and such, which currently exist, provide customers with an accurate picture of the comparable quality of online firms. With regard to disclosures, the Report lauds the disclosure of outages to the public. The Report states that a clear and concise disclosure of significant outages is necessary to educate the customers both of the sophistication of the technology and the risks of online trading.
Recommendations
At the conclusion of the report, the AG makes several recommendations including:
Performance measurement--the AG recommends that the firms' technology development and management expertise be assessed in a standardized report.
Customer Service Metrics--the AG further recommends that the customer service areas of firms be similarly evaluated.
Investor Education--the AG recommends that online brokerage firms spend a substantial portion of their advertising budget on investor education ads and ensure that their ads do not contradict or confuse the investor education message.
Disclosure of Outages--the AG recommends that the firms self-disclose outages as they occur.
Heightened Margin Requirements--it is recommended that firms should advise their customers of certain higher margin requirements that they have placed on certain stocks on the home page of the online brokers' web page.
Communicating Market Conditions--the AG recommends that firms use technology to apprise customers of market conditions when they log-in, including when a market maker has curtailed the auto-ex procedures for a particular security.
Buying Power of Investors' Accounts--The AG suggests that firms apprise their customers when a purchase may significantly exceed the value of their account.