* The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission.
It is appropriate that we enter the new millennium with technology very much on our minds. Before I actually started my term eighteen months ago, I knew that I wanted to focus on technology issues relating to retail investors. Even the casual observer cannot help but notice the Internet's incredible force in changing and expanding investors' role in the marketplace. The Internet has empowered investors. They now have access to all kinds of information and the ability to trade for as little as $7.95. The speed and breadth with which the Internet can provide information to the marketplace also has wide ranging implications for the Commission's regulatory scheme.
Little did I know that online trading would grow so tremendously in just the last year and a half. The phenomenal growth in online brokerage is particularly astonishing when you consider that it did not exist until 1995. Today, about 14 percent of all orders are entered online. Over 30 percent of the volume in Nasdaq and NYSE stocks result from trades entered on the Internet. The Internet's impact on trading by small investors is even more pronounced: nearly 37 percent of all individual investors' trades are entered online, up from 17 percent in 1997.
How do regulators adapt to the market changes wrought by technology? This article will explore some of the more pressing issues that soon will demand the Commission's attention, including issues that touch upon investors and the veritable faucet of market information now available to them over the Internet.
In a borderless digital world, under what circumstances will foreign markets be able to access U.S. investors?
In a recent report on electronic commerce (the "OECD Report"), the Organization for Economic Development aptly described the challenge that the Internet raises for regulators everywhere:
The nature of the Internet forces a reconsideration of the most effective way to govern and of whether centralized decision making can keep up with the speed and fluidity of the Internet. This suggests the need to consider decentralized modes of decision making, such as self-regulatory mechanisms. Another option may be to consider methods of controlling speed by 'throwing sand into the wheels.' This points to the need to develop a deeper understanding of the impact of faster and more interlinked exchanges on individuals, organizations, governments and communities.
In my opinion, it would be quite premature for the Commission to consider throwing any sand into the Internet's wheels. The Commission and other financial regulators should proceed cautiously so that we don't unintentionally impose unnecessary and burdensome regulation that eliminates the very positive benefits of the Internet.
As Internet trading truly takes off in its fifth year, however, the Commission does need to consider some of the longer-term implications for regulation. The Internet eliminates the traditional barriers between market participants imposed by time and distance, creating many challenges for securities regulators.
Some Longer Term Issues: The 50,000 Foot View
Foreign Market Access
One of the most significant challenges—literally involving the most time and distance—involves facilitating the global securities market that technology has made inevitable. In a borderless digital world, under what circumstances will foreign markets be able to access U.S. investors? It is technologically feasible for investors to link to a foreign market by "passing through" a member of that market—typically the investor's broker-dealer—through a proprietary system or through the Internet.
In a 1997 concept release, the Commission reevaluated its regulation of the market in light of the growth of alternative trading systems (ATSs), registered exchanges, and foreign market activities in the United States ("Concept Release"). As part of that reevaluation, the Commission raised the issue of foreign markets' activities in the United States. The Commission asked for comment on three non-exclusive approaches it could take.
Mutual Recognition Approach: The Commission could rely on a foreign market's primary regulatory authority if the Commission determined that the foreign authority provided "comparable" regulation to U.S. exchange regulation.
Exchange Registration Approach: The Commission could require foreign markets that provide direct access to U.S. investors to register as U.S. exchanges.
Access Regulation Approach: Instead of regulating the foreign exchange, the Commission could regulate those entities that provided U.S. investors access to trade on the foreign exchange.
The Commission received 40 comment letters on the Concept Release expressing views about cross-border trading. Commenters differed on what the Commission's regulatory approach should be. Many commenters supported a framework that permits cross-border trading through a U.S. registered intermediary. Some commenters suggested that U.S. institutional investors and retail investors should have direct access to foreign markets. Not surprisingly, most foreign exchanges and foreign associations supported an approach based on mutual recognition of home country regulations.
Not wanting to hold up the ATS portion of the Concept Release any longer than necessary, the Commission deferred judgment on the issue of foreign market access for another day. However, it has separately addressed aspects of the issue of foreign markets' activities in the United States twice since the publication of the Concept Release.
First, in an interpretive release regarding offers of securities on the Internet by offshore markets, the Commission stated that it would not consider a foreign issuer, investment company, investment adviser, broker or exchange's advertising on the Internet to be activity taking place in the United States if the foreign party took measures reasonably designed to ensure that it did not effect securities transactions with U.S. persons as a result of its activities on the Internet. To avoid triggering a registration obligation, the foreign broker or foreign exchange would have to post a prominent disclaimer and refuse to transact business with potential investors it had reason to believe were U.S. persons. In addition, a foreign exchange would have to refrain from providing U.S. persons with access indirectly through its members.
Second, in March 1999, the Commission issued only its second limited volume exemption from exchange registration in 62 years—this time to a foreign exchange. This exchange, Tradepoint, trades securities listed on the London Stock Exchange. The exemption allows U.S. investors to trade in U.K. equities directly without having to go through an intermediary.
Tradepoint, however, fully submitted to the Commission's jurisdiction and was treated the same way as any U.S. exchange seeking an exemption from registration based on limited volume. Thus, although the Commission's exemption was the first allowing a foreign exchange to interact with U.S. investors directly, it basically only allowed U.S. investors to trade securities as they already do, but more efficiently and cheaply. The exemption does not provide a solution for most foreign exchanges that wish to operate in the United States.
In the 1997 Concept Release, the Commission recognized the development of a truly global securities market and acknowledged that we want to participate in that market by opening up foreign markets to U.S. investors. The SEC and its foreign regulator counterparts are addressing one aspect of this issue by encouraging a project led by the International Accounting Standards Committee to develop a set of accounting standards that could be used for cross-border offerings and listings. The focus of this project—the language businesses use to communicate with investors—is a critical issue for transitioning to a global marketplace.
It remains to be seen whether the benefits to the public from the increased pre-trade transparency requirement outweigh the regulatory burden on high-volume ATSs.
This issue will not wait forever. U.S. exchanges already feel the foreign exchanges breathing down their necks. For example, the Canadian exchanges just restructured their operations to try to recapture the market share that they lost to foreign exchanges, particularly the New York Stock Exchange and the Nasdaq Stock Market. Recent developments in Europe, such as the birth of the euro and the creation of a strategic alliance between Frankfurt and London, may lead to increased competition for U.S. exchanges.
Transparency
Another regulatory challenge will be deciding the level of transparency that should exist in cyberspace. As the OECD Report noted, "an expectation of openness is building on the part of consumers/citizens, which will cause transformations, for better (e.g., increased transparency, competition) or for worse (e.g., potential invasion of privacy), in the economy and society."
The questions become: (1) is more transparency always better; (2) who owns market information, and how quickly should it be available; and (3) how much reliance should an investor place on the information that he or she sees? The simple answer is that more transparency is always better. For the more complicated answer, keep reading.
Is More Transparency Always Better?
Regulation ATS
How much transparency is enough? That issue arose most recently in the Concept Release. Although there have been ATSs serving market functions since 1969, ATSs did not become increasingly significant players in the national market system until the late 1980s. By 1997, ATSs comprised at least 20 percent of the Nasdaq volume and four percent of the listed volume.
Not until last year did the Commission take the step of including ATSs in our exchange regulatory system. One of the Commission's primary goals in changing the regulatory approach to ATSs was to improve overall market transparency.
In adopting Regulation ATS, the Commission increased market transparency by requiring ATSs with more than five percent of the volume in any exchange-listed or Nasdaq security to make all their best priced orders in that security available to the public quote stream and accessible to non-subscribers. In principle, I support the goal of market transparency, but not at any cost. It remains to be seen whether the benefits to the public from the increased pre-trade transparency requirement outweigh the regulatory burden on high-volume ATSs.
Central Registration Depository
Of course, transparency issues are not limited to market information. Some registered representatives have raised concerns over the NASDR's proposed plan to display certain disciplinary information through the NASDR's Public Disclosure Program on the Internet. Currently, a broker's registration information is immediately available on the NASDR's Internet Web site, and disciplinary information is available through either a toll-free hotline or via e-mail. The NASDR is considering making all disciplinary information viewable on its Web site.
Some registered representatives have expressed concern that providing disciplinary information on the NASDR's Web site provides too much transparency about their backgrounds. They are particularly concerned that information they consider irrelevant to their job performance will be more easily accessible than under the current system.
Proposed Revisions to the Regulatory
Scheme under the Securities Act of 1933
The question "is more disclosure better?" arose again in the Commission's proposed use of its exemptive authority to revise the regulatory scheme under the Securities Act of 1933. The proposed revisions were intended in part to minimize selective disclosure of information. One immediate concern is whether the proposal causes a shift from written disclosure to oral disclosure, thus actually reducing transparency.
The goal of the proposing release is to modernize regulation of the capital formation process. Securities offerings by the largest seasoned companies would be deregulated under the proposal, while offerings by smaller companies would only be deregulated when directed exclusively to more sophisticated buyers.
The current system of securities registration imposes certain restrictions on communications before and during the time an issuer conducts an offering. The proposal would change that by lifting the current restrictions on communications, or "free writing," around the time of the offering. The quid pro quo though is that written materials used in connection with the offering must either become part of the registration statement or be filed separately with the Commission.
The filing requirements would ostensibly give investors equal access to the information in those materials—thereby preventing selective disclosure to well-connected investors. In other words, retail investors would have equal access to all materials given to larger investors by companies and underwriters marketing the securities. Even if this cures the so-called selective disclosure problem, however, it raises the wholly separate issue of whether individual investors will know what to do with the additional information.
Who Owns Market Information?
How Quickly Should it be Available?
Online investors have demonstrated that they really want to get their hands (and eyes) on price quote information. I have heard anecdotes about how online investors circumvent their firms' limitations on this information—which is usually only provided in connection with a buy order—by placing limit orders to buy at prices the investors know will never be reached.
The current debate over real-time quote fees best exemplifies the issue of who owns the information, how quickly it should be made available and at what price. The Consolidated Tape Association ("CTA"), which runs the consolidated quotation system and is composed of the exchanges and the NASD, sets the fee schedules for market data. Until 1997, broker-dealers that disseminated market data to their customers generally were charged $4.25 per month for each customer account with access to quote information. However, since 1991, the CTA has also offered several pilot programs with alternative pricing structures. Under one pilot, brokers paid a half cent for each quote delivered to a customer, whether real-time or delayed, but were prohibited from delivering delayed quotes during market hours. In 1997, the CTA proposed to increase the monthly fee to $5.25 and the per quote charge to one cent for real-time quotes, with no charge for delayed quotes. The CTA later withdrew the one cent real-time quote fee charge, but then resubmitted it as a pilot, which is ongoing. Online brokers, particularly one high-volume firm, complained vociferously that heavy customer use of the real-time data resulted in a huge increase in their payments to CTA.
Congress has joined the debate over this data ownership. Congressman Howard Coble introduced a bill to protect commercial database owners against piracy of their data. The bill would confirm that the exchanges own the market data and allow them to sue to prevent its misuse. Another bill by Senator John McCain takes the opposite approach, putting the information into the public domain and ensuring no limitations on its dissemination.
In February, the Commission announced that it would review the fee structure for market data and the role of data revenue in the operation of the markets. Responding to the Commission's planned review and concerns by online brokers, the NYSE and the NASD have wisely sought to restructure the market data fee schedules for listed securities.
How Much Should Online Investors Rely on the
Information That They See?
So how good is the quality of the reams of information that investors now access through the Internet? Can they believe what they see? An increasing challenge for the Commission and other regulators will be how to address the growing incidence of fraud occurring online.
In July 1998, the Commission created the Office of Internet Enforcement to coordinate and oversee its existing efforts related to the Internet. Among other things, the Office supervises a 125-person "cyberforce" which spends time each week surfing the Internet looking for questionable securities-related activities. So far, the Commission staff mostly sees old scams resurfacing in a new venue. The troubling new dimension is the ease with which the fraudsters can widely and cheaply disseminate false information on the Internet. For example, a marketer on the Internet can buy 12 million e-mail addresses for $300 and use these names to "spam" unsuspecting investors.
The Commission staff has focused some of its attention on the dangers that fraudulent hyping in chat rooms poses to investors, and for good reason. At least one recent university study confirmed that buyers tend to believe what they hear—even if they know it might be false.
In this study, which simulated what occurs in chat rooms, students were divided into buyers and sellers of low, medium, and high quality assets. Buyers did not know the quality of the assets they were offered, but knew that sellers might lie. In the first round, sellers were not permitted to describe their assets. In the second round, called "cheap talk," sellers were allowed to say whatever they wanted about their assets. Results showed that sellers made fraudulent statements half the time and buyers tended to believe what they heard. Researchers found that a third session—where sellers could describe their assets but could not make fraudulent statements—was most advantageous to both buyers and sellers.
We have all recently had a taste of how unfounded chat room rumors can dramatically move a stock price. Appian Technology soared in early April when investors mistook this penny stock for that of another firm, AppNet Systems. AppNet Systems, an electronic commerce company, had been planning an IPO—the subject of much discussion on online chat rooms. Another stock, Omega Research, almost doubled in price within half an hour based on a chat room discussion by someone posting Internet stock picks. A third stock, PairGain Technology, rose over 30% in less than 90 minutes based on a phony Bloomberg News screen that was posted on a widely-read Internet message board.
Another troubling development are "whisper numbers" posted on some Web sites. Whisper numbers claim to be extremely accurate earnings forecasts passed only around to "smart money." The owner of one of these sites acknowledged that his information is sometimes based on just a single e-mail that he finds on an Internet bulletin board.
Some Nearer Term Issues:
The 10,000 Foot View and Descending
Because I am interested in discussing some of these issues with market participants personally, I have begun convening a series of roundtables on Internet trading issues around the country. The first one was held in San Francisco in February. I intend to host another roundtable in New York in this month and one in Washington, D.C. in June. Some issues that the roundtables focus on show the growing pains of Internet trading.
Suitability
Generally, a broker has an obligation to recommend only those investments that are suitable for its customers. Does the Internet affect a broker-dealer's suitability obligation when an investor enters an order to purchase or sell a security online? Does the analysis change if an investor receives information that is somehow personalized, either because the investor "pulled" it from the broker's Web site or because the broker "pushed" it based on a profile that the broker developed about the investor while she was online? Underlying this question is whether the Internet is merely another distribution channel for the sale of securities or is a paradigm shift where investors are making unsolicited trades based on their own independent research.
Privacy
Given that electronic commerce generally is moving towards one-to-one marketing based on profiles gathered from customers, how are brokers collecting their data? What do customers know about the information-gathering and sharing practices of broker-dealers? To what extent do they care?
Systems and Capacity Problems
How realistic are customers' expectations for continuous access to online brokers and immediate execution of trades? How can brokers realign customers' expectations?
Financial Portals
How do unregistered portals and broker-dealers differ? Portals, whether media companies, software companies, or registered broker-dealers, are all vying for control of investors' eyeballs. Web sites that are not registered as broker-dealers may only be paid a connection fee for connecting investors to registered broker-dealers. How do financial arrangements for financial portals differ from compensation arrangements for the rest of e-commerce? Should these arrangements differ?
Best Execution
To what extent do investors understand what is required by a broker's duty to provide best execution for its customers? Do retail investors understand that price improvement opportunities differ among markets?
Conclusion
Reports of the impending demise of time and distance on the Internet do not seem to be greatly exaggerated. The challenge for regulators will be how to regulate in an environment where the natural barriers are disintegrating. As discussed in this article, many of the technological developments bring great benefits to investors—such as greater transparency and more information—which empowers them to make more informed investment decisions. This has changed the role of investors in the marketplace, and consequently the dynamics of the markets. The Commission needs to rethink its current regulatory regime and see how best to accomplish our mission of protecting investors and promoting fair and efficient markets.
The final question we must answer is: what will make sense for tomorrow's investor in tomorrow's marketplace?