Online Trading Firms Under Fire

The results of separate inquiries by the U.S. Securities and Exchange Commission (SEC) and the New York State Attorney General are warning online trading firms to clean up their acts or risk regulatory crackdowns.

The SEC wants to see an increased amount of discussion between trading companies and SEC staffers to develop regulatory strategies that will protect consumers in the fast and risky online trading world.

New York Attorney General Elliot Spitzer went a step further, announcing an agreement between his office and the Securities Industry Association (SIA) to conduct a public information campaign to teach consumers how to protect themselves.

Both inquiries stemmed from the dramatic rise in online trading volume this year, partly driven by an increase of first-time investors. From 3.7 million online accounts in 1997, the business had boomed to 9.7 million by the second quarter of this year, the SEC said.

While Internet and computer technology put more financial power into the hands of individuals, the two offices said, the risks of grabbing that power are not always apparent to the average consumer.

New York Starts With Education

Spitzer, whose purview includes the hallowed trading halls of Wall Street, is spearheading a $500,000 (US$) education campaign with the SIA to make clear the benefits and risks of online trading. The two offices plan to run full-page newspaper ads and produce educational materials to be available in public libraries and on the Internet.

The nine-month investigation stems from consumer complaints that the Attorney General’s office received early this year about online trading practices. Spitzer’s office examined seven online brokerages and a few other industry hands, reviewing about 120,000 pages of documents. The inquiry focused on disclosure, oversight, advertising and public education efforts to determine whether the measures that online brokers take are enough.

In addition to the consumer education component, the Attorney General’s report calls for online firms to voluntarily improve disclosure of technology performance issues, services and new technology arrivals, “so that consumers can make appropriate comparisons among firms when it comes to capacity, trade execution, and service.” Such disclosure plans could be federally implemented by the SEC or voluntarily by bodies such as the New York Stock Exchange and the NASDAQ.

Advertising should also be clearer and more straightforward, Spitzer said. “If you were to believe all the online advertising today, you would get the impression that investors have access to both instant trades and instant wealth, neither of which is true.”

Sounding a subtle warning note, Spitzer said that if the report’s guidelines and recommendations are ignored and the problems his office observed earlier this year continue, he may “consider more serious remedies.”

SEC Will Wait and See

The SEC is also willing to step up government regulation of online trading if necessary, but is taking a comparatively hands-off approach for now. The commission released a set of priorities to encourage investment firms to help consumers make wise online moves. The recommendations were culled from a series of online investing roundtables that the SEC conducted earlier this year.

“The Internet is rapidly making online trading ubiquitous. This report provides the Commission with a comprehensive examination of the critical issues to be addressed in the area of technology,” Commissioner Laura Unger said. However, she stopped short of saying that the commission needs to take concrete action to control online trading. “I think it may still be premature for extensive rulemaking in this area, but the report will allow the Commission to focus upon and consider the most vital issues concerning online brokerage,” she said.

Among the critical issues setting online trading apart from traditional broker-assisted trades, is the significant question of whether online trading firms meet the SEC’s “suitability” rule. Under that rule, a securities broker has an obligation to recommend “only those investments that are suitable for a customer,” the SEC says.

For that rule to be an issue, however, a registered broker’s representative must make a recommendation to the customer. “In the online environment, pinpointing what constitutes a recommendation can be difficult. As data mining technology enables online firms to customize information and provide it to customers, this question becomes even more pressing,” the report says.

Therefore, the SEC plans to look more closely at such “data mining” products and how they affect or influence do-it-yourself online investors.

Industry Standards

The commission also wants the trading industry to support standards of speed and “certainty of execution” that all online trading sites should meet, and the commission will consider requiring brokers to explain to customers the execution quality available through different sites and the broker’s order handling practices.

According to the report, the SEC should also push online trading firms to make the broadest possible amount of real-time market data available to investors and examine whether online brokerages’ current pricing structures restrict access to that information.

The SEC report also calls for a closer look at online trading system capacities, noting that the commission should consider requiring online trading firms to establish and periodically test contingency plans, maintain records of system outages and disclose to investors the risk of system outages and their impact on trading.

Like Spitzer in New York, the SEC report also endorses an investor education effort, suggesting that trading firms work with the SEC toward that goal. However, unlike in New York, where Spitzer and the SIA are ready to act, the SEC would start by conducting another study to “determine the best place and time to educate investors on the Internet” before it would take action.