THE INTERNET BASED SECURITIES TRANSACTIONS

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THE INTERNET BASED SECURITIES TRANSACTIONS

• MEHMET FAHRI ERCAN

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Securities industry has been affected
significantly by technological developments
during recent years. One of the most important
changes stems from the way which brokerage firms
use the Internet to communicate with their
customers. Using the Internet provides lower
cost and range services to customers.
Broker/dealers have used the Internet to
provide investors with tools to obtain access to
important analytical information conduct their
own research and place their own orders.
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Capabilities of the Internet The Internet began
in the 1960's as a network of computers funded by
the Department of Defense, intended to facilitate
communication in the United States in the event
of a nuclear attack. In the 1970's,
universities and other nongovernmental entities
started linking with this net. PC revolution of
the 1990s has incrased information processing
capability of the Internet enourmously. The
Internet decreases the importance of physical
distance as an obstacle to market access. It
lowers the costs of obtaining and exchanging
information.
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Use of the Internet for Securities Transactions
Web sites, bulletin boards, e-mail and push
technology can all be used in advertising,
offering and selling securities and for
delivering investment advices. They permit
communication instantaneously with millions of
people worldwide at low cost. They allow
matching proposed trades and circulating
information in broad-based markets. They also
permit individuals to access vast amounts of
information far more quickly and directly than
any other mean. The Internet is an efficient
mean (1) for issuance of new securities
(2) for secondary trading in already-issued
securities (3) as a powerful new information
tool.
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The Internet As A Mean To Trade New
Securities The Internet causes two main changes
in the issuance of new securities. 1) investment
bankers can post new underwritings of stock
issues on the World Wide Web and thereby expose
them to vast numbers of prospective investors at
very low cost. 2) Issuers can bypass traditional
underwriters and make direct public offerings of
securities using the Web bulletin boards and push
technology.
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The Regulatory Framework For Cybersecurities 1.
Federal Regulations The issuance of new
securities in the United States is primarily
ruled by the Securities Act of 1933. The 1933 Act
generally requires registration with the SEC of
securities that are publicly offered. The
Securities Act of 1934 generally requires
registration of broker-dealers and national
securities exchanges with the SEC. Both of these
Acts regulate securities fraud, the 1933 Act
focuses on securities issuance while the 1934 Act
deals broadly with both issuance and after-market
trading. The Investment Advisers Act of 1940
governs both open and closed-end investment
companies that offer their securities to the
public. In October 1995 interpretive releases and
a 1996 concept release, reflect an SEC effort to
encourage electronic delivery of information to
investors. The SEC also published in 1998 an
interpretive release on the application of U.S.
federal securities laws to offshore offering and
sales of securities and investment services over
the World Wide Web.
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Electronic Transmission of Information. The SEC
has stated that electronic distribution of
information through electronic means as
satisfying the delivery or transmission
requirements of the federal securities laws if
such distribution results in the delivery to the
intended recipients of substantially equivalent
information as these recipients would have had if
the information were delivered to them in paper
form. However, unlike information transmitted in
paper form, an issuer must obtain the investor's
informed consent to the receipt of information
through the Internet.
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Secondary Trading of Securities in Cyberspace
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Discount Broker-Dealers Contrary to a common
misconception, the Internet does not cause
disintermediation. By increasing the availability
of information, lowering transaction costs and
enlarging the span of the potential
relationships, it creates a strong demand for new
forms of intermediation. And the Internet
technology provides both a network infrastructure
and a flexible set of tools to develop and
deploy new transaction systems. Even before it
was used for offerings of securities, the
Internet had begun developing a new dimension for
secondary trading in already-issued securities.
Small discount brokerage firms were the first to
offer full online trading services and research
to account holders in 1995. The online firms
allowed it was estimated that in 1966, there were
1.5 million online accounts.
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In 1997, the number had grown to almost three
million, and the number is about 20 million
today. Internet-based trading accounted for 17
of total retail sales in 1997. In US 76 brokers
were offering some form of electronic trading in
mid-1998. The most prominent are Charles
Schwab  Co., and E-Trade. As of March 1997,
Schwab had 700,000 active on-line accounts and
50 billion in on-line customer assets, and by
December 1997, Schwab's sales by means of
electronic trading for the month for the first
time were more than half the firm's total retail
sales. Assets managed by on-line investors are
predicted to grow from over 100 billion today to
524 billion in 2001 and account for more than 8
of the total assets held by small investors.
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The explosive growth of the Internet-based retail
brokerage has been the most obvious sign of the
Internet impact on securities markets. In the
late 1990s, superior market performance of
technology stocks attracted technology-savvy
investors, who used Internet brokers for their
trades. In turn, Internet brokers focused their
marketing on technology stocks. However the
sharp technology market downfall of 2000 has
changed the picture.Technology distressed
investors reduced their trading activities and in
many cases left the market altogether. The
trading activity and assets under management of
Internet brokers dropped significantly. Revenue
growth slowed sharply and in many cases turned
into a revenue drop, leading to heavy losses.
Market expectations have been revised downwards.
The market capitalisation of the global market
leader, Charles Schwab has dropped over 60
between January 2000 and January 2002.
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Table Leading on-line brokers summary data  
 
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ECNs In the US, alternative trading systems such
as the Electronic Communication Networks (ECN)s
are not a new phenomenon. They were launched in
the 1980s in response to three requirements, to
which the established stock exchanges were unable
to respond in satisfactory manner After-hours
trading, Order matching for institutional
investors (crossing networks), Support for
market-makers for position management. The ECNs
remained relatively marginal as their access was
restricted and prices were not widely
disseminated. The situation changed in the late
1990s, when the advent of Internet broking
created a strong demand for rapid execution of a
large flow of retail orders.
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These orders were heavily concentrated in
technology stocks, traded on NASDAQ via market
makers, whose models depended on spreads between
sell and buy prices. Some online brokers wanted
to eliminate the spread by matching orders
directly. Their development was supported by the
SEC, which saw the ECNs as a means of enhancing
price discovery process. In January 1997 the
SEC adopted the Order Handling Rules - requiring
market makers and specialists to reflect in their
quote the price of any orders they placed with an
ECN if this price was better than what they were
displaying to the public. The SECs regulatory
support caused a rapid growth of the ECNs. By
mid-2000, the ECNs have captured over a quarter
of trades on NASDAQ listed stocks. However with
NYSE-listed equities, the figure is only slightly
more than one percent of trades.
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The Effect of Online Discount Trading on
Suitability and Other Obligations of
Broker-Dealers Technological innovations have
presented new regulatory problems, including the
application of the suitability rule to online
activities. The NASDs suitability rule states
that in recommending to a customer the purchase,
sale or exchange of any security, a member shall
have reasonable grounds for believing that the
recommendation is suitable for such customer.
Because online discount trading is essentially
impersonal and customer-based, online firms have
less of certain broker-dealer obligations, such
as those of suitability and a reasonable basis
for recommendations.
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• Applicability Of The Suitability Rule To
  Electronic Communications
•  There has been ongoing debate about the
  application of the suitability rule to online
  activities.
• Two major questions have arisen
• whether the current suitability rule should apply
  to online activities,
• If so, what types of online communications
  constitute recommendations for purposes of the
  rule.
• NASD Regulation believes that the suitability
  rule applies to all recommendations made by
  members to customers including those made via
  electronic means- to purchase, sell or exchange a
  security. Electronic communications from
  broker/dealers to their customers clearly can
  constitute recommendations. The suitability rule,
  therefore, remains fully applicable to online
  activities in those cases where the member
  recommends securities to its customer.
•  

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For the second question, NASD Regulation does not
seek to identify in this Policy Statement all of
the types of electronic communications that may
constitute recommendations. As NASD Regulation
has emphasized, whether a particular transaction
is in fact recommended depends on an analysis of
all the relevant facts and circumstances. That
is, the test for determining whether any
communication constitutes a recommendation
remains a facts and circumstances inquiry to be
conducted case-by-case basis.
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Bulletin Boards and Message Groups as Secondary
Trading Tools on the Web Assuming a small issuer
successfully completes an online DPO, its
securities may not become eligible for trading on
NASDAQ or even in the over-the-counter ("OTC")
market maintained by broker-dealers. Registration
under the 1934 Act is only required when an
issuer has at least 500 recordholders of a class
of its securities and at least 10 million in
assets. Because of the small size of DPOs and
the issuers that use them, 1934 Act registration
of the issuers is therefore generally not
mandated. Newly-issued securities will not
qualify for listing on NASDAQ unless the issuer
meets NASDAQ requirements, such as minimum per
share bid price, minimum proportion of shares
owned by the public minimum market value, total
assets, total equity and number of shareholders.
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For a DPO issuer, the World Wide Web offers
bulletin board trading as an alternative to
trading on NASDAQ or in the OTC market. On a Web
bulletin board, potential buyers and sellers can
post bids and offers and contact each other to
facilitate transactions.
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Real Goods Case One of the early boards was that
of "Real Goods Trading System," which issued the
stock traded on the board, markets
environmentally-oriented consumer goods such as
energy-saving appliances. The SEC stated that
Real Goods could operate the site without
registering as a broker-dealer or investment
adviser, on the condition that Real Goods would
play no role in effecting any transaction,
receive no compensation for creating and
maintaining the system, not receive, transfer or
hold funds or securities in connection with
operating the system, put disclaimers on the site
regarding any registered status, keep records of
all quotes entered, and inform users of the
applicability of securities laws to offers and
sale.
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Effects of Electronic Trading on Stock
Exchanges As electronic trading of all kinds has
expanded, the prices of seats on major stock
exchanges have decreased. In the first half of
1998, prices of seats on major exchanges in New
York, Chicago, Philadelphia and London dropped
between 10 to 40 percent. While other factors
have played a role, the largest concern is the
rise of electronic trading. The growing
competition from the extranets such as Instinet
and Island has raised concerns over the existence
of the auction markets conducted on exchange
floors.
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The Internet As an Information Services Tool The
wide availability of information is certainly a
major factor of the impressive success of
Internet securities trading. Portals, such as
Yahoo Finance and CBS Market Watch or MSN Money
Central offer retail investors a wide range of
pricing information, company analysis and
research previously available, at a very high
cost, only to professional traders. They also
offer linkages to online brokers. Financial
portals have captured market shares from
traditional financial press as well as from
specialised data suppliers such as Reuters and
Bloomberg and have become the preferred financial
information source for many investors. Internet
also stimulated the emergence of new types of
financial data services.
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NYSE and NASDAQ have created sophisticated Web
sites, which provide a wide variety of current
and historical information. SEC, between 1999
and 2001, moved its database of listed companies
financial information and regulatory filings,
EDGAR, to the Internet today, all company
filings are done through the Internet. Investors
can access all 500 000 EDGAR documents on-line
for free. The growth of financial information
industry has not been limited to the Internet.
The on-line trading boom also stimulated the
growth of specialised cable television financial
channels. These channels, each of which has a
supporting web site have transformed online
trading into a mass media phenomenon.
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However, The on-line financial information
explosion has been highly controversial. On the
one hand, it clearly increased and democratised
the availability of data, thus lowering the
information asymmetry between market
professionals and market users. On the other
hand, many specialists have argued that the
increase in the quantity of information has not
lead to the improvement in its quality, quite to
the contrary. Forceful arguments have been made
recently about the negative influence of the
widespread financial information availability,
made possible through Internet technology.
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After the adoption of the Fair Disclosure
Regulation (FD Reg) by the SEC in 2000, some
parties claimed that the FD Reg has increased
market volatility by eliminating a necessary
filtering process between the companies and the
general public. The widespread access to market
information has created illusion of easy gains
among retail investors and led them to make
hazardous investment decisions. Particularly
high-tech companies took the advantage of this
information illusion to enhance their ability
to manipulate markets. Thus, information
explosion played a major role in the market
bubble and subsequent fall. It is paradoxical to
accuse Internet of weakening financial markets,
when its most important impact has been to
increase the availability and to facilitate
access to market information.
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Jurisdiction of Blue-Sky Laws Over Internet
Transactions. In order to reconcile technology
the North American Securities Administrators
Association (NASAA) adopted a model rule to
clarify jurisdiction over Web-based securities
offerings. Under the NASAA policy, states will
generally not attempt to assert jurisdiction over
an offering if the Web site contains a disclaimer
essentially stating that no offers or sales are
being made to any resident of that state, the
site excludes such residents from access to the
purchasing screens and in fact no sales are made
to residents of that state. As of January 1998,
32 states had adopted the NASAA safe-harbor.
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Summary and Conclusion. Digital communication
and electronic commerce are still in their way of
advance. The ultimate impacts they will cause
on public offerings, secondary trading and
capital formation are impossible to predict. A
few facts can be drew. Big and small issuers
can reach more potential investors faster,
reducing the advantages of intermediaries.
Smaller financial institutions have instant
access to vast amounts of complex financial data,
creating a leveling influence.
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Despite a more level field in terms of
information access and outreach to viewers, data
on the World Wide Web may ultimately confuse some
operators to combine. It remains to be seen
whether the cost to build software systems that
will allow for larger and more sophisticated
securities offerings in the future will be so
substantial that it will limit the number of
players. Because of the global and
instantaneous nature of the World Wide Web,
jurisdictional barriers are more vulnerable than
ever. Finally, the individual investor will be
increasingly empowered by access to types of
information previously available to only large
institutions.
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