ON-LINE TRADING

Better Investor

Protection

Information Needed

on Brokers’ Web Sites

United States General Accounting Office

GAO Report to the Congressional Requesters

May 2000

GAO/GGD-00-43

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-00-43 Better Investor Protection Information Needed

B-283098

May 9, 2000

The Honorable John D. Dingell

Ranking Minority Member

Committee on Commerce

The Honorable Ron Klink

Ranking Minority Member, Subcommittee on Oversight and Investigations

Committee on Commerce

The Honorable Edward J. Markey

Ranking Minority Member, Subcommittee on Telecommunications, Trade,

and Consumer Protection

Committee on Commerce

The Honorable Edolphus Towns

Ranking Minority Member, Subcommittee on Finance and Hazardous

Materials

Committee on Commerce

House of Representatives

The Honorable Carl Levin

Ranking Minority Member, Permanent Subcommittee on Investigations

Committee on Governmental Affairs

United States Senate

This report responds to your requests that we review various aspects of

on-line trading. As agreed with your offices, our objectives were to

determine: (1) the growth in on-line trading; (2) the extent to which on-line

broker-dealers had experienced trading system delays and outages,

including the causes of these problems and their reported effect on

investors; and (3) how on-line broker-dealers address investor protection

issues related to margin, privacy of information, risk disclosures, best

execution, suitability, and advertising.

Investors who trade on-line submit orders to broker-dealers electronically

through the Internet. This report summarizes information collected from

12 on-line broker-dealers. These firms represented less than 10 percent of

the total estimated number of firms that offer on-line trading. However,

they accounted for about 90 percent of the on-line trading volume during

early 1999.
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On-line trading is a rapidly growing segment of the securities industry.

From the last quarter of 1997 to mid-1999, the number of broker-dealers

offering on-line trading more than doubled to about 160 firms. Also, the

number of on-line trading accounts established nearly tripled to 10.5

million within this time period, and the volume of on-line trades increased

to about 37 percent of all retail trading volume in equities and options.

Industry analysts expect this growth to continue as more full-service

broker-dealers offer on-line trading services to their customers.

This growth in on-line trading has been accompanied by a series of delays

and outages in broker-dealers’ automated trading systems that have caused

some investors to suffer losses or miss investment opportunities. Each of

the 12 on-line broker-dealers we contacted had experienced trading system

delays or outages. Officials from these firms maintained that several

factors caused delays and outages, such as inefficient message routing by

Internet service providers, glitches in vendor-supplied systems, and

computer hardware and software failures often associated with service

upgrades. The officials said that they expect delays and outages to

continue because they must constantly upgrade their systems’ services and

capacity to remain competitive and to keep up with the growth in on-line

trading.

The on-line trading industry is new and evolving. Its regulators, the

Securities and Exchange Commission (SEC) and the securities selfregulatory organizations (SRO), have issued some guidance on maintaining

adequate capacity or notifying their customers about the potential for

service disruptions. These regulators have also posted some of this

information on their web sites. However, they have not issued final rules in

these areas. The most frequent complaint SEC has received concerns

investors’ difficulty in accessing on-line trading accounts. Requiring that

consistent records be kept on delays and outages and investors be

informed of the potential for delays and outages could help investors

better understand the limitations of on-line trading technology and prepare

for delays and outages.

On-line investors have access to extensive financial information through

the Internet and other sources, but they are responsible for their own

trading decisions in the absence of solicitations and recommendations by a

broker-dealer. To help investors make informed decisions, SEC and the

SROs require that broker-dealers furnish investors information relating to

margin trading, have proposed rules concerning privacy of information,

and recommend that broker-dealers also furnish information about trading

risks and best execution of trades. These actions are all key investor

Results in Brief
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protections. However, the broker-dealers that we contacted did not always

provide their customers all such information, especially on the firms’ Web

sites where it would be most useful since this is where investors go to

trade on-line. For example, only 4 of the 12 firms we contacted posted

information about special margin requirements for volatile stocks on their

Web sites for investors to check before making a trade. At one firm that

did not post this information, a customer unknowingly placed a trade on a

stock that the firm had determined could not be bought on margin. After

the purchase, the customer had to pay the total price for the security,

which resulted in him owing the firm an additional $75,000.

Some customers have complained to SEC that they lost money or missed

financial opportunities because they did not understand how on-line

trading worked. SEC and the securities SROs are responsible for

overseeing the securities industry and markets for the ultimate benefit and

protection of the investor and each has taken initial steps to monitor the

activities of on-line brokerage firms. Ensuring that investors receive

appropriate information on margin requirements, privacy considerations,

risk disclosures, and trade executions is especially important considering

that an estimated 8 million new on-line trading accounts could be opened

by the year 2001.

This report contains recommendations that would enhance oversight of

on-line broker-dealers in key areas of system capacity, outages and delays,

and information disclosure. It also contains information on suitability and

advertising issues associated with on-line trading.

On-line trading is transforming the relationships that investors have with

broker-dealers. Before 1995, investors typically bought and sold stocks by

calling or visiting registered representatives of broker-dealers who

executed their orders. Today, nearly 6 million investors buy and sell stocks

through the Internet.1

 The services on-line broker-dealers provide their

customers have differed from their full-service counterparts, but these

differences are diminishing, and both are subject to the same rules and

regulations. Their activities are regulated by the regulatory arm of the

National Association of Securities Dealers, Inc. (NASD), NASD Regulation

(NASDR), and by SEC for the ultimate benefit and protection of the

investor. They also may be members of and regulated by the New York

Stock Exchange (NYSE).

 

1

On-line Financial Services Update, U.S. Bancorp Piper Jaffray, September 1999.

Background
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The terms on-line trading and day trading are sometimes used

interchangeably. Unlike on-line investors, however, day traders have

virtually direct access to markets and generally trade more frequently,

attempting to profit from short-term movements in stock prices. Although

on-line trading differs from day trading, the differences between them are

diminishing.

Trading on-line is typically an experience much different from trading

through a full-service broker. Instead of talking to a registered

representative about a trade or an investment strategy, on-line investors

primarily access their broker-dealers’ Web sites through the Internet and

order securities trades without assistance from a registered representative.

Automating transactions and accepting payment for order flow (as

discussed below) allow broker-dealers to charge on-line investors less for

trades. The top 10 on-line broker-dealers generally charged their

customers commissions that averaged about $15.75 a trade, for any

number of shares less than some specific amount. They might charge more

for larger trades, such as those exceeding 1,000 shares. In contrast, fullservice broker-dealers generally charge commissions that are based on the

size of the order and the dollar value of the transactions. These

commission fees can exceed $90 or more but may be negotiable for

customers that have large accounts. As we discuss later, the total cost to

trade includes not only the commission charge, but also differences in

stock purchase or sale prices that may result from different methods of

executing trades. Full-service brokers provide assistance to their

customers through registered representatives. Although on-line investors

do not generally receive such personal assistance, they do have access to a

vast array of financial information, often at no charge, such as market data,

historical charts, industry reports, and analyst reports. This information

can assist them in making trading decisions. Full-service brokers have

provided this information routinely only to high net worth individuals and

institutional investors, such as the firms that manage mutual funds and

state pension funds.

Broker-dealers that offer on-line trading install an additional layer of

computer hardware and software to their trading systems. This layer,

called the “front-end system,” allows customers to access information on

the firms’ Web sites and submit orders to the firm for processing. The

firms also have internal systems that provide customers the information

they request, such as price quotes, as well as deliver messages that confirm

their orders have been received and executed. Both on-line and full-service

broker-dealers have “back-end” systems that route trading orders to be

executed.

On-line Trading Differs from

Full-Service Trading
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On-line broker-dealers are beginning to offer financial services that used to

be offered only by full-service broker-dealers. These services include

opening mutual fund accounts; trading mutual fund shares, listed options,

and fixed-income securities; and access to initial public offerings (IPOs).

In addition, on-line broker-dealers now offer new services, such as afterhours trading and pre-opening trading. Also, online broker-dealers are

developing software that can provide tailored portfolio and investment

advice. Conversely, some full-service broker-dealers have begun to offer

on-line services that once only on-line firms provided.

On-line trading is sometimes confused with day trading. Although on-line

investors and day traders both place electronic trading orders to buy or

sell stocks, their access to markets and investment strategies differ.

Trading on-line provides investors a fast way to place orders with their

brokerage firms. On-line investors may use any number of trading

strategies designed to profit from either short-term or long-term price

movements in the stocks they buy or sell. Day trading, on the other hand,

is a more focused strategy used by traders who generally submit trading

orders from computers physically located on the premises of a brokerage

firm. These traders attempt to profit by buying and selling stock frequently,

taking advantage of minute-by-minute price movements. Day traders prefer

to start each day with no open positions and end the day the same way, so

they do not carry overnight market risk. Although millions of investors

trade on-line, industry estimates suggest that there are fewer than 10,000

active day traders.

A significant difference between on-line investors and day traders is their

access to the markets. On-line investors access the markets through their

Internet service providers and their brokers’ order routing systems. This

process can take several seconds or minutes, exposing trading orders to

fluctuations in stock prices between the time of order entry until its

execution. By contrast, day traders have virtually direct access to the

markets. Day traders trade at the offices of day trading firms that have

direct connections to market centers.2

 The day trading firms, as on-line

firms have begun to do, also generally provide day traders in-depth news

and information about the securities markets, including real-time price

quotes for stocks. This enables day traders to execute trades attempting to

capitalize on anticipated stock price movements. We address day trading

issues in a separate report.3

 

2

Market centers include exchanges, Nasdaq, and electronic communication networks (ECNs).

3

Securities Operations: Day Trading Requires Continued Oversight (GAO/GGD-00-61, Feb. 24, 2000).

On-line Trading Differs from

Day Trading
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The differences between on-line trading and day trading are diminishing as

these industries develop. For example, some on-line broker-dealers now

offer their active traders news and price quote services similar to those

already provided to day traders; and they offer customized software, such

as that used by day traders, for their most frequent users. Also, some day

trading firms are providing remote access terminals so that their day

traders can trade from home via the Internet.

To determine the extent of recent growth of on-line trading, we obtained

and reviewed reports prepared by an SEC commissioner, Gomez Advisors,

and Credit Suisse First Boston Corporation. We collected data from the

reports on the number of on-line broker-dealers, trading accounts, and

trading volume from the last quarter of 1997 through July 1999. We did not

verify the accuracy of these reports.

To determine the extent of system delays and outages experienced by online trading firms, including the circumstances for these problems, we

contacted 12 on-line broker-dealers. We selected these firms primarily on

the basis of their market share of on-line trading volume.4

 Ten of the firms

selected represented about 90 percent of the on-line trading volume for

March 1999, nearly 500,000 trades a day. We also selected two small firms

to determine whether the issues they faced were different from those

experienced by large firms. These two firms had a combined market share

of less than 1 percent of total on-line trading volume. We asked officials at

each firm to provide information on the number of system delays and

outages and the reasons for these occurrences. We interviewed industry

system professionals at Keynote Systems, Inc., an Internet performance

measurement, diagnostic, and consulting firm, to obtain their views on

system delays for 11 of 12 on-line broker-dealers in our review. We also

used Keynote’s data to examine the possible effects of trading system

outages and delays. Finally, we obtained and reviewed investor complaints

submitted to SEC between January 1998 and June 1999 concerning on-line

trading system outages and delays.

To determine how on-line broker-dealers implement investor protections

related to margin, privacy of information, risk disclosure, best execution,

suitability, and advertising, we discussed these issues with officials from

the 12 selected on-line trading firms. We obtained and reviewed SEC and

NASD regulations and guidance, and reports. We interviewed senior

 

4

Six of the 12 broker-dealers began on-line trading after 1995 and represented 56 percent of the market

share of daily on-line trades. The other six firms are subsidiaries of well-established full-service or

discount broker-dealers and represented 35 percent of the market share of daily on-line trades. Before

1995, some of these firms offered on-line trading using proprietary software.

Scope and

Methodology
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agency officials at SEC, NASDR, NYSE, and the North American Securities

Administrators Association (NASAA) to obtain their views on the various

investor protection issues. Also, we reviewed the Web sites and customer

account agreements of the on-line broker-dealers. In addition, we obtained

and reviewed 1999 reports prepared by the Office of the New York State

Attorney General, From Wall Street to Web Street: A Report on the

Problems and Promise of the On-line Brokerage Industry; and by an SEC

commissioner, On-line Brokerage: Keeping Apace of Cyberspace. Finally,

we obtained on-line trading complaints submitted to SEC between January

1998 and June 1999 to identify problems experienced by investors.

We conducted our work in accordance with generally accepted

government auditing standards between June 1999 and February 2000.

According to information we obtained from industry analysts and SEC, the

number of on-line broker-dealers and trading accounts more than doubled

between the last quarter of 1997 and mid-1999. On-line trading accounted

for about 37 percent of all retail trading volume in equities and options for

1998. Industry analysts also forecast that the growth in on-line trading will

continue.

Broker-dealers are not required to report to SEC or NASD when they offer

financial services on-line. As figure 1 shows, however, available

information from industry analysts and SEC indicates that the number of

broker-dealers offering on-line services grew from 37 in the last quarter of

1997 to 160 by July 1999.

On-line Trading Has

Grown Rapidly
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Sources: Analysis of information from Gomez Advisors, Inc., and SEC.

Over the same period, the number of trading accounts at on-line brokerdealers also increased significantly. As figure 2 shows, the number of

accounts more than doubled from about 4.1 million accounts in the last

quarter of 1997 to nearly 10.5 million by mid-1999.5

 We found no

comprehensive statistics to show how many of these accounts were from

investors new to securities trading. However, estimates from one study

suggest that just over half of 7.5 million new accounts established in 1998

were from investors who converted from full-service or discount

brokerage accounts to on-line accounts.6

 Industry projections show that by

2001, on-line trading accounts could nearly double again to about 18

million accounts.7

 By then, some of the largest U.S. full-service brokerdealers plan to have implemented on-line trading operations.8

 

5

These accounts include only active on-line trading accounts.

6

Securities Industry Trend, Securities Industry Association, May 1999.

7

Ibid.

8

We did not identify how many of the estimated 7,785 broker-dealers nationwide are planning to offer

on-line trading to their customers.

Figure 1: Number of Broker-Dealers

with On-line Trading Systems From the

Last Quarter of 1997 Through July 1999
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Source: Gomez Advisors, Inc.

The rapid growth in the number of on-line broker-dealers and trading

accounts is reflected in the increased number of average daily trades by

on-line investors. Figure 3 shows that in the last quarter of 1997 the

number of on-line trades averaged about 153,000 a day, increasing to about

500,000 trades a day by March 1999. Ten of the 12 on-line broker-dealers in

our review processed about 90 percent of all these trades.

Figure 2: Number of On-line Trading

Accounts From the Last Quarter of 1997

to May 1999
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Source: On-line Trading Quarterly: 1st Quarter 1999, Credit Suisse First Boston Corporation, June

1999.

An industry report stated that on-line trading orders represented about 37

percent of all retail trades in equities and options for 1998.9

 According to

another industry report, future growth of on-line trades will depend on the

features that make on-line trading attractive to investors, such as low

commission fees and free company research.10 The report also cited other

factors that could affect future growth, including more broker-dealers

offering on-line trading; increased Internet access, which is expected to

reach over 225 million people worldwide by the end of 2000; and increased

investment of Individual Retirement Account and other retirement funds in

the stock market. The report further stated that a strong market could

influence on-line trading growth. However, a major market disruption or

prolonged downturn could greatly reduce the extent of future trading.

 

9

Online Financial Services Update, U.S. Bancorp Piper Jaffray, March 1999.

10Online Brokerage: Industry at a Critical Inflection Point, U.S. Bancorp Piper Jaffray, October 1988.

Figure 3: Number of Average Daily Online Trades From December 1997

Through March 1999
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Complaints filed with SEC by customers of the on-line broker-dealers we

contacted have stated that they lost financial opportunities because their

on-line trading systems experienced delays and outages.11 Although the

press reported some of the more significant trading system outages, we

could not determine their full extent because securities regulators

generally do not require broker-dealers to record or report delays and

outages. Officials at each of the on-line broker-dealers we contacted

attributed delays and outages to a number of factors, including heavy

Internet traffic and problems with vendor trading systems. They said that

they expect delays and outages to continue and are taking actions to

minimize their effects on customers.

Officials from each of the on-line broker-dealers we contacted told us that

their trading systems had experienced either delays or outages or both.

Some said system delays happened more frequently than outages, but they

provided us information only on outages.

Without records on the number and extent of system delays, we could not

determine the significance of delays. However, in analyzing data from

Keynote Systems on the performance of on-line firms’ Web sites, we found

that delays could adversely affect on-line investors’ ability to get their

trades executed.12 For example, we analyzed data from Keynote that

measured the average time it would take for investors to enter an order

after they had accessed a Web site. Data for a 17-week period from June

through September 1999 showed a statistically significant association

between average Web page processing speed and the rate of success in

submitting an order.13 Thus, investors at firms that took longer to enter a

trade had a greater chance that their orders either would not be executed

or would be executed at an unexpected price. Officials from a brokerdealer that had longer processing times told us their speed was influenced

by the type and amount of information contained on their Web sites. They

said Web sites with more information take longer to process an order than

those with less. However, they said investors may benefit from the

information provided. NASD officials told us that the amount of

 

11Delays occur when customers’ access to firms’ Web sites or firms’ ability to process trading orders is

slowed. Outages occur when customers can not access the firms’ Web sites or when the firms cannot

process trading orders.

12Keynote Systems had data for 11 of the 12 broker-dealers in our review. It did not have data for the

remaining firm during the time period we reviewed.

13Keynote Systems allows each page necessary for order entry to take 12 seconds. For example, if an

on-line broker-dealer requires customers to download five pages to enter an order, then Keynote

allows a total of 60 seconds for processing. Therefore, an attempt is considered successful if it is

processed within the 12 seconds per page time limit.

System Delays and

Outages Were Not

Reported

On-line Broker-Dealers Had

Trading System Delays or

Outages
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information on a Web site might determine the length of time it takes an

investor to download Web pages, but it should not affect the speed at

which the on-line broker processes orders.

Officials from 11 of the 12 on-line broker-dealers we contacted said they

monitored trading system outages that prevented their customers from

entering trading orders or prevented firms from processing these orders.

Officials from the remaining firm told us about one outage but said they

had so many outages that they did not keep track of them all. Although this

was one of the small firms, officials from the other small firm said they had

no outages. In total, officials from 11 firms reported 88 outages between

January and September 1999.14 However, this number may not capture all

outages because officials from one firm explained that they track only

outages that last 25 minutes or more and affect at least 25 percent of their

customer base. Of the 88 outages that firms reported, about 40 percent

lasted less than 25 minutes.

On-line broker-dealer officials told us that trading system delays were

primarily caused by heavy Internet traffic, especially during times of high

market volatility. The most commonly identified reason they reported for

trading system outages involved problems with vendor-supplied trading

systems. Nearly all the officials from the firms we contacted told us they

have excess capacity and that the capacity of their systems has not been a

cause of delays or outages, but rather to system upgrades implemented to

expand capacity or improve capability.

On-line broker-dealers, market analysts, and regulators attribute some

delays for on-line investors to problems with Internet service providers as

well as the investors’ own equipment. On-line broker-dealer officials said

that they often do not know when customers served by Internet service

providers located outside their local area encounter such delays. Keynote

Systems officials provided an example of an Internet service provider

problem. They said they found delays caused by U.S. Internet service

providers that routed messages intended for U.S. broker-dealers through

Japan. In addition, SEC’s Web site warns investors that they might incur

delays because of problems with their own computer equipment, such as

slow modem speed.

To a lesser extent, on-line broker-dealer officials attributed system delays

to market makers who switch from automated to manual processing of

 

14The number of outages the firms reported ranged from 1 to 25.

Delays and Outages

Attributed to Many Factors

On-line Trading System Delays

Attributed to Problems With

Internet Service Providers,

Investors’ Equipment and

Market Makers
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trading orders.15 Market-making officials explained that during periods of

abnormal volatility in stock prices and high trading volumes, market

makers have the option to suspend automatic electronic execution of

trading orders. They said this generally happens when the number of

shares that customers want to purchase exceeds shares available in the

market makers’ inventory. Market makers subsequently shut down their

automated systems until they can refill their inventories by buying shares

from other market makers. When this happens, delays in filling customer

orders may occur at the broker-dealers that originated the customers’

orders, whether on-line or off-line. Sometimes these delays can last several

hours after customers submit their orders to the broker-dealers.

Officials from 5 of the 12 on-line broker-dealers we contacted said that

vendor-operated systems caused most of their outages. SEC staff stated

that many on-line firms rely on vendor systems for major parts of order

processing; and when these systems experience problems, system outages

can result for more than one firm.16 Generally, vendor systems handle the

processing, routing, or execution of trading orders for broker-dealers.

None of the firms in our review could provide specific information on the

causes of their vendors’ system problems. Officials from one firm told us

that their vendor does not disclose the factors surrounding trading system

problems. An industry report expressed concern about the technical

capabilities of vendors that are being pressured by on-line broker-dealers

to respond to their demands for faster processing.17 SEC Staff Legal

Bulletin No. 8, issued by the Division of Market Regulation in 1998,

recommends that brokerage firms oversee vendors’ operations to ensure

that vendors adequately address capacity problems.

Officials from four broker-dealers cited hardware problems as another

reason for system outages. These problems included failures of new pieces

of system hardware and memory caches and incorrect coding of hardware

products developed by vendors. To better understand the nature of these

problems, we discussed two outages in detail with on-line broker-dealer

officials. In each of the cases, human error compounded hardware

problems.

 

15Market makers are NASD member broker-dealers who quote prices at which they are willing to buy

(bid quote) or sell (ask quote) securities for their own accounts or for their customers.

16SEC identified at least 31 on-line broker-dealers that were electronically linked to a single vendor’s

trading system.

17eBrokerage Quarterly, BancBoston Robertson Stephens, June 1999.

System Outages Attributed to

Vendor Systems and Firm

Hardware and Software

Problems
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For example, officials from one firm told us that a major outage occurred

when they attempted to implement a significant upgrade to the firm’s

trading system to speed the routing of investor trading orders. The new

piece of hardware functioned properly during simulation testing but failed

after 3 days of operation. The firm corrected the problem; but shortly

thereafter, another outage occurred when an employee ran a massive

report during regular market hours in violation of company procedures.

Officials told us that no customer closed a trading account because of

these outages.

Officials from another firm told us of an outage that stemmed from a

failure of a device that contained customer account information necessary

for processing trades. Although they designed the system to contain five

other similar devices that would take over should any one of them fail,

efforts to repair the initial failure inadvertently disabled these devices. This

action prevented customers from accessing 70 percent of the firm’s trading

system. Officials explained that this outage might have been prevented had

the device been installed properly in the first place.

Some broker-dealer officials attributed other outages to software-related

problems. For example, officials from one firm described a malfunction in

a newly installed software program that was designed to allow 250,000

customers to log on simultaneously. This led to a 90-minute outage shortly

after the stock market opened that prevented customers from either

accessing their trading accounts or obtaining pricing information on stocks

and mutual funds.

Officials from five broker-dealers said the only trading system outages

related to capacity have been those that occurred during or soon after

system upgrades to expand capacity or improve capability. Officials from

11 of the 12 broker-dealers told us they build excess capacity into their

systems.18 Officials from seven firms told us they have excess capacity

ranging from two to five times peak trading volume, based generally on

historical or projected trading volume data. Officials from 3 other firms

said their total system capacity can handle 1 million trading accounts, or

up to 3 times their average daily trading volume. Officials from the

remaining firm said that their system could handle up to 100,000 trades a

day but is only averaging about 40,000 trades a day.

 

18Officials from one remaining firm told us they do not know their total system capacity because the

firm relies on its vendor to process its trading transactions.

Problems Stemming from

Upgrades to System Capacity

Are Reported As Causes for

Outages
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SEC staff stated that daily trading volume does not provide an adequate

gauge of available system capacity during periods of peak usage. They

explained that surges in trading volume generally occur during the first

minutes after market opening and before market closing. Thus, although a

system may be able to process a significant number of trades over the

course of a day, it may have difficulty handling large numbers of trades

over a short period of time. SEC staff stated that trading system capacity

evaluations should consider all uses of a system, both historical and

projected, and the system’s ability to process such uses.

An SEC staff legal bulletin recommends that broker-dealers establish

comprehensive planning and assessment programs to determine system

capacity.19 In addition, the bulletin emphasizes to broker-dealers the

importance of having adequate capacity to handle high-volume or highvolatility trading days and conducting capacity planning on a regular basis.

With few exceptions, officials from the firms SEC reviewed, as well as the

ones we contacted, said they tested their systems regularly, although the

frequency of testing varied. Officials from the firms we contacted that did

not regularly test their systems said they had vendor systems that

processed trades, and they relied on these vendors to ensure adequate

capacity.

Securities regulators generally do not require broker-dealers to report

system delays or outages. NYSE requires firms to report only those

outages that threaten the viability of the firms.20 NASD recommends that

firms inform investors of the problems resulting from potential trading

system delays and outages.21 SEC has added information to its Web site

informing investors that technological “choke points” may exist that can

slow or prevent investors’ orders from reaching their on-line firm. The

Chairman of SEC has stated that each on-line broker should completely

and clearly explain to investors the limitations of on-line trading

technology and their effects on placing and executing orders. He stated

that it would be useful to investors if firms’ Web sites better explained to

 

19In 1989 and 1991 respectively, SEC issued two Automation Review Policies. Automation Review

Policy I states that self-regulatory organizations, on a voluntary basis, should establish comprehensive

planning and assessment programs to determine system capacity and vulnerability of trading systems.

Automation Review Policy II provides guidance on the type of independent review that should occur in

overseeing capacity planning.

20NYSE Rule 401 states that members must report system problems if they could lead to capital,

liquidity, operating problems, or impairments in recordkeeping, clearance, or control functions. To

help track system outages, NYSE recently added an “on-line trading” category to reports of customer

complaints that member firms are to file quarterly.

21NASD Notice to Members 99-11 and 99-12.

Not All On-line BrokerDealers Warned Their

Customers About the

Potential for Systems

Delays and Outages
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Page 16 GAO/GGD-00-43 Better Investor Protection Information Needed

customers the possibility of system delays and outages. By better

informing investors of the points at which their orders may be delayed,

investor expectations would be more consistent with the capabilities of

technology. He added that these disclosures would be useful to investors

only if they are readily visible on brokers’ Web pages. Also, investors might

be better able to minimize or avoid the disruptions to their trading that

delays and outages might otherwise cause.

Eight of the 12 on-line broker-dealers we contacted notified their

customers of the potential for delays and outages. These firms either

explained the types of circumstances that could cause delays or outages

and possible financial loss or provided a link to NASDR’s or SEC’s Web

sites, which also contained this information.22 One firm recommended that

its customers open an account with a competitor to avoid trading

disruptions should a delay or outage occur. The remaining four firms

either did not notify their customers or did not provide clear notices. For

example, two of the firms stated that system response time may vary due

to a variety of factors, such as trading volume, market conditions, and

system performance.

The most common investor complaint to SEC about on-line trading

concerned difficulty in accessing the Web sites of broker-dealers. (See app.

I.) Many investors reported lost financial opportunities. For example, one

on-line investor said that he lost up to $6,000 in his 2-day unsuccessful

effort to submit a sell order through one of the major on-line firm’s Web

site. Officials from two on-line broker-dealers said they made efforts to

compensate their customers for losses due to outages. These officials told

us they reimbursed some customers over $1 million in commission credits

and trade adjustments. SEC staff said that many firms have refused to

provide compensation for their customers’ losses in this regard.

Officials from several large on-line broker-dealers told us they anticipate

that trading system outages and delays will continue as firms expand or

upgrade their systems. According to these officials, frequent trading

system upgrades have been necessary to compete with other on-line

broker-dealers and to keep up with the growth in on-line trading. For

example, officials from one firm said they made over 600 changes between

January and June 1999. Officials from each of the firms said they are

providing alternative means of order entry to reduce the effects of outages

 22In its comments on a draft of this report, NASDR indicated that it has just completed development of

a new Web page directed to on-line investors that includes information about the mechanics of on-line

investing and margin, among other matters.

Firms Expect Delays and

Outages to Continue and

Are Making Contingency

Plans
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on their customers, including call centers, touch-tone services, or

redundant trading systems.

Officials from 8 of 12 on-line broker-dealers we contacted said they use

call centers as their primary backups should on-line systems fail. SEC staff

have questioned whether, in the event of a system outage, broker-dealers’

call centers have sufficient capacity to process normal on-line trading

volumes. Officials from 5 of the 12 firms reported that they are planning to

build new call centers.

Officials from two broker-dealers said they use secondary or redundant

on-line trading systems as their primary backups. They explained that

should one system fail, another system would handle all the transaction

processing. Officials from five other firms told us they were building, or

planning to build, redundant trading systems.

To help investors make informed decisions, SEC and the SROs require that

on-line broker-dealers furnish investors with information relating to

margin trading, have proposed requirements for privacy of information,

and recommend that broker-dealers also furnish information about trading

risks and best execution of trades. These are key investor protections.

However, the on-line broker-dealers that we contacted did not always

provide their customers all such information, especially on the firms’ Web

sites, where it would be most useful for investors trading on-line. Most of

the on-line broker-dealers provided some information on their Web sites to

educate investors, but officials from one firm said they did not want to

overwhelm their customers with information; and others said they had to

work through a burdensome process with vendors to provide this

information. Some customers have complained to SEC that they lost

money or missed financial opportunities because they did not understand

how on-line trading worked.

SEC and SROs are also addressing other information issues that might

affect on-line investors. As on-line broker-dealers provide investors

information tailored to their individual needs, they get closer to becoming

responsible for determining if these investments are suitable for their

customers. SEC is reviewing which activities might require suitability

determinations. Also, SEC and SROs require that advertising for on-line

broker-dealers be fair and honest and not mislead customers. Some

broker-dealers have withdrawn advertisements that the regulators found

misleading.

On-line Brokerages’

Web Sites Lack

Information on Trading

Risks, Rules, and

Procedures
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The regulations governing the information to be provided to investors on

margin trading—buying stocks using money borrowed from a broker—are

the same for investors who trade on-line as they are for investors who

trade through full-service brokers. However, investors who are trading online do not normally use a registered representative who might help

explain the risks or rules of margin trading. Some on-line broker-dealers

have personnel available to discuss margin rules by telephone. An SEC

commissioner reported, with many broker-dealers SEC contacted in

agreement, that the most effective means to educate on-line investors

would be on the firms’ Web sites. All the on-line broker-dealers we

contacted provided their customers required information on margin

trading, but many did not provide all of that information on their Web sites.

SEC has determined from its customer complaints that many investors

who traded on-line did not understand margin requirements.

Margin regulations for securities trading specify the maximum amount of

borrowing, or leverage, allowed by investors (usually 50 percent). For

example, an investor with $5,000 cash in a brokerage margin account

would be allowed to borrow a maximum of an additional $5,000 from the

brokerage firm for total stock purchasing power of $10,000. In return, the

investor would pay interest on the amount loaned from the brokerage firm.

Although margin trading allows investors additional purchasing power, it

also has additional risks because of the leverage it provides. For example,

investors who borrow on margin and buy twice as many shares can suffer

twice the losses if stock prices fall. Also, margin regulations allow

brokerage firms to sell investors’ stocks the firms hold as collateral for

margin loans should the value of the stocks fall below a certain level.

Consequently, investors must provide additional collateral quickly or risk

having the firm sell the investors’ stocks to pay back the loan. Margin

regulations also require broker-dealers to disclose their policies and

procedures regarding margin trading that might affect investors’ accounts.

The lack of sufficient disclosure on when firms would sell securities in a

margin account to cover margin loans was among the leading marginrelated complaints that SEC received.23 All of the on-line broker-dealers we

contacted provided their customers some type of information on margin

trading, such as requirements for account opening, procedures for selling

securities to cover account losses, or special requirements for volatile

 

23This situation could occur when the value of cash and securities in an investor’s margin account falls

below brokerage firm maintenance margin requirements (usually 30 to 50 percent at on-line brokerage

firms). Broker-dealers have the legal right to sell the investor’s securities to bring the account back to

the maintenance margin requirement at any time without consulting the investor, although firms

generally inform investors of an immediate need to replenish their accounts, called a margin call.

Investors Are Not Always

Provided Margin

Information on Brokerages’

Web Sites
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stocks. However, nearly half of the firms automatically opened margin

accounts for new customers without informing them of the risks and

benefits of margin trading. Those that provided clear indications of the

type of account to be opened offered their customers the option to choose

either cash or margin accounts, or both, on the Web site. The other firms

offered only the choices of ownership, such as a joint or individual

account, that all the firms offered. These broker-dealers automatically

opened margin accounts; at three firms, customers would find out about

their account type only if they read and understood their account

agreements, which SEC staff stated are written in legal language and may

be too difficult for investors to understand.

Three of the 12 on-line broker-dealers we contacted took extra measures

to ensure that their customers understood that stocks could be sold to

cover outstanding loans in a margin account. The three firms included

information on their Web sites that explained accounts could be liquidated

in fast-moving markets before the customary 3-day period given to

investors to replenish their margin account collateral. At one firm that did

not take extra measures to inform its customers, a customer complained

to SEC that the firm sold stock in his account without his knowledge

before the 3 days he thought he had to cover his margin obligation.

Each of the 12 on-line broker-dealers we contacted had margin

requirements higher than 50 percent for volatile stocks, and nearly all of

them considered some stocks too volatile to be traded on margin.

However, only 4 of the 12 firms we contacted posted information about

special margin requirements on their Web sites for investors to check

before making a trade. The remaining eight firms did not post this

information. Officials from two of these firms said that investors could

telephone the firms to obtain this information before making a trade.

Officials from the other six firms said that customers would find out about

these special requirements when the firms asked them for money after the

trades were made. One investor complained to SEC that he received a call

from his firm that he owed the firm $75,000 after he unknowingly placed a

trade on a stock that the firm did not allow to be bought on margin.

Officials at one firm told us that they were trying to improve their

customer service in this area.
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Under the Gramm-Leach-Bliley Act adopted in November 1999, SEC has

proposed rules to require broker-dealers to provide investors with a notice

of their privacy policies and practices. The rules also describe the

conditions under which broker-dealers may disclose nonpublic personal

information about a consumer to nonaffiliated third parties.24 The act also

requires broker-dealers to implement procedures to protect the privacy of

nonpublic customer information. SEC’s examination of 38 on-line firms

found that these broker-dealers implemented a variety of measures to

address customer privacy and confidentiality. However, on-line investors

have complained to SEC that their broker-dealers inappropriately released

personal account information.

Nine of the 12 on-line broker-dealers we contacted included information

about the firms’ privacy policies on their Web sites.25 However, at the time

of our review, the privacy policies generally stated only that the firms do

not rent or sell customer information to independent vendors. Officials

from four of these firms said they might share this information with

affiliated vendors offering related financial services that might be of

interest to their customers, such as mortgage companies, banks, and

mutual funds.

Also, three of the on-line broker-dealers generally provided their

customers information on how the firms internally use customer data, on

whether customers have a choice about how the firm uses their data, and

on what procedures firms use to protect the confidentiality of the data.

The remaining nine firms had not yet provided such information to their

customers.

To determine how well on-line broker-dealers protected customer

information, SEC reviewed the adequacy of password protections adopted

by on-line broker-dealers.26 It found that all of the firms used at least one

level of password protection to restrict access to their on-line trading

systems. This level of password protection requires a customer on a firm’s

Web site to enter a password before gaining access to the trading site. Few

firms required customers to periodically change their passwords. SEC also

found that five on-line broker-dealers used a second level of password

 

24Financial data can be gathered on-line from customers or from potential customers, which then could

be used for possible marketing purposes. For example, financial information obtained by brokerdealers may provide allied businesses opportunities to solicit customers for potential banking services.

25Officials from the three remaining broker-dealers told us they did not yet have written policies in

place, but were using informal internal policies.

26SEC also reviewed other security measures, such as the use of firewalls and encryption.

On-line Brokerages Did Not

Generally Inform Investors

About the Privacy of Their

Data
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protection that requires the customer to enter another password to submit

a trading order. SEC staff concluded that double-layer password

protection can reduce the likelihood that trades will be either accidentally

or intentionally entered without the customer’s consent. However, they

said even these protections can be overcome by computer hackers.

In addition, SEC found that 22 of the 38 on-line broker-dealers it examined

tested the efficacy of their security systems on preventing unauthorized

access. The firms either conducted their own tests or contracted with

outside security consultants. Some tested their systems daily or when

system changes occurred. SEC staff stated that without regular and

comprehensive testing, broker-dealers could not ensure the integrity of

their on-line trading systems for use by the public. However, recent events

showed that even testing may not make brokers’ systems immune from

outside disruption. In February 2000, some of the major on-line brokerdealers’ systems were targets of attacks by hackers on a number of

popular Web sites. These attacks, called denial of service attacks, made

the on-line brokers’ trading systems unavailable to their customers for as

much as an hour or more.

SEC and NASDR are addressing investor complaints involving

inappropriate securities trading, misuse of personal information, and

unauthorized access to trading accounts. Some of these complaints

involved four on-line broker-dealers in our review. For example, one

customer reported that his firm gave him a user identification number and

password to gain access to his trading account. However, the account

accessed using this information belonged to another customer and

contained over $400,000. In their customer agreements, some on-line

broker-dealers specify that should theft or other financial loss occur due to

breaches in security or confidentiality, they may not be held liable

regardless of who the responsible party is. SEC staff told us that

arbitrators or the courts would ultimately determine the validity of such

disclaimers.

NASD and SEC recommend that on-line broker-dealers inform their

customers about the various risks of securities trading, such as the

differences between limit and market orders,27 the effect of these different

orders on trade executions, and the effects of trading volume on trade

executions. SEC staff stated that investors need this information to fully

 27With a limit order, investors can establish the maximum price they are willing to pay for a stock or the

minimum price at which to sell the stock. With a market order, the trade is executed as fast as possible

without regard to price.

On-line Brokerages Did Not

Always Disclose Risks

Related to On-line Trading

on Web Sites.
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understand the risks of on-line trading or of securities trading in general.

The firms we contacted provided some of these disclosures, but they

disseminated the information in various ways and did not always include it

on their Web sites.

Seven of the 12 on-line broker-dealers we contacted generally disclosed

information to their customers in each of the recommended categories,

either on their own Web sites or by providing a link to the Web sites of

securities regulators, which also contained this information. Three firms

provided their customers some, but not all, of the recommended

disclosures; and two—one small and one major firm—provided no

disclosures to their customers on their Web sites. Officials from one of

these two firms told us that because they had to work with a vendor, it was

too burdensome to have this information placed on their Web site.

Officials from the other firm told us that they mail this information to their

customers.

All of the 12 on-line broker-dealers we contacted provided customers other

information about securities trading on their Web sites. For example, some

firms offered a glossary of investment terms, answers to frequently asked

questions, letters and speeches by regulators, and links to guides on

personal investing. Other firms provided more extensive education

programs for their customers. One established an “institution for higher

learning” on its Web site and offered a free on-line curriculum about

securities investing. Another provided simulated trading accounts for

practice in on-line trading.

Despite these efforts, SEC staff told us many on-line trading complaints

came from investors who lacked knowledge about securities trading. For

example, SEC staff said that they received many complaints from investors

who wanted to know more about initial public offerings (IPO), especially

how firms allocated IPO shares and the total amount of shares available.28

SEC staff stated they are planning to offer guidance to on-line brokerdealers on disclosure of IPO allocation and on-line distribution methods.

SEC staff also stated that broker-dealers offering IPO shares to on-line

investors should provide clear and meaningful disclosure about the on-line

distribution of IPO shares, including their allocation methods and any

restrictions on share distributions. The eight on-line broker-dealers that

offered IPOs did not generally provide information on their allocation

methods, the probability of any one customer receiving shares, or the

 

28An IPO is a firm’s first offering of stock to the public. IPOs appeal to investors because in recent years

the prices of some IPOs have risen rapidly on the first day of trading.
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number of shares to be allocated to the firms. Instead, some of these

broker-dealers informed investors that a limited number of shares were

available or presented data on the total number of shares offered to the

industry as a whole. SEC staff have stated that investors, especially those

new to trading, could mistakenly assume that the on-line brokerage firm

had sufficient IPO shares available for purchase.

The 12 on-line broker-dealers we contacted generally routed their

customers’ orders to third-party broker-dealers who guaranteed to fill the

orders at the best prices available at the time they were received or at least

the national best bid or offer (NBBO) price.29 As a result, the quality of the

execution of their trades was dependent on the third-party broker-dealer.

Determining whether investors were getting the best possible executions

of their orders was difficult because the quality depended on a number of

factors, such as price, speed, and the likelihood of execution. SEC, NYSE,

and NASD require broker-dealers to obtain the best execution reasonably

available under the circumstances for their customer orders, and SEC’s

review of the execution practices at 29 on-line broker-dealers indicated

that over half were not meeting their duty to ensure best executions. SEC

sent deficiency letters to those firms that failed to meet their best

execution obligations to get the firms to take corrective actions. On-line

investors can take steps to ensure quality trade executions, such as

specifying where they want their trade to be executed, but eight firms we

contacted did not provide this information to their customers. SEC staff

said that this may require customers to call the firm to specify where they

want their order executed. They also said that this is a very complex issue,

and a typical investor may not currently know how to make this decision.

Officials from one firm said they did not want to overwhelm their on-line

customers with information on the Web site. Those from another firm said

this issue is complicated, and if customers needed more information they

could call the firm.

When customers submit orders to on-line broker-dealers, the firms decide

where to send the orders. They can send the orders to exchanges, such as

NYSE, Chicago, or Philadelphia; Electronic Communications Networks

(ECN), which electronically link buy and sell orders; or over-the-counter

market makers. The on-line firm itself could also act as a market maker

and execute the orders out of the firms’ own inventory—known as

 

29The best bid is the highest priced buy order, and the best offer is the lowest priced sell order in the

market at a point in time. Although NYSE and Nasdaq are the primary market centers for stock trades,

trades can also occur in other marketplaces. For example, Electronic Communication Networks

(ECNs) traded nearly 10 percent of the volume of Nasdaq-listed stocks as of March 1999. The best buy

and sell prices listed on any of these marketplaces would be the NBBO.

Some On-line Brokerages

Had Problems Ensuring

Quality Execution of

Trading Orders

On-line Broker-Dealer

Customers Do Not Have Direct

Access to the Markets
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internalizing order flow. The on-line firm could also route orders to its

clearing firm, which would generally execute orders from the clearing

firm’s own inventory or through other firms that quote prices to buy and

sell particular stocks.

Ten of the 12 on-line broker-dealers we contacted said they routed the

majority of their customer orders for Nasdaq-listed stocks to market

makers. Officials from five firms said they used a single market maker, the

rest used as many as nine market makers. The particular market maker

chosen depended on parameters programmed into the firms’ trading

system software, such as the type or size of the order or payment for order

flow. Three firms routed Nasdaq orders to ECNs. The 12 firms generally

routed NYSE-listed orders to either the Chicago or Philadelphia

Exchanges, or both.

When third-party firms or exchanges receive orders from an on-line

brokerage firm, they generally fill the orders from their own inventories at

NBBO prices. Although this price is the best price displayed at the time of

the order, it may not be the best price available at the time of the trade.

Because the orders are filled internally, other market participants, such as

market makers or specialists, do not see them and, thus, do not have a

chance to better the NBBO price. SEC staff stated that routing order flow

for execution at the NBBO does not necessarily satisfy a brokerage firm’s

duty of best execution for retail-sized orders.30

SEC requires broker-dealers to seek the most advantageous terms

reasonably available under the circumstances for a customer’s trading

order. These circumstances include price, speed, and the likelihood of

execution, among others. SEC has not promulgated a separate best

execution rule or explicitly defined best execution. Traditionally, price has

been the predominant factor in determining whether a brokerage firm has

satisfied its best execution obligations. This position was reiterated in

1994.31

In 1999, in its examinations of the trade execution practices of 29 on-line

broker-dealers, SEC found that 17 firms improperly emphasized “payment

for order flow” in deciding where to send orders, rather than considering

factors that could benefit trade executions, such as the best price.

Payment for order flow occurs when a market maker, ECN, or an

 

30Retail size trading orders can vary up to 10,000.

31SEC Exchange Act Release No. 37619A (Sept 6, 1996), 61 Fed Reg. 48,290.

SEC Has Found Problems With

Broker-Dealers Meeting Best

Execution Requirements
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exchange pays an on-line brokerage firm for its orders. The payments

could include rebates of up to 1 or 2 cents a share and credits or discounts

against fees charged for executing the order. Broker-dealers might also

receive a portion of the profits made by the market maker.32 Thus, SEC

found that the 17 firms, including 6 that we contacted, were not ensuring

that their customers’ trades received the best execution possible. The

firms did not evaluate execution quality available from other competing

market makers in making order routing decisions.33 Instead, most of them

routed orders to market centers whose execution quality, or percentage of

trading orders that received price improvement, were well below industry

averages. In response to SEC’s findings, 7 of the 17 firms claimed the data

used by SEC to identify these problems were flawed, or that their clearing

firms were responsible for ensuring execution quality. However, the firms

supplied the data SEC used to make its determinations; and according to

SEC, the firms are ultimately responsible for ensuring that their customers

receive best execution. SEC staff sent each firm a deficiency letter and

plan to focus future examinations on broker-dealers’ best execution

obligations.

Officials from five of the on-line broker-dealers we contacted told us they

emphasized speed and liquidity—the ease with which the market can

accommodate large volumes of securities trading without significant price

changes—over price improvement in providing their customers the best

trade executions. According to SEC officials, these factors can be

considered as long as the brokerage firm conducts a regular and rigorous

evaluation of the quality of the different market makers trading in a

particular security.34 However, SEC found that 17 broker-dealers were not

taking the steps necessary to determine whether other market centers

offered faster execution or executions that were just as fast but had a

greater likelihood for price improvement. SEC also identified these

problems in its deficiency letters and plans to focus future examinations

on broker-dealers’ best execution obligations.

Officials from 3 of the 5 on-line broker-dealers that emphasize speed of

execution explained that many investors were not willing to wait to get an

 

32Six of the 12 firms in our review disclosed in their customer account agreements that they could

receive payment for order flow.

33Some of these problems may be mitigated as changes in market structure occur, such as centralizing

securities prices and orders or changing to decimal trading with the prospect of penny differences

between offers to buy or sell stock.

34Exchange Act Release No. 26870 (May 26, 1989) 54 Fed. Reg. 23,963 (1989); Exchange Act Release No.

34,902 (Oct. 27, 1994), 59 Fed Reg. 55,006 (1994).
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opportunity for a price improvement of 1/8 or 1/16 on a specific stock in

order to save a few pennies on a trade. However, the Chairman of SEC said

in a November 1999 speech that retail investors might be willing to give up

a few seconds if it meant receiving more money on the sale of a stock or

saving money on the purchase of stock. He explained that if a brokerage

firm receives payment for order flow from a market maker at the rate of a

penny a share on a 1,000-share order, the brokerage firm gives up the

possibility of obtaining price improvement from another market maker. A

price improvement of 1/16th on a 1,000-share order would mean that the

customer has overpaid by $62.50.

In its examination of on-line broker-dealers, SEC found that six brokerage

firms we contacted were not fulfilling their best execution duty. Officials

from five of the six firms told us that they have implemented

improvements to help ensure that investors receive the best price for a

stock. These improvements included establishing execution quality

committees to monitor trade executions on a weekly basis, implementing

software programs that automatically flagged trading orders executed

outside of the bid and ask price of stocks, and requesting price

improvement data from other market centers. Officials from one major

firm that did not implement any specific measures told us that execution

quality was the responsibility of the broker-dealer executing the trades,

which was contrary to SEC’s view. They also said that they respond to

complaints made by individual investors on execution quality.

On-line investors can also take steps to help ensure quality trade

executions. In its on-line trading examinations, SEC found that many online broker-dealers would accommodate a customer’s request to route an

order to a specific market center, although the customer would likely be

charged higher commission fees. Investors may be able to offset the higher

fees by getting better prices for their trades. Eight of the 12 firms in our

review did not provide this information on their Web sites or customer

account agreements. The Chairman of SEC said investors would benefit

greatly from more information about execution quality. SEC staff said they

are considering what additional information on trade execution could

benefit investors and in what form that information should be provided.

When broker-dealers or registered representatives recommend specific

securities to investors, securities rules make them responsible for

determining whether the potential investment is suitable for those

investors. Officials from the on-line broker-dealers we contacted reported

that they do not provide their customers the type of specific stock

recommendations that would trigger the suitability requirements.

Firms Are Addressing Best

Execution Problems

Suitability Considerations

Are Not Clear in the On-line

Trading Environment
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However, the suitability rules may begin to apply as these firms develop

information tailored to individual investors.

NASD first adopted suitability rules in 1939 as part of its Rules of Fair

Practice. Currently, NASD’s suitability rules require member brokerdealers to make reasonable efforts to obtain and document the data they

use or consider in determining whether their recommendations are

suitable for their customers. The data are to include customers’ financial

and tax status and investment objectives. Other SROs have similar rules

that are grounded in concepts of professionalism, fair dealing, and just and

equitable principles of trade. For instance, NYSE’s “Know Your Customer

Rule” requires members to use due diligence to learn the essential facts

relative to every order, cash or margin account accepted, and every person

holding a power of attorney over any account.35 In addition to customerspecific suitability, firms must have a reasonable basis for believing that a

particular security being recommended is appropriate for any investor. To

have such a reasonable basis, firms must perform due diligence on the

security to be in a position to recommend the security to a customer.36

Each of the 12 on-line broker-dealers in our review either displayed

disclaimers on their Web sites or told us that they do not offer advice on

the suitability of particular investments or “recommend” specific stocks to

individual customers. However, suitability determinations depend on the

facts and circumstances relative to every customer, and these brokerdealers provided a wide range of information to their customers. They

offered their customers investment and research reports prepared by

unaffiliated companies that contained recommendations for thousands of

stocks, and they linked these reports to their Web sites. In addition, some

firms we contacted charged their customers for general stock

recommendations by specific industry or risk category. Officials from

several firms told us their investment research services are the same tools

used by professional brokers. An SEC commissioner expressed concern

about whether this research raises suitability issues because investors

might assume that information posted on firms’ Web sites is a

recommendation by the brokers.

In addition to research from unaffiliated companies, 2 of the 12 on-line

broker-dealers we contacted offered their customers research information

from the firm’s analysts. An SEC official told us that suitability

 35All of the 12 on-line broker-dealers we contacted were members of NASD, and 4 were also NYSE

members.

36Hanley v. SEC, 415 F. 2d 589, 596 (2d. Cir. 1969).
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requirements typically have not applied to analysts’ recommendations

unless the recommendations are brought specifically to the attention of

individual investors. However, a legal expert on securities trading told us

that some type of suitability obligation might apply when broker-dealer

analysts prepared the research provided to on-line investors. Officials from

four on-line broker-dealers generally agreed, especially, as one official

said, when a firm’s own research is the only information provided on the

Web site. All of the on-line broker-dealers we contacted used disclaimers

on their Web sites or in customer account agreements that the research

service they offered should not be used or considered as a

recommendation to buy or sell a particular security. Such a

recommendation might trigger suitability requirements. SEC staff told us

that broker-dealers could not use such disclaimers to make their

customers waive their rights under federal securities laws.

Further, two on-line broker-dealers offered their customers access to

personalized messages about particular stocks through chat rooms and

bulletin boards. Chat rooms and bulletin boards include participants’

opinions about specific stocks. These firms also sponsor “live events” in

their chat rooms that present financial analysts who sometimes

recommend specific stocks in response to customer questions. SEC staff

expressed concern that investors may believe that the on-line firms had

endorsed the recommendations. In a series of roundtable discussions SEC

held with broker-dealers in 1999, many participants favored additional

guidance from SEC on what types of information and what delivery

mechanisms might trigger suitability responsibilities. SEC staff told us they

are reviewing which on-line trading activities might require suitability

determinations.

NASD regulations on advertising require firms to portray the risks and

rewards of investing on-line in an honest, fair, and balanced manner.

Eleven of the 12 on-line broker-dealers we contacted plan to collectively

spend about $1 billion on advertising to attract new on-line customers

during 2000. Because of the volume of advertising for securities trading in

general, overseeing the quality of on-line trading advertising has been

difficult. In early 1999, NASDR found that firms engaged in extensive and

aggressive advertising campaigns had minimally complied with advertising

regulations. Later in 1999, SEC found improvements in the quality of

advertising by on-line broker-dealers. However, NASDR reported that it

plans to monitor advertising by on-line broker-dealers more aggressively.

An NASDR official told us that NASD’s review of television advertising by

on-line broker-dealers in early 1999 found that firms’ use of expensive

Regulators Plan More

Extensive Oversight of

Advertising for On-line

Trading
B-283098

Page 29 GAO/GGD-00-43 Better Investor Protection Information Needed

material goods in advertisements or suggestions about investment returns

portrayed unrealistic expectations about opportunities to profit through

on-line trading. For example, in its advertising campaign one firm showed

a person trading on-line in a mansion. Another firm’s ad had “Al the tow

truck driver” telling a passenger about the island that he now owned due to

trading through his on-line broker-dealer. In another ad, a jogger

sheepishly admits that she still invests in mutual funds in response to a

friend who boasted that she had just made $1,700 in an on-line trade. This

ad may be demeaning to those who would invest in mutual funds. Rather

than taking formal enforcement actions against these firms, NASDR

negotiated the voluntary withdrawal of certain misleading advertising

campaigns. NASDR also sponsored three advertising roundtables between

June and July 1999, at which the legal and ethical responsibilities of

broker-dealers who promote on-line trading were discussed.

SEC’s mid-1999 review of on-line broker-dealer advertising found that

firms have begun to modify their advertisements. For example, two on-line

broker-dealers had televised ads that communicated the risks associated

with on-line trading in a volatile market. One of these firms instructed

investors not to view on-line trading as playing the lottery, and the other

firm suggested that investor education was important in on-line trading.

To prevent misleading advertisements, NASD rules require compliance

personnel at member firms to approve advertisements before they are

used and to submit certain marketing material and sales literature to

NASDR. NASDR rules do not require that firms submit all advertisements.

Officials from many of the firms told us they sent advertising materials for

NASDR review only when they were concerned about the content of the

advertising. NASDR officials told us that they review all of the advertising

submissions.

In September 1999, NASDR announced plans to adopt more aggressive

oversight and investigation of possible rule violations for television

advertising. NASDR monitors advertisements for on-line trading and works

with other regulators and NASD members to educate the investing public.

If firms are required to file advertisements, NASDR also plans to require

members to file a final filmed version of a television or videotape

advertisement within 10 days of its first use or broadcast.

The on-line trading segment of the securities industry is growing and

evolving rapidly. What began as primarily an order entry system has

evolved into a myriad of on-line services and programs to help investors

independently plan and track their investments, including allowing them to

Conclusions
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engage in more risky strategies, such as margin trading and IPOs. Industry

analysts expect the growth in on-line trading to continue.

On-line trading has generated many benefits to individual investors, such

as reduced commission costs to trade securities and free research and

other investment tools that had previously been available only to

professional brokers and institutional investors. However, on-line

investors have also experienced problems, such as trading system delays

and outages. On-line broker-dealers neither consistently monitor these

disruptions nor disclose that such disruptions could occur. Maintaining

consistent records about delays and outages could provide the brokerdealers information that could be used to better inform investors about the

potential for, and adverse effects of, delays and outages. The information

could also assist securities regulators in assessing whether these brokerdealers comply with SEC guidance on maintaining adequate system

capacity.

Investors might be able to find all the information they need about how to

trade on-line and the risks of doing so from a combination of sources,

including their broker-dealers’ Web sites or written material, regulators’

Web sites, or other Internet sources. However, on-line investors make their

trades on the Web sites of their broker-dealers, and regulators and industry

members agree that this is the best place to provide the information online investors need. Some Web sites of on-line broker-dealers were

incomplete or missing key pieces of information in the investor protection

areas of margin requirements, privacy considerations, risk disclosures, and

trade executions. As SEC complaints have shown, many on-line investors

may not understand the risks they are taking or the rules and procedures

for trading. Providing complete information on the Web sites of on-line

broker-dealers could help investors make more informed investment

decisions.

We recommend that the Chairman, SEC, require broker-dealers with online trading systems to maintain consistent records on systems delays and

outages and their related causes and to disclose the potential for service

disruptions on their Web sites. We also recommend that the Chairman

monitor these records to ensure that firms have adequate capacity to serve

their customers.

We also recommend that the Chairman, SEC, ensure that broker-dealers

with on-line trading systems include accurate and complete information on

their Web sites in the key investor protection areas of risk disclosure,

margin requirements, privacy considerations, and trade executions.

Recommendations
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SEC provided oral technical comments on a draft of this report, which we

have incorporated where appropriate. In addition, SEC provided written

comments (see app. II) in which it said it appreciated our thoughtful

recommendations in this new and evolving area. SEC highlighted the

actions it has taken, or plans to take, in each of the areas we discuss in our

report, and said it believed these efforts were responsive to our

recommendations. For example, it said the Chairman has actively

encouraged on-line brokers to use their web sites to better inform

customers and SEC would continue to focus broker-dealer examinations

on best execution. SEC also plans to closely monitor adherence by the

firms to privacy rules when they go into effect. These examples show that

SEC is working to increase the information available to investors in the

areas we identified. However, we continue to believe that on-line investors

need to be able to access this information directly on their brokers’ Web

sites. We also believe that SEC, through its examinations,

recommendations, and rule proposals, can help ensure that on-line brokers

provide such information.

SEC noted that it has published recommendations and proposed rules

addressing on-line systems’ capacity, vulnerability, and operational

capability. SEC also said it often includes an assessment of system

capacity and reliability in its examinations of both on-line and traditional

brokers, including reviewing records on system delays and outages and

their causes. However, these activities do not address variations in the

methods firms use to track delays and outages, or the disclosure of the

potential for disruptions on firms’ Web sites. This makes it difficult for

investors to understand the potential limitations of on-line trading systems

or compare system performance for various on-line brokers. Therefore,

we believe SEC should have broker-dealers with on-line trading systems

maintain consistent records on delays and outages, which includes

defining at what point a trading system disruption is considered an outage.

We also believe that SEC should have broker-dealers inform customers of

their track record for trading system disruptions, and the potential for

these occurrences.

NASD and NYSE provided oral technical comments on a draft of this

report, which we have incorporated where appropriate. NASD also

provided written comments (see app. III) in which it said our report

provides insight into the public policy issues relating to on-line trading that

will be helpful in illuminating several important on-line trading issues.

NASD also mentioned it created a new page on its Web site directed to online investors.

Agency Comments and

Our Evaluation
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As we agreed with your offices, we plan no further distribution of this

report until 30 days from its issuance date unless you publicly release its

contents sooner. We will then send copies of this report to Representative

Tom Bliley, Chairman, House Committee on Commerce; Representative

Fred Upton, Chairman, Subcommittee on Oversight and Investigations,

Representative W.J. “Billy” Tauzin, Chairman, Subcommittee on

Telecommunications, Trade, and Consumer Protection, and

Representative Michael G. Oxley, Chairman, Subcommittee on Finance

and Hazardous Materials, House Committee on Commerce; Senator Susan

M. Collins, Chairwoman, Permanent Subcommittee on Investigations,

Senate Committee on Governmental Affairs; the Honorable Arthur Levitt,

Chairman, SEC; Mr. Frank Zarb, President and CEO, NASD; and other

interested committees and organizations. Copies will be made available to

others upon request.

Major contributors to this report are acknowledged in appendix IV. Please

call me or Michael Burnett on (202) 512-8678 if you or your staffs have any

questions about the report.

Richard J. Hillman

Associate Director, Financial Institutions

 and Markets Issues
Page 33 GAO/GGD-00-43 Better Investor Protection Information Needed
Page 34 GAO/GGD-00-43 Better Investor Protection Information Needed

Contents

1 Letter

Appendix I 36

Top Ten On-line

Trading Complaints to

SEC, January 1998 to

June 1999

Appendix II 37

Comments From the

Securities and

Exchange Commission

Appendix III 39

Comments From the

National Association

of Securities Dealers

Appendix IV 40

GAO Contacts and

Staff

Acknowledgments

Figure 1: Number of Broker-Dealers with On-line Trading

Systems From the Last Quarter of 1997 Through July

1999

8

Figure 2: Number of On-line Trading Accounts From the

Last Quarter of 1997 to May 1999

9

Figure 3: Number of Average Daily On-line Trades From

December 1997 Through March 1999

10

Figures
Contents

Page 35 GAO/GGD-00-43 Better Investor Protection Information Needed

Abbreviations

IPO Initial Public Offering

NASD National Association of Securities Dealers

NYSE New York Stock Exchange

SEC Securities and Exchange Commission

SRO self-regulatory organization
Appendix I

Top Ten On-line Trading Complaints to SEC,

January 1998 to June 1999

Page 36 GAO/GGD-00-43 Better Investor Protection Information Needed

Source: SEC Office of Investor Education and Assistance.
Appendix II

Comments From the Securities and Exchange

Commission

Page 37 GAO/GGD-00-43 Better Investor Protection Information Needed
Appendix II

Comments From the Securities and Exchange Commission

Page 38 GAO/GGD-00-43 Better Investor Protection Information Needed
Appendix III

Comments From the National Association of

Securities Dealers

Page 39 GAO/GGD-00-43 Better Investor Protection Information Needed
Appendix IV

GAO Contacts and Staff Acknowledgments

Page 40 GAO/GGD-00-43 Better Investor Protection Information Needed

Richard J. Hillman, (202) 512-8678

Michael A. Burnett, (202) 512-8678

In addition to those named above, Denise Callahan, Robert Pollard, Kate

Mannen, and Don Yamada contributed to this report.

GAO Contacts

Acknowledgments
Page 41 GAO/GGD-00-43 Better Investor Protection Information Needed
Page 42 GAO/GGD-00-43 Better Investor Protection Information Needed
Page 43 GAO/GGD-00-43 Better Investor Protection Information Needed
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