E-trading Case Essay Example for Free

E-trading Case Essay Introduction Perhaps nowhere else is the impact of the Internet felt as much as in the service sector. The Internet has opened new channels for service delivery, shortened turnaround limes and offered unprecedented convenience to consumers. The financial services have leveraged the Internet and exploited its many benefits. E-trading is the financial service most amenable to E-enablement. It has already witnessed a meteoric growth in the United States and is staging a similar show in other economies.   E-trading offers tremendous benefits to the investors and will probably expand the market itself. This paper discusses issues of E-trading, its evolution and key characteristics. Then it examines scope of E-trading, significant players and groups involved in. After that discussion about benefits of E-trading, either for users or for brokers, technology and security issues related to this industry. And finally some insight in future of E-trading is presented. Evolution of the Industry The first ever ECN, Instinet, founded in 1969, was a means for brokerages lo display bid and ask prices for stock in North America and abroad. It was first used by institutions to transact with each other, but today ii also includes a select group of smaller brokerages. However, e-brokerage, or offering Internet transactions to clients, was pioneered in the by E*Trade securities (FreeTrade), one of the firs of all-electronic brokerages, which first started operations and offered online investing services through America Online and CompuServe and launched its own website, www.etrade.com, in 1996. The first E-trade was conducted on E*trade on July 11, 1983 and since that time has changed the way the world invests. Charles Schwab, now the largest in the US with 7 million on-line accounts and $1 trillion under management via the Internet, also launched its online trading venture in 1996. In January 2005, Charles Schwab clients executed an average of 300,000 electronic trades every working day. (www.aboutschwab.com) There are now more than 130 millions on-line brokerage firms in the US (Exhibit 1) offering E-trading services to consumers, who can be physically located anywhere on Earth. Today, about half of transactions made by US retail investors are done through the Internet. In fact, there is a range of websites on which one can not only trade stocks online but also buy and sell futures and options. According to International Data Corp the number of US households using online brokerage to meet their financial needs has grown from the 2000 figure of over 7 million to 19 million in 2004, with over $2.5 trillion of assets managed online. (Tower Group Research) Online brokerage in the US grew out of the discount brokerage industry and has fundamentally changed the retail brokerage industry. Online trading developed as a low-cost self-service approach to equity investing. Rather than paying high commissions that are typical of full service brokerage firms, investors could place trades directly at a fraction of the usual commission costs. In addition, online trading was more efficient and less costly than telephone trading a common channel used by discount firms. As a result, online brokers began competing on cost. (Colkin Cuneo) Exhibit 1 Online commission prices that started at between US$25 and $30 per trade have been cut significantly over the years. Currently, average online commission price per trade hovers around $12-15, and some deep discount firms offer trades as low as $5. A few firms—American Express, Free Trade, Com1 (a subsidiary of AmeriTrade), and most recently, thefinanciatcafe.com—have even introduced free online trading. (thefinancialcafe.com) The online commission pricing battle demonstrates the commoditization of online transactions. Initially, price may have been a differentiating factor, but currently, price alone is not sufficient for attracting and retaining individual investors (excluding the day-trading segment). Online brokerage firms must seek to provide greater services and support to clients. The number of US online brokerage accounts continues to grow consistently. After an initial period of astounding growth, the number of online brokerage accounts is still steadily increasing. (Tower Group Research) E-trading Scope The term E-trading stands for trading in equity or debt instruments on the exchange through an Electronic Communication Network (ECN). Although online trading strictly refers only to the electronic execution of trade, an ecosystem of E-trading has three dimensions: Electronic execution of the trade Payment for the transaction through a payment gateway Transfer of shares in electronic form. There have been three distinct phases of development of E-trading. These are: Phase 1: The open-outcry system with the transactions taking place manually in the ring Phase 2: The electronic system, enabling brokers to place orders online Phase 3: The E-trading system, empowering customers to transact online. The mechanics of the E-trading system begin with the user logging onto the ECN through the Internet. The user then accesses his E-trading account with the help of a password. The user is now connected directly with the exchange and any transactions would be instantaneous and irrevocable. The user also has access to real-time price movements of various scrips and other contextual information to assist him in his decision. An integrated E-trading system consists of not only a transaction enabler but also a payment gateway for funds transfer and a d-mat account for transfer of stocks. Such a service enables smooth, convenient and transparent operations. E-trading model is based on the proposition that a service which does not require sophisticated skills, is standardized, has a wide geographic spread of clients and a high number (statistic) of clients who use the service very frequently (scope) and whose automatable processes account for a high proportion of costs (savings), offers the best potential for E-enablement. Using this framework, it becomes clear which financial services are amenable to E-enablement (Colkin Cuneo): Corporate banking: The corporate banking industry involves understanding client needs, analysis of the project proposal, evaluation of various alternatives and finally recommendation of a suitable alternative. The task involves high-level skills, is not highly standardized and not amenable to automation. The number of clients per entity, i.e. the corporate customers, of a bank is limited, though the geographic spread may be diverse. The frequency of transactions is also limited. Thus, corporate banking does not seem to be amenable to E-enablement. Investment banking: For the reasons cited above, investment banking, like corporate banking, does not appear a suitable subject for E-enablement. Retail banking: The retail banking industry comprising credit-cards, management of savings accounts etc. is characterized by a large number of clients spread geographically utilizing a simple, repeatable and standardized service. For servicing the customer specialized-skills are not required and automatable processes comprise a significant proportion of the overall costs of service. Using the framework, it appears that retail banking would be highly amenable to E-enablement. Stock trading: A stockbroker collates orders from various customers and executes the same through a trading terminal. Customers typically place orders through the telephone and a representative of the broker executes the order on behalf of the client on the trading terminal. The skill-set used by the representative is not highly specialized as the action being considered is only the execution of the order and not client advisory. While other processes such as risk monitoring, exposure monitoring and client monitoring are also involved, they are typically automated for effectiveness. Thus, the broker acts purely as a manual interface between the client and the exchange. The task performed by the broker is simple, standardized and easily repeatable. Given that the frequency of transactions by the customers is at least moderate if not high, there is a significant scope for reduction in overall costs through automation. The geographic span of the clients is also widespread. All these characteristics make trading highly amenable to E-enablement. (Berber) Significant Players and Groups Involved OnlinÐ µ invÐ µsting bÐ µgan in thÐ µ US and is a big businÐ µss thÐ µrÐ µ. In thÐ µ first quartÐ µr of 2004, thÐ µrÐ µ wÐ µrÐ µ approximatÐ µly 25 million onlinÐ µ invÐ µstors with ovÐ µr US $ 4 trillion in assÐ µts. In yÐ µar 2002, 14 million onlinÐ µ invÐ µstors with an assÐ µt basÐ µ of US $ 700 Billion were activÐ µ. ThÐ µ markÐ µt lÐ µadÐ µrs arÐ µ a mixturÐ µ of full sÐ µrvicÐ µ firms (DLJ DirÐ µct, Morgan StanlÐ µy DÐ µan WittÐ µr, DiscovÐ µr), wÐ µll-Ð µstablishÐ µd discount brokÐ µrs (FidÐ µlity and CharlÐ µs Schwab) and nÐ µw on-linÐ µ spÐ µcialist firms (Е*TradÐ µ). MarkÐ µt SharÐ µs, in tÐ µrms of onlinÐ µ trading volumÐ µs, arÐ µ such that just 9 on-linÐ µ brokÐ µrs havÐ µ 86 pÐ µr cÐ µnt of thÐ µ markÐ µt sharÐ µ. Individual InvÐ µstors havÐ µ to opÐ µn an account with a firm bÐ µforÐ µ commÐ µncing trading and thÐ µ minimum account opÐ µning balancÐ µ rangÐ µs from US $ 500 (with Jack WhitÐ µ and Company) to US $ 10,000 (with Wall StrÐ µÃ µt AccÐ µss, IntÐ µrnÐ µt Trading Com and J B Oxford). (Tower Group) AnothÐ µr important fÐ µaturÐ µ that attracts on-linÐ µ invÐ µstors is thÐ µ frÐ µÃ µ rÐ µsÐ µarch providÐ µd by thÐ µ on-linÐ µ firms. PrÐ µviously this was availablÐ µ only to largÐ µ institutional invÐ µstors. In addition to fundamÐ µntal information about stocks, bonds and mutual funds sophisticatÐ µd tools likÐ µ tÐ µchnical analysis rÐ µports and charts arÐ µ also availablÐ µ for frÐ µÃ µ. SomÐ µ of thÐ µsÐ µ arÐ µ also customizablÐ µ, Ð µithÐ µr fully or partly. ThÐ µ problÐ µm for invÐ µstors is onÐ µ of information ovÐ µrload and how to absorb all thÐ µ information providÐ µd as wÐ µll as analyzÐ µ and act upon it. RÐ µcognizing this nÐ µÃ µd somÐ µ firms havÐ µ takÐ µn concrÐ µtÐ µ stÐ µps to summarizÐ µ and focus thÐ µ information to mÐ µÃ µt with individual rÐ µquirÐ µmÐ µnts. PricÐ µ alÐ µrts arÐ µ a standard fÐ µaturÐ µ with most brokÐ µrs. (Berber) ThÐ µ nÐ µw on-linÐ µ brokÐ µrs do not havÐ µ any lÐ µgacy systÐ µms and in spitÐ µ of making hÐ µavy invÐ µstmÐ µnts in tÐ µchnology (which is thÐ µ backbonÐ µ of any on-linÐ µ trading systÐ µm) havÐ µ vÐ µry low transaction costs, typically about lÐ µss than 10% of full sÐ µrvicÐ µ brokÐ µrs cost.   ThÐ µ Ð µxisting discount brokÐ µrs likÐ µ CharlÐ µs Schwab who startÐ µd offÐ µring on-linÐ µ trading did so by Ð µstablishing a sÐ µparatÐ µ division for Е-trading rathÐ µr than risk thÐ µ wholÐ µ organization. ThÐ µ main worry for thÐ µsÐ µ brokÐ µragÐ µs has bÐ µÃ µn thÐ µ rÐ µlations and businÐ µss prospÐ µcts of thÐ µir Ð µxisting salÐ µs forcÐ µ of brokÐ µrs. (www.aboutschwab.com) Benefits of E-trading Switching over to E-trading results in several benefits, both to the user and to the broker. Benefits to Users Lower transaction costs: Typical brokerage-rates in India are in the range 1.0-1.5%, whereas the rates for E-trading are as low as 0.1 %. E-trading brings down costs of not only the execution of the transaction but also the transfer of securities. In physical purchase of securities, the stamp duty rates are 0.5% of the value of the shares. With dematerialization of securities, the stamp duly charges are not applicable, in the US, brokerage costs before E-trading was introduced were as high as 7%, and have now come down to about 1%.(Colkin Cuneo) Transparency: E-trading empowers the customer to transact directly on the stock exchange. It delayers the process thereby improving transparency. The user does not need to rely on the brokers word-of-mouth or transaction slips for confirmation of the price at which his trade was conducted. Convenience: Online trading is available at the click of a button » making it much more convenient for the customer to trade. Also, with limit based orders being allowed, customers can place their orders even during the non-trading hours, which are executed at the earliest trading possibility. Procedural benefits: Unlike the earlier scenario, where the customers had to physically go to the broker to complete the formalities of trade i.e. payment/receipt of shares, involving procedural hassles, under the E-trading paradigm, these procedures are done away with. The entire cycle-of-trade i.e. placing the order, transfer of funds and transfer of securities trade is done electronically. Benefits to Online Brokers Easier risk management: Offline brokers collect margins from their clients and establish limits for trading based on the same. This may result in a situation where the broker would have to collect funds after the execution of the trade, exposing the broker to client credit-risk. However, under the online mechanism, the system would first check the status of funds available with the client in his bank account and only then allow the trade to take place. This reduces the exposure of the broker to client-risk. Greater business potential: The new paradigm of E-trading, which allows simple, convenient and transparent transactions may encourage more participants to trade. It is expected that the introduction of E-trading will expand the market itself resulting in better business for brokers. Lower staff costs: Automation of the processes, resulting in reduced requirement of manpower, offers significant cost-savings to the brokers. Technology and Security Issues Technology companies have developed online transaction processing (OLTP) applications that allow real time transaction execution. An extension of the OLTP transaction is the Straight-through Processing technology that allows an application to directly interface with the central system of any market place, without any manual intervention. Straight-through processing technology permits financial software products to directly interact with the stock exchange system by communicating with the exchange market structures. (odysseytec.com) The cycle of E-trading has to pass through three layers: The Client Interface Layer: the front-end The Middle Layer: risk management systems that access data from banks and depository participants (DP), calculate client exposure at that instant, and give the Go/No go advice to the trade. †¢ The End Layer: the back-end, where the accounting modules, pay in/pay out schedules, etc, operate. From a technical perspective, there are three key success factors for E-trading: Scalability and robustness of the trading system: The fundamental difference between the Internet as a transaction medium and the conventional closed user group network is that the Net is a universal platform providing concurrent access to infinite users at any given point in time. Consequently, it becomes imperative for any Net-based application to have a prove capability for scalability and robustness, which ensures the ability to handle and process requests from multiple users at any given point in time. Bandwidth optimization: The application software should demonstrate intelligence in optimizing the available bandwidth by deploying advanced technologies such as streaming. Integration with third party systems: On the Net, with information feeds available from multiple. points, it is prudent to deploy applications that are built on open architecture methodology for interfacing with third party systems. Security Any system to be successful should provide security, reliability and confidentiality of data. This can be achieved through the use of encryption technology before the online trading begins. The exchange must ensure that records maintained in electronic form by the broker are not susceptible to manipulation, and adequate back-ups and storage are available. The security features demanded by regulatory authorities include a unique user identification number and passwords that can be renewed from time to time to prevent hacking by outsiders. The major security requirements of e-broking1 are: Trusted means of authentication over open networks Confidentiality of the transaction Means to ensure integrity of data in transit Means to ensure ruin-repudiation of payment or its receipt. Various security models are adopted to secure e-broking transactions. The commonly employed security models in e-Broking are: passwords. Secure Sockets Layer (SSL), Kerberos, Pretty Good Privacy (PGP), Public Key Infrastructure (PKI), and Custom Implementations. (Odyssey Technologies) Future of E-trading Industry Exchanges across the globe are exploring an alliance that will create a 24-hour global equity market. The NYSE and exchanges from three main time zones—Australia, Tokyo and Hong Kong in the Asia-Pacific; Sao Paulo, Mexico and Toronto in the Americas; and Euronext, the combined Amsterdam, Brussels and Paris exchanges in Europe—plan to form a trading mechanism that will allow trading of the worlds global companies. Each of the partnering markets will retain its brand and form a platform to allow companies with worldwide demand to experience 24-hour trading of their shares. This is expected to lead to a better price discovery on a global basis. (Marlin) The proposed Global Equity Market (GEM) link the trading systems of each exchange to provide a global market structure based on the principles of transparency, self-regulation and agency-auction price discovery. (Angel)   This high-tech linkup of auction markets will create a global pool of liquidity, facilitate global price discovery and provide investors with better access to global stocks. The GEM will address investors appetite for big-capitalized stocks by providing them easier access to stocks not currently available on their local Stock Exchange. The market capitalization of the companies listed on the participating exchanges is expected It) exceed $20 trillion, representing more than 60 percent of the worlds market capitalization. Like the 24-hour Forex market and its electronic network SWIFT, the GEM will have an Electronic Communication Network (ECN), thereby realizing the ultimate potential of E-trading.   (Marlin) Nowadays, the structure of commercial finance is about to change dramatically. In place of the traditional bank-centered model, where institutions call the shots about who gets loans and who carries risk, we are going to see dominant players in their supply chain (companies such as Hewlett Packard or General Electric) use E-trading tools to drive the provision of financial services in the future. Today, companies like HP, GE, GM, and FedEx already exert tremendous influence on their trading partners. Their expressed and inferred capital goods requirements drive billions of dollars in marketing, sales, investment, and product decisions by their global business partners. (Macauley) Emerging E-trading environments will provide an ideal vehicle for investors to get access to transactions at the point of salethrough independent E-trading platforms or direct access to legacy enterprise systems. Their development will drive a major revolution in working capital financing in the United States, and that the funding vehicle is securitization. And there is also belief that the runway to securitization of commercial assets is shorter than one might expect. Securitization is a proven financial technology that is used to fund trillions of dollars of credit card, mortgage, auto loan, and a variety of specialty consumer loans each year. It provides the lowest cost, is the most efficient vehicle for funding large pools of financial assets, and, with modest enhancements, can be adapted to the E-trading environment. With small equity charges, high liquidity, low processing costs, and capital markets pricing, it presents a compelling opportunity for E-traders. (Berber) Today a few triple-A companies like GE are able to fund their own working capital requirements through their captive commercial paper conduits, and finance companies frequently fund their deal flow through third-party conduits (and a thick layer of equity capital). (Kelly) But to do so, there is need to solve several complex problems such as standard risk scoring, transaction capture, and back office processing services. Major initiatives are underway to solve eachand winners will innovatively combine them to create this new marketplace. Ultimately, it expected to see hundreds of billions in capital liberated from de-levered balance sheets of enterprises around the world. Bibliography Macauley, John T. The End of CI Lending. ABA Banking Journal, Vol. 93, 2001 Colkin, Cuneo.   E-trading Hangs On. InformationWeek, Issue 918, (12 Sep 2002):43. Kelly, Susan. The Rocky Road to Corporate E-trading. Treasury Risk Management, Vol. 11 Issue 9, (Oct 2001):55 Berber, Philip. From SOES to E-SOS: The Rise of E-trading, The Fall of Exchanges. Securities Industry News, , Vol. 12 Issue 15, (04 Oct 2000):3 Marlin, Steven. NYSE Aims at E-trading. InformationWeek, Issue 1001, (8 Sep 2004):22 Tower Group Research: Online Brokerage Becoming the Norm: Discount and Full Service Brokers Seek New Ways to Differentiate, July 2004 New York Stock Exchange., The Formation of a Global Equity Market, July 2002 www.nyse.com/content/articles Angel, James J, Consolidation in Global Equity Market, An Historical Perspective, 1998 Odyssey Technologies, PKI for E-broking, www.odysseytec.com E*Trade Website   www.etrade.com Schwab Charles Company Website http://www.aboutschwab.com/schwabcorp/history.html FreeTrade by AmeriTrade Website www.freetrade.com The Financial Cafe.com Website www.thefinancialcafe.com