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The Hidden Costs of Online Investing
Is this popular new practice as efficient as advertised?
by Balasubramanian, Konana, & Menon
- Introduction
- How the Trading Process is Structured
- Implications for Online Trading
- Oversight of Online Trading
- Conclusion
The number of online "do-it-yourself" investors has grown at a remarkable rate since the first electronic brokerage (e-brokerage) opened its virtual doors in 1994. These e-brokerages have attracted over 6 million investors in less than five years, now accounting for over 33 percent of retail stock trades. While the number of online trading accounts represents just 12.5 percent of all accounts, that proportion is expected to increase to 29.2 percent by 2002, as reported in Fortune magazine (October, 1999). The number of e-brokerages has also grown from 12 in 1994 to more than 150 in 1999.
With the increased competition, commissions per trade have fallen dramatically, dropping an average of 50 percent in 1997 and leveling off in 1998. These developments are commonly attributed to the efficiency of "friction-free" electronic markets that lower transaction and information processing costs by reducing human intermediation.
But, how efficient are electronic markets, really? Ratings of e-brokerages typically evaluate ease of use, quality of research, reliability, commission rates, customer service, and reporting. These studies, however, have given insufficient attention to some less obvious factors, including the timeliness of transaction execution and the ability of investors to obtain the "best" prices. These factors heavily influence investors' total transaction costs.
A closer analysis of the online trading process reveals that, in many cases, the only thing that has changed as far as the investor is concerned is the interface, which now involves Web-based interaction. Despite proposed changes in the securities trading process and the introduction of electronic trading systems such as OptiMark, other processes determining market efficiency - order flow, price discovery, and order execution - remain virtually unchanged.
In order to evaluate the true costs of online transactions, we must separate the efficiency "perceived" by investors from the "real" efficiency of the transactions and patterns of information flow beyond the interface itself. To understand the differences between perceived and real efficiency, we've examined how the trading process is structured (often invisible to the investor).
Perceived efficiency is determined largely by information provided by e-brokerages that customers can verify, such as commission rates and research, and is tempered by investors' attitudes about risk and the degree to which they trust online brokerages. In contrast, real efficiency is influenced by market structure and related transactional arrangements. For example, overall cost structures for the investor can differ depending on how intermediaries coordinate among themselves.
How the Trading Process is Structured
Investors using e-brokerages initiate their transactions through Web browsers and the front-end tasks are performed electronically; however, once an order is received, each e-brokerage may process the request differently. Essentially, there are four types of e-brokerages:
- Type 1 - Those trading exclusively on exchanges or other main market centers.
- Type 2 - Those trading with one or more third parties under contract but not on exchanges. It is possible that these firms may trade on exchanges using a differential pricing schedule.
- Type 3 - Those trading with market-makers or on the exchanges depending on the liquidity context.
- Type 4 - Those trading either on exchanges or with (external) market-makers or functioning as principals (or broker-dealers) when executing orders.
So, what is the effect of these different trading strategies on real efficiency? Figure 1 shows the revenues and incurred costs in the trading context. When investors place orders with e-brokers, they incur costs by way of commissions. These costs constitute a revenue source and are the most visible (or observable) from the investor's viewpoint. All other revenue flows and incurred costs usually cannot be observed by the investor. For example, e-brokerages can trade directly on exchanges, thereby incurring costs by way of commissions to the representatives on exchanges. On the other hand, they may complete transactions directly with market-makers and may receive a fraction of the bid-ask spread (or a fixed commission per transaction) as a 'kick-back' from the market-makers for steering orders toward them.
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First, note in Figure 1 that the revenue to the e-brokerage can flow from both the consumer and the market-maker. When investors are poorly informed, e-brokerages can extract larger commissions from the market-makers to compensate for low direct commission-based revenue from each trade. Market-makers themselves can recover the cost of these commissions by operating on a larger bid-ask spread, thereby passing on unobservable transaction costs to the investors as indicated in Figure 1. If the investors are aware of this spread, the market would correct itself to a more efficient structure. The problem, however, is that the spread quoted by market-makers is often unobservable to investors.
Second, the order flow from e-brokerages to specific market-makers is often based on pre-existing contracts between these parties. Some e-brokerages even engage a single market-maker for executing all their trades. In such cases, there is limited competition to obtain best prices for each order, and it is highly likely that the bid-ask spread increases.
With an increasing number of e-brokerages charging minimal or even zero commissions, e-brokerages are more likely to seek revenue from other sources, including payment for orders. In such cases, investors need to be sensitive to the unobservable costs that may be incurred on account of the opportunistic behavior of e-brokerages and market-makers.
Implications for Online Trading
Online trading also engenders some changes in the traditional investing scenario. First, the wide variation in investor knowledge of the stock market and of trading is crucial in the online setting. The costs to investors of bad judgment are likely to be borne by new entrants to the world of individual investing; these investors are pleased with the simplicity of the interactive user-friendly formats of e-brokerages, but are seldom proficient in the mechanisms and arrangements beyond the interface. Experienced investors can better identify the benefits and costs of choosing specific e-brokerages.
Second, the frequency of online investor trading deserves special attention. Many market analysts suggest that the growing U.S. economy and the low commissions charged by e-brokerages influence investors to trade more often. For example, an average Merrill Lynch (full service broker) customer makes four to five trades per year while the core investors in an e-brokerage such as E*Trade Group Inc. make an average of 5.4 trades per quarter. Frequent trading is generally contrary to the recommendations of financial theory. Ultimately, it is possible for an e-brokerage to allow investors to trade frequently at very low or even zero costs per trade while earning large profits on the fraction of the increasingly large bid-ask spread that is pushed back by the market maker. At the same time, the investor may be unaware of the indirect costs incurred with each trade.
Third, the evolution of electronic trading may increase market fragmentation in the short run. E-brokerages may increasingly channel trades away from exchanges and toward market-makers to compensate for lost revenue resulting from low direct commissions. Market fragmentation may have a negative impact on prices, increasing the bid-ask spread and potential for arbitrage opportunities (e.g., buy low in one market and sell high in another market within a short period of time). This is contrary to the belief that electronic markets may force centralization and increase liquidity (that is, the ability to buy and sell securities quickly).
Electronic trading will likely evolve into a competitive and self-disciplined operation in which investors punish inefficiency and dishonesty (invisible as well as visible). But in the shorter term, the movement toward such a market may require regulatory oversight. An ideal oversight process would simply nudge the market toward full information exchange and free competition-rather than foster unnatural controls over the way the market functions. A number of themes are relevant in this context:
- Transaction transparency. Transparency is the degree of openness about how, where, and when individual investors' transactions are executed. Openness reduces uncertainty and will bring about the convergence of perceived and real efficiencies. Investors would be able to monitor transactions themselves and decide when to switch e-brokerages in a more informed manner.
- Practice of payment for orders. The dual sources of e-brokerage revenue - from investor and from the market maker - represent a clash of interests. This arrangement can allow an e-brokerage to project a very low direct transaction fee and supplement these fees with payments for order flows from the market-maker. A clearer alignment between an e-brokerage's and the investors' interests seems appropriate.
- Pitfalls of frequent trading. Decisions regarding when and how often to trade - even in electronic trading - will always belong to the investor. But statutory regulations can impose certain minimum information standards on e-brokerages regarding the pitfalls of frequent trading as well as the structure of the payments they receive for channeling orders.
- High levels of system availability. When investors are unable to trade due to failures in an e-broker's systems, the ensuring costs are difficult to quantify, often costly when aggregated across investors, and practically impossible to cover in explicit contractual terms, like those in typical product warranties. But online intermediaries need to provide "utility-like" stability to their customers. The SEC could require online brokers to conform to certain statistical standards of system availability over time.
E-brokerages provide convenience, encourage increased investor participation, and lead to lower upfront costs. In the long run, they will likely reflect increased market efficiency as well. In the short run, however, there are a number of issues related to transparency, investors' misplaced trust, and poorly aligned incentives between e-brokerages and market makers, that may impede true market efficiency.
For efficiency to move beyond the user interface and into the trading process, consumers need a transparent window to observe the actual flow of orders, the time of execution, and the commission structure at various points in the trading process. In this regard, institutional rules, regulations, and monitoring functions play a significant role in promoting efficiency and transparency along the value chain in electronic markets. Our analysis confirms that in the context of online stock markets, the need for such intervention and oversight is particularly strong.
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