Full service versus online cost structure
For the majority of retail investors cost will be the ultimate determinant of where they trade. The online broker industry's cost structure is dictated solely by the mechanics of order execution, the cost of which keeps sinking with the relentless march of technology. The full service broker industry's cost structure is dictated by the cost of credit risk management, the human being who dispenses advice and take's the client's order, and the research infrastructure on which the broker's advice is based. There is little room for the full service broker to compete with the online industry in terms of cutting order execution costs. The human interface is an insurmountable bottleneck. There are no economies of scale for the full service broker. In contrast, the processing bottlenecks that plague the online brokers on heavy days will disappear as high speed Internet access and more powerful hardware evolve. In terms of research, the explosion of online information and independent research boutiques is making it easy for the online brokers to offer their clients everything but personalized advice. A full service broker is unlikely to offer better advice on any particular stock than is available from an online research report. In terms of personalized asset allocation strategies for portfolios, increasingly sophisticated interactive questionaires on which the online client spends as much time as he wishes will probably do a better job than a harried full service broker with a long list of calls to be returned.
The suitability rule roadblock to online trading
So why have online brokers made no inroads in Canada? Why does Canada's biggest discount broker, TD GreenLine, not offer true online trading accounts? The answer lies in a special rule called "client suitability" which the brokerage industry had to invent in years past to stop its brokers from abusing clients. The suitability rule stipulates that before a broker executes a client's order, he must make a judgement about the trade's suitability for the client in terms of his net worth, investment objectives, and risk tolerance. This rule was invented to prevent a broker from loading up a widow's account with wildly speculative stocks or churning the account with some sort of day trading momentum strategy. Initially the rule was intended to stop abusive brokers from pitching unsuitable investments to their clients. But the rule developed a problem as investors who made their own trading decisions realized that the courts and regulators tended to side with a client in any client/broker dispute. Suddenly brokers had no defence against the accusation that a stupid trade was the broker's idea, and not the client's. The brokerage industry dealt with this problem by extending the suitability rule to any transaction, whether it was solicited or unsolicited. To some degree this paternalism was self-serving, because it reinforced the full service broker creed that brokers were wise while retail investors were foolish.
The suitability rule is a crock
As you can imagine, this attitude does not sit well with individualists who take 100% responsibility for their decisions. In practical terms a broker can only be expected to refuse a trade that is blatantly unsuitable. Even then he is unlikely to act on his suitability judgement because it would probably cost him a lucrative client. Most trades are not obviously unsuitable. Furthermore, if a client engages in a series of unsolicited trades of a gradually riskier nature, he establishes a historical risk tolerance that may be inappropriate for his financial circumstances or clash with his original stated objectives. If the client has not disputed the "unsolicited" status stamped on his purchase contract, any claim that a broker did not make proper suitability judgements becomes weaker. Individualists weaken their protection in an additional manner. The suitability judgement has its roots in the "know your client rule". When a client opens an account he must provide all sorts of personal financial information and sign that it is complete and accurate. The boiler plate includes a promise to inform the broker if financial circumstances change in some vaguely significant manner. The fact that clients rarely keep this promise is another loophole that the broker's lawyers can use as a defence against a claim. In practice investors are very protective about their privacy, and tend not to be precise about their net worth and income because they just don't trust what will be done with this information. Brokers also have no way of verifying the client's statements. They simply trust the information to be correct. Once the account is open and active, the client never thinks again to update the broker about any major changes in his financial circumstances. So what does the broker really know about his client beyond that he is not dirt poor? The bottom-line is that the requirement of a suitability judgement serves no practical purpose other than to minimize the brokerage firm's exposure to the embarrassment of indisputably unsuitable trades recommended by rogue brokers. The suitability rule also buttresses the imbalance of power between the brokerage firm and the individual broker. If management wants to lean on a broker for any reason, it may not have to look far in the broker's trading history to find trades a nitpicker could deem unsuitable. With this hammer hovering over him, and the impossibility of proving the firm's hypocrisy, your typical broker has little choice but to stay in tune with management's vaguer wishes like placing that financing or touting the firm's favorite play.
Short-circuiting the electronic online connection
Unfortunately, the requirement that a broker know his client and render a suitability judgement with each trade has no exceptions in Canada. Even Canada's discount brokers, who by definition and the choice of their clients dispense no investment advice whatsoever, must make a suitability judgement. A discount broker client can place dozens of orders and never talk to the same phone clerk more than once. And yet with each trade a suitability judgement has supposedly been rendered. Canada's discount brokers have online order placement systems, but they are not true online order execution systems. After a Canadian "online" order is submitted, it must first be screened by a human being before the brokerage firm can submit the order into the exchange's order execution system. In practice the discount brokers use software to red flag orders that clash with pre-established client profiles. In such cases an employee will take a closer look at the order before approving it. This check typically reveals that the client has defined his account as 100% high risk, short term trading. Only prudent, long term investments are unsuitable. In most cases the discount broker only pretends to have rendered a suitability judgement. So what is the problem? The requirement for a suitability judgement means that a Canadian online account cannot have a direct computer link to the actual order execution system. A human middleman is required, and as soon as you have a human being between the client and the execution of an order, you do not have a true online trading system. What you have is expensive inefficiency. And that suits the established full service Canadian brokers just fine. Online trading is not a threat to the way Canadian brokers do business and their high commission structure because it is forbidden. Outfits like TD GreenLine have been fighting to get the suitability rule waived for discount and online accounts. Can you guess from where the opposition comes?
What if Canadians open online US accounts?
This barrier to online trading spells doom for the Canadian securities industry because Canadian investors will not tolerate it. Their American neighbours are turning them green with envy. Will Canadians rattle the brokerage industry's cage and insist on changes? That would be too confrontational. Canadians will deal with the lack of online accounts by figuring out how to open US online accounts. Once Canadian investors have American online accounts, they will not bother trading stocks that are not available for retail online trading, namely Canadian stocks not inter-listed on NASDAQ, New York, or even the OTC BB.
NASD has no suitability rule for its members
Admittedly, the suitability rule also exists in the United States, but it only applies to the brokerage firms who are members of stock exchanges. There are only about 300 firms which are members of the New York Stock Exchange. But there are over 5,000 members of the National Association of Securities Dealers (NASD), which does not have a suitability rule. NASD members are entitled to trade on the NASDAQ and Bulletin Board systems. They can jitney their exchange listed orders through an exchange member firm, whose wholesale role exempts it from rendering a suitability judgement. Any one of these NASD firms can develop an online system that interfaces directly with NASDAQ's small order execution system. The volume and value now traded on NASDAQ has eclipsed that of New York. Who needs to be a member of the NYSE when the action is all on NASDAQ? Ironically, according to a New York Times article on February 21, NASD is re-examining its lack of a suitability rule in light of the rise of online trading. No doubt the impetus comes from the market making members of NASD, who correctly see online trading as the ultimate threat to the American brokerage industry. Don't count on NASD to pull the plug on online trading. In Canada the online industry was stillborn thanks to the suitability rule. The US online industry is booming, and cannot be stopped in its tracks by a technicality that turns online trading into a logical contradiction. At most NASD will adopt a software solution as a compromise. The software solution would be a client designed trading profile that the online computer uses to vet the client's own trades before zipping them off for execution. And unlike in Canada, no human being will have to pretend he checked the order for suitability.
Quote versus order driven execution systems
Canadians are chafing at the bit about their high commissions and inefficient brokers. This is truly a sad situation, because the Canadian exchange system is infinitely more suited to online trading than the US system. Unlike the United States, whose NASDAQ is an archaic quote driven order execution system, all the Canadian exchanges except Montreal and the Canadian Dealing Network have adopted electronic order driven execution systems. Quote driven systems are fundamentally flawed because they do not disclose market depth. The amount of stock behind the bid and ask prices is a secret known only to the NASDAQ market makers. The same applies to the Over-the-Counter Bulletin Board. The market makers are engaged in a chaotic juggling act as they try to eke out commissions by exploiting inefficient bid-ask spreads. The quote driven market making system is designed to serve the brokerage industry and exploit the retail investor. It is synonymous with market manipulation, chaos and flakiness. Because it involves countless human actions performed in a relative information vacuum, the quote driven order system is inherently unstable. In contrast, order driven systems such as Vancouver's VCT are models of market transparency, simplicity and fairness. What you see is what you get, and first come first serve. The Canadian stock exchanges are grounded on these principles. NASDAQ and the OTC Bulletin Board are not. So why are the superior Canadian exchanges languishing while the inferior American trading systems are flourishing?
Alternative trading systems doom NASDAQ
I don't have an answer why NASDAQ has become so popular, except perhaps to suggest that NASDAQ was in the right place at the right time. The US bull market has been so enduring and powerful that the fundamental flaws of a quote driven system have been swept under the carpet. But there are changes happening that will undermine and eventually destroy NASDAQ as we know it today. The threat comes from so-called alternative trading systems such as Island and Instinet. These are order driven trade execution systems that run parallel to NASDAQ and the stock exchanges. They were initially designed to handle institutional orders and after-hours trading. They resemble Vancouver's VCT system. It is only a matter of time before they open themselves to retail online accounts. Once the market has tasted the efficiency of liquid order driven execution systems, it will only use quote driven systems as a last resort. Technology will kill the traditional form of market making. The market making broker of the future will have no special status. He will be like every other trader, except that he will possess more capital and greater sophistication than the millions of online traders with whom he will compete in the market. And he will no longer be bound by rules that prohibit leading the market with a buy or sell order. These former market makers will become samurai warriors in the trading wars that have captivated online investors.
Waiting for a market panic to crash the NASDAQ system
The American securities system has two flaws. The first is the inherent instability of quote driven execution systems. The second is the absence of a proactive regulatory system. If the bull market enters a period of extreme volatility, the NASDAQ system will freeze. If the online broker computers do not seize up because volume exceeds their capacity, they will find themselves careening into a pileup on a foggy freeway. The experience of October 1987 will be repeated, except this time it will be much worse. Not only are there far more people invested in the market today, but the feedback loops created by the Internet multiply the urge to trade. If a panic engulfs the market, the entire NASDAQ system will crash. But it will not disappear. Instead, the market will shift to the alternative trading systems.
Post a sentry at every corner or send out the posse?
The ultimate alternative trading system is EBay, the utterly unregulated electronic flea market where anything can be auctioned. EBay is a place where you could make a market for beanie babies. Thanks to the powerful feedback loop of an online market, somebody could manipulate the price of Snort the Bull skyhigh. Tulip bulbs could make a comeback. Why not start trading OTC Bulletin Board stocks through EBay? The NASDAQ and OTC BB system are regulated only in a reactive manner. NASDAQ companies file their quarterlies with EDGAR, and OTC BB companies until recently have not had to file anything. (On January 4, 1999 NASD implemented a new rule that requires companies to file audited annual and unaudited quarterly financial statements with the SEC if they are to be quoted on the OTC BB. It is a staged implementation that starts with A and is expected to finish with Z by June 2000. There is no requirement yet to file with EDGAR so that investors can access the financials via the Internet.) Is the information correct? Are the disclosures complete? Who checks? Certainly not the SEC, which merely reacts to complaints. The American system depends on brokers, investors and class action predators to enforce itself. When fraud is exposed, the American regulatory and legal systems come down hard on the culprits. Just ask the guys from Livent. The same cannot be said for the Canadian regulatory system. Who from Bre-X, Golden Rule or Timbuktu is going to jail? The American system relies on the threat of harsh consequences to keep people honest. But with over 20,000 companies in a system that stretches over 50 states inhabited by 250 million people, the crooks just play the odds of being in the wrong place at the wrong time. An investor in American NASDAQ and OTC BB stocks has no assurance that his stock is not engaged in some form of fraudulent activity. By the time the complaints are filed and the SEC initiates an investigation, it is too late. The Canadian regulatory style is to post a sentry at every street corner to catch criminals in the act or scare them off. The American regulatory style is to send out a posse with a hangman's noose after the crime has been committed. Legitimate promoters prefer the Canadian system while the crooks prefer the American system.
Canadian exchanges regulate proactively
The Canadian exchange system is vastly superior because it plays a proactive regulatory role, particularly in the arena of speculative stocks. The Vancouver Stock Exchange ensures that its companies maintain minimum listing requirements. It screens company disclosures to make sure they conform with reporting standards. It investigates complaints of corporate abuse. It keeps tabs on the suitability of directors and officers. It has an approval system in place for corporate transactions involving the issue of stock. It has a market surveillance system that monitors for market manipulation or insider trading. It has an online information system that supplements SEDAR, Canada's filing equivalent to EDGAR. Does this mean you won't lose money investing in VSE stocks? Of course not. Does the VSE always get it right? No, but at least you know they are trying. Is the market surveillance crew sometimes too quick to pull the trigger? Perhaps, but when there was nothing wrong, there was no harm done in halting trading. As a newsletter writer I prefer to cover VSE stocks because the exchange gives me confidence that if I am to lose money, it was because of the nature of the venture and the market, not some market manipulation or fraudulent disclosure. When I look at the NASDAQ and OTC BB systems, I cannot even come close to the same comfort level. These are pure predator-prey systems where outsiders cannot escape their status as prey.
Migration of Canadian securities to US listings
The danger for the Canadian securities industry is that senior listings will all gradually list on American exchanges and NASDAQ in search of greater liquidity and larger audiences. The US dollar is now the world's primary currency and the US order execution systems are open to the entire world. Today it makes more sense for a Canadian resident to have a US dollar account that trades liquid US listings than to have a Cdn dollar account that trades illiquid TSE listings. The biggest and best Canadian companies trade in the United States, where they will inevitably develop the most liquid markets with the narrowest spreads. In the case of inter-listed stocks, the most liquid market ultimately dominates at the total expense of the less liquid listing. The long term outlook for the Toronto Stock Exchange as a senior equity market is not good. The same applies to junior listings, which are finding that if they want to attract American investors they must get themselves quoted on NASDAQ or the OTC Bulletin board. The advantage of an American "listing" is that Americans can trade them through their US online accounts in US dollars. None of this currency exchange hassle. The Canadian dollar has become equivalent to the Mexican peso in the eyes of Americans. The situation is so bad that I cannot even get rid of Canadian pennies. When I haul out a handful of change, the store clerks spot the Queen and maple leaf before I do and push them back at me as though they were mouse turds.
US audience is ten times bigger than Canada
The United States has a population in excess of 250 million, ten times that of Canada. Estimates indicate that 24% of all household wealth is now invested in the stock market, the highest level in history. Not only is the American capital pool is ten times bigger than the Canadian capital pool, but owning stocks has become part of the American lifestyle. A Canadian junior has a much better chance of raising money for its ventures if it has access to American investors. Would a Canadian junior, however, not encounter stiff competition from thousands of American juniors? The answer is no if the junior is involved in the resource or energy sector. I cannot argue that Canadian technology juniors are better than American technology juniors, but I can say without hesitation that Canadian resource and energy juniors offer better odds than their American counterparts.
Canadian frauds spawn changes; American ones don't
The Canadian exploration industry has a long history of using speculative markets to fund exploration, and the Canadian exchanges have developed sophisticated reporting standards and disclosure enforcement systems. When fiascos like Bre-X and Golden Rule lurch onto the scene, the Canadian industry responds by refining its oversight system. When a NASDAQ fraud like Delgratia comes along, nothing happens to prevent repeats. When the desert dirt frauds were chased off the Canadian exchanges, where did they go? They flourished in the unregulated OTC BB market in the United States. The American regulatory system is ill-equipped to deal with resource and energy juniors in a proactive manner.
Canadian mining frauds get much more media play
If you regularly read both Canadian and American newspapers you would get the impression that a lot more fraud happens on the Canadian exchanges. This impression is a function of priority, not incidence. The Canadian frauds receive intense media scrutiny when they are in the process of being exposed. American frauds get an odd feature article in the Wall Street Journal long after the fraud has been exposed and the damage done. The reason is simple. Canadian resource and energy juniors are an intrinsic part of Canadian culture. New discoveries garner headlines in the business section of the national Canadian newspapers. So do fraud stories. In the United States resource and energy juniors are a tiny percentage of a giant hodge podge of juniors promoting everything under the sun. Each American fraud is just a tiny blip on a vast horizon, and hardly worth a mention in the newspapers Americans read on a daily basis. The reactive nature of the resource-strapped SEC ensures that exposed fraudulent stock promotions are a fraction of the fraud that gets carried out in various degrees by Bulletin Board stocks and even NASDAQ listings. Canadian stocks have earned a bad reputation because the Canadian media and regulators are far more effective at rooting out fraud than the American media and regulators. It would be a shame if the Canadian system dies a slow death because Canadian juniors migrate to the American system, and Canadian investors open American online accounts to trade stocks on a system where the protection of their interests is vastly inferior to that offered by the Canadian system.
Best Regards
KEITH
(lifted from the Kaiser Report) |
