Online Brokerage Services in Financial Industry

1
Online Brokerage Services in Financial Industry

• Dr. Yunfeng Zou

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Outline

• Who are the players, why do they trade, and what
  products they usually trade
• Trading facilitators and US trading markets
• Trading instruments
• New exchanges and products
• Brokerage services, online brokerage services
• Leading brokers with new services and products
• Interesting order types
• Conclusions

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Players

• Buy Side
• Investors Individual, corporate pension
  funds, insurance funds, charitable and legal
  trusts, mutual funds, etc.
• Why To move wealth from present to the
  future for themselves or for their clients
• Products Stocks, Bonds

4
Players

• Buy Side
• Borrowers Homeowners, Students, businessman,
  corporations
• Why Need money for current operations.
• Products Mortgage, Bonds, Notes

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Players

• Buy Side
• Hedgers Industries (farmers, miners,
  manufactures), financial institutions,
  international corporations, government, and etc.
• Why Reduce business operation risk.
• Products Future contracts, forward
  contracts, swaps, and etc.

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Players

• Buy Side
• Asset exchangers International corporations,
  manufactures, investors, travelers and etc.
• Why Acquire an asset that they value more
  than asset that they tender.
• Products Currencies, commodities.

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Players

• Buy Side
• Gamblers Individuals
• Why Entertain themselves
• Products Any

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Players

• Sell Side
• Dealers Market makers, specialists, floor
  traders, day traders, etc.
• Role Earn trading profits (buy low, sell
  high) by supplying liquidity of the market.

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Players

• Sell Side
• Brokers Retail/Institutional brokers,
  discount/full service brokers, block traders
• Roles Provide service for client and earn
  commissions by arranging trades for clients.

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Players

• Sell Side
• Broker-dealers Warehouses
• Role Supply liquidity and arrange trading for
  clients.

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Trade Facilitators

• Exchanges Provide forums for traders to meet
  each other. Include dealers, brokers and buy-side
  traders. Only member can trade with each other.
  Nonmembers trade by asking member-brokers to
  trade for them.
• Floor trading, and electronic trading.

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Trade Facilitators

• Clearing and Settlement agents
• Buyers and sellers compare their records. The
  clearing agent matches the buyer and seller
  records and confirm that both sides agreed to the
  same term. Once cleared, trades could be settled.
  
• Settlers receives cash/securities from both
  sides and gives cash to seller and securities to
  buyer.
• T3, cash settlement.

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Trade facilitators

• Clearinghouse
• Clear and settle trades. Issuers and
  guarantors of trading contracts.
• How it works Owned by clearing members. Traders
  without clearing members must have a clearing
  member guarantees the settlement of their trades.
  Clearing member must settle trade if trader fails
  to do so. Clearing house tax its member to settle
  the trade if member fails, due to bankruptcy. It
  functions like a mutual insurance company.

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Trading Instruments

• Stocks
• Futures
• stock, index, commodities
• Options
• Future options
• Currencies
• Bonds
• ETF

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US Equity Markets (SEC)

• Primary
• NYSE New York Stock Exchange (order driven,
  specialist, auction)
• AMEX American Stock Exchange (gt 100 ETF)
• NASDA Nasdaq natinal market, smallcap market,
  OTC bulletin board service, pink sheets. (Quote
  driven, multiple market makers compete, buy order
  flows)
• Regional
• Boston, Chicago, Cincinnati, Pacific,
  Philadelphia Stock exchange.

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US Equity Markets

• ECNs Electronic communications networks.
• Archipelago, Brut, Instinet, Island, RediBook,
  TradeBook.
• (Arch merged to NYSE, may trade both stock and
  option, Hybrid order routing system)
• Essentially electronic exchanges. Important for
  best execution and online brokerage.

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US Equity Options Exchange

• CBOE Chicago Board Options Exchange
• AMEX American Stock Exchanges
• PSE Pacific Exchange
• PHLX Philadelphia Stock Exchange
• ISE International Securities Exchange
• BOX Boston Options Exchange

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US Future Exchanges (CFTC)

• CME Chicago Mercantile Exchange (Livestock,
  stock index, etc.)
• CBOT Chicago Board of Trade (Grains, Treasury
  notes, bonds, stock index)
• NYMEX New York Mercantile Exchange (Precious
  metals, energy products)
• NYBOT New York Board of Trade (Sugar, coffee,
  cotton, orange juice, stock index)
• ONE Chicago One (Single stock future) (SEC and
  CFTC)

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New Exchanges and Products

• OneChicago Single stock future (Nov. 2002).
  Regulated by SEC and CFTC.
• - High leverage (20 initial and maintenance
  margin)
• - No down tick rule
• - Fast trading
• - No 60/40 tax break rule (long term capital
  gain 60)
• - Not gained popularity as expected (NQLX
  closed door)
• - Bid/Ask spread is wider
• - Only over 150 products (mostly single stock
  future)

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New exchange and product

• Box Boston Option Exchange (Feb, 2004)
• - 2nd electronic US option exchange
• Unique feature PIP (Price improvement period) 3
  seconds price auction at least one penny better
  than NBBO.
• Multiple market makers compete for the order
  (direct order)
• Dont pay for order flow.
• Controversial at beginning, ISE is proposing
  similar feature.
• Internalization??

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New exchange and product

• HedgeStreet Internet-based exchange offering
  future contracts of Event Derivatives
• subject to regulatory approval by the Commodity
  Futures Trading Commission (CFTC).
• Retail derivative market through internet
• Unique products Hedgelets, easy to understand
  product
• Products Energy, Real estate, currency, interest
  rate, etc.

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Brokerage Services

• Task Arrange trades for their clients
• Revenues Payments for routing orders, interest
  on cash balance, margin interest on loans,
  securities lending fees, and other income.
• Deep discount brokers cheapest commissions but
  least service
• Full service brokers Higher commissions but more
  service and advice.
• Primary cost Labor costs.
• Honest, trustworthy, and creditworthy

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Idea Broker

• Access to all markets and all products
• Trading globally
• High quality executions
• Low commissions
• Good customer services
• Comments Markets are highly fragmented.
  Regulated by SEC and CFTC. Traders have different
  requests.

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Online Brokerage Service

• Internet cuts the cost deeply.
• Target self-directed investors and active
  traders.
• Compete with exchange to arrange trades
• Browser Based (SUV)
• Etrade, Ameritrade, TD Waterhouse, Schwab,
  Scottrade, OptionsXpress, etc.
• Software based (Sports car)
• IB(InteractiveBrokers), Terra Nova Trading,
  PowerEtrade, TradeStation, Thinkorswim, MB
  Trading, Rush Trade, Cyber Trader

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Comparison

• Execution speed
• Best executions
• Usability
• Range of products
• Cost
• Research
• Access to help
• API and trade automation
• System reliability

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Who are the leaders

• OptionsXpress (Only 1/2)
• 3 years in a row, clear winner, highest scores
  in all respects.
• IB, Terra Nova Trading, TradeStation, Thinkoswim,
  MB Trading.
• 1/2

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Advanced features from IB

• Universal account to access 50 markets in 14
  countries.
• Lowest trading cost
• US commissions
• 0.01 lt 500, 0.005 gt500 shares
• 1 per contract for US options smart routing
• 0.55 to 1.3 per future contract(plus exec
  and clearing fee)
• Smart routing for stock, options, and
  inter-exchange spread.
• Over 30 order types.
• API for trade automation
• Minimum service, good only for active traders.

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Interesting order types

• Basket
• Bracket
• OCA group
• Conditional order
• Spread
• Inter-exchange spread
• Trailing stop
• Relative order

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Interesting order types

• Discretionary
• Iceberg
• VWAP
• Hidden
• All or None
• Fill or Kill
• Good till/Good after/IOC

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Evolving paths

• Etrade
• Front end and customer services, backend
  started with quote provide service. Bank, market
  makeing follow up
• IB
• Internal network extended to outside customers.

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New business opportunities

• Software development for automatic trading,
  investment management, and brokerage services.
• Access world markets easily with low cost and
  trading all products.

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Conclusions

• Old business, new technology brings a lot of
  opportunities for new comers
• Opportunities for IT professional
• The larger the better
• Right business strategy
• Opportunities for/in China.