Overview of the Online Trading System
1. The birth of the online brokerage industry.
Many of the brokerage firms offering online trading services are not new to the securities industry. In fact, these same firms have been servicing the securities industry since well before the advent of online trading. For example, prior to servicing the online brokerage community, Schwab, Fidelity, and Waterhouse were leaders in the offering of traditional discount brokerage services. As a result, some of these older brokerage firms already had substantial technology in place for providing brokerage services before entering the online market. As discussed more fully below, these older trading systems are generally referred to as "legacy systems," many of which were not originally designed to handle high transactional, 24 hours-a-day, 7 days-a-week customer access.
When servicing traditional brokerage clients, orders were manually entered into the system by a broker after the broker received instructions from the client. In contrast, online investors place orders directly into the brokerage firm's trading system, via the Internet, and circumvent the need for order entry by a broker. The implementation of direct order placement by online investors has revolutionized the securities industry with the facilitation of online trading. Notwithstanding, many online brokerage systems have given rise to a number of highly publicized outages, slowdowns and associated problems.
2. How an online brokerage system operates.
Many of the online brokerage firms utilize a three tier architecture system consisting of the following: a front-end system, middleware and back-end system. Although discussed in greater detail in subsequent sections, the following diagram and overview of system operations is useful.
The first tier of architecture consists of the "front-end system." (See above graph.) The front-end system enables online investors to place orders directly into the firm's trading system. Generally, the front-end is comprised of computer servers or webservers, which are controlled by application software designed to manage individual client sessions.
After accessing the Internet through an Internet Service Provider, and typing in the online brokerage firm's website address or Internet Protocol address, an online investor connects to the online brokerage firm's system, through the firm's web servers. For certain features, such as free research and delayed quotes, the online investor can obtain the information without logging into the firm's secure investor account and trading areas, also known as "member areas." When logging into member areas, the online investor is asked to provide his or her account name and password. Once this information is authenticated against the brokerage firm's member database, the online investor is admitted into the member area and may begin requesting account information and placing trades.
The second tier of architecture, or "middleware," provides messaging, routing, and access to the firm's trading system. (See above graph.) The middleware determines the type of request that the user is placing, such as a request for research, quotes, or customer support, and routes that request to the appropriate part of the system for a response. For example, if the user requests a quote for a security, the middleware sends a message to the quote server in order to retrieve that quote. The quote server forwards the appropriate response through the front-end system, through the webservers and eventually back to the user, via the Internet. Similarly, if the online investor places a trade, the middleware routes the transaction to the system's trading and account components in order to accomplish the task requested.
Trading functions occur within the third tier of architecture or "back-end system." (See above graph.) Generally, it is the back-end of the system where the firm maintains its customer trading information, on either database servers or a mainframe, and its "trading functionality," again on either servers, or a mainframe. Once a member enters an order, the front-end system will return a message to the member asking for confirmation of that order. At that time, the member is usually provided with a real-time quote for that security. From the time the order is confirmed and until the order is routed to the market for execution, the order passes through the front-end to the back-end of the system. It is at that time that the order undergoes a vetting procedure to check for restrictions on the member's account, to verify that the member has adequate capital, and to ascertain whether the member is authorized to trade on margin. Generally, the vetting procedure is performed by the firm's systems without human intervention according to pre-programmed instructions. While some firms perform these checking functions through their own systems, others contract with third party back-office providers which serve as the firm's clearing agent. One example of a prominent back-office provider is Automated Data Processing ("ADP").
Once an order passes through all of the firm's pre-programmed vetting criteria, the order is sent to the market for execution. If the order does not pass the pre-programmed vetting procedures, the order will become what is called an "exception," and will be manually reviewed by a broker at the brokerage firm. After being reviewed by a broker, and assuming that the reason for the exception has been adequately addressed, the broker will then submit the order for execution.
Whether the order is approved manually or electronically, ultimately the order is routed to the marketplace for execution. The order may be routed to various markets for execution depending, at least in part, upon which market makers the brokerage firm has established a relationship with, and on which exchange the security is listed. An order may be routed to an electronic marketplace, such as the NASDAQ, and traded by market makers, such as Knight/Trimark, or it may be routed directly to an exchange such as the New York Stock Exchange. Orders may also be routed to Electronic Communication Networks (ECNs) for execution, such as Island or Brut. As a general rule, the order is routed to various markets using pre-programmed logic.
Generally, brokerage firms receive payments from market makers when orders are routed to them for execution; this is known as "payment for order flow." In contrast, brokerage firms do not receive payments for orders routed to ECNs. In fact, when using an ECN, the opposite occurs: brokerage firms are charged relatively small fees. Currently, individual users are not provided with the opportunity to choose where and how their orders are routed, but the issue is under consideration within the industry and may become a reality in the near future.
Once the order has been executed, the market maker, exchange or ECN forwards an execution report back to the online brokerage firm, through the firm's back office provider or clearing agent. The agent or provider then forwards the execution notification to the online brokerage firm's back-end system, which is used to update the user's account information and order status screens. At times of high market volume and/or volatility, these execution reports may be delayed due to capacity limitations and/or system bottlenecks. As a result, although an online investor's order may have already been executed, the online investor's account may not be updated to reflect the execution. Once the investor's account information is updated, however, the investor may log into member areas and review the status of his or her order. In some firms, the investor may also be able to check the new buying power of the account. As discussed later in this Report, however, some firms may not be able to update buying power until the next day. The brokerage firm's clearing agent also generates a paper confirmation, which is sent to the user through regular mail. The investor then has three days from the date of execution, known as the "settlement date," within which to fund the transaction.