The Obligations and Regulatory Challenges of Online Broker-Dealers and Trading Platforms

Abstract

Investing has been evolving for decades. On “Mayday” in 1975, the SEC abolished fixed commissions, changing the face of the brokerage industry. A few months later, Charles Schwab opened its first offices, and discount brokerages were born. By the mid-1980s, there were over 600 discount brokers operating. By 1990, discount brokerage firms captured just under than 10% of the market, although Charles Schwab captured 40% of the discount brokerage market. Throughout the 1990s, new firms entered the market, including E*Trade and AmeriTrade. Online trading became more prevalent; by 1999 25% of all trades occurred online. The term “day trader” entered our vocabulary. Commissions declined, until they reached zero. Investors now have more choices than ever when deciding how and with whom to invest. In addition to the large full service brokerage firms, there are independent broker-dealers, discount brokers, and online platforms and apps. Across the models, the level of service varies, as does the minimum amount needed to open an account and the ease with which an account can be opened.

Both new and experienced investors responded to these new trading models and reduced barriers to entry. 2020 witnessed a surge in new retail brokerage accounts opened on online platforms. One research analyst at JMP Securities estimates that more than 10 million new online brokerage accounts were opened in 2020. According to a joint study conducted by the FINRA Investor Education Foundation and NORC at the University of Chicago, 66% of survey respondents who opened a new account in 2020 were new investors, who had not previously owned a taxable investment account. The FINRA/NORC study found that the new investors were younger, had lower incomes, and were more racially diverse, compared to the other groups measured, specifically experienced investors that also opened online brokerage accounts in 2020, or “holdover” account owners who owned a brokerage account but did not open a new account in 2020. The FINRA/NORC study attributed the surge in new retail investors to the reduction in barriers to entry for retail investing, including no-minimum and low-minimum accounts and low or zero trading commissions.

In addition to lowering the barriers to the markets, the online platforms have changed how investors interface with firms and the markets. They offer a number of different design features, commonly described as “gamification.” These may include games when an investor opens an account; animations, including confetti when a milestone is reached; social networking tools; prizes or rewards for activity streaks; points, badges, and leaderboards; lists of popular stocks; free stocks for referring additional customers; and push notifications.

However, regulators are concerned that many new investors, prompted by gamification, have engaged in high-risk trading strategies without an appreciation of the risks. Noting the surge in online trading, including options trading, in its 2021 exam report FINRA identified emerging “digital communications risks” associated with digital platforms and mobile apps that have interactive and “game-like” features, that could mislead investors about the risks of certain trading, such as options trading. FINRA also recently announced that it will seek public comment on gamification practices utilized by these platforms, with a view towards potential new rulemaking. SEC Chairman Gensler also expressed concern about the “gamification” of trading apps with features that “encourage investors to trade more,” and indicated that these new models may require new rules.

While regulators may ultimately promulgate new rules to address unique features of these platforms or amend existing rules to address new technology and communication practices, this article reviews the current regulatory obligations owed by online brokerage firms.

Keywords: Securities Regulation; Broker-Dealer Regulation; Online trading; Gamification