U.S. markets close in 1 hour 21 minutes
  • S&P 500

    -55.09 (-1.29%)
  • Dow 30

    -290.55 (-0.85%)
  • Nasdaq

    -258.04 (-1.99%)
  • Russell 2000

    -42.85 (-2.14%)
  • Crude Oil

    +0.32 (+0.35%)
  • Gold

    -8.20 (-0.46%)
  • Silver

    -0.44 (-2.28%)

    -0.0050 (-0.49%)
  • 10-Yr Bond

    +0.0960 (+3.33%)

    -0.0112 (-0.94%)

    +0.9500 (+0.70%)

    -1,883.33 (-8.09%)
  • CMC Crypto 200

    -33.15 (-6.12%)
  • FTSE 100

    +8.52 (+0.11%)
  • Nikkei 225

    -11.77 (-0.04%)

For Investors, Information Overload Creates New Risks

By Daniel S. Gorfine

Advances in information technology and the proliferation of open networks are having a profound impact on the world, ranging from transforming communication and commercial marketing practices to enabling political change.

There is a compelling part to this story, however, that has garnered less attention: that these same technological forces are decentralizing and democratizing financial markets, where traditionally a select few institutions have dominated in large part because they had unique access to information and trading platforms. By expanding access, this process is revolutionizing how transactions are executed, information is processed and disseminated, and capital is allocated. This shifting landscape carries with it significant risks to market stakeholders, including individuals, corporations, and governments — but also opportunities for those who adapt.

A Recent Trend

Perhaps most remarkable is the speed of change, especially since the onset of the global financial crisis in 2008. Until the last decade, the world of finance was highly centralized, with securities exchanges and their broker/dealers at the hub and spokes fanning out to a limited number of large financial institutions. These big players served as high-cost trading intermediaries for investors ranging from giant funds to individuals, providing research, broker/dealer services and market-making activities.

In recent years, however, advances in IT and timely, Internet-based dissemination of market data and insights have eroded the competitive advantage once held by research analysts and traders at the largest institutions. At the same time, new trading technologies have made it possible to bypass physical exchanges dominated by big broker/dealers. And that has triggered, according to PriceWaterhouseCoopers, a cascade of international mergers of stock exchanges and markets, connecting investors to more investment opportunities.

Increasingly, trading is now being done through automated trading platforms or via "dark pool" trading systems that enable investors to buy and sell equities off the exchanges so long as final execution prices are reported. The market research firm TABB Group estimates that approximately one-third of all trades are now off-exchange. Moreover, new technology is increasing the speed and efficiency with which funds can be moved between investments and accounts, thereby lowering a major barrier that had held customers captive to particular institutions.

Everyday Investors Involved, Too

Additionally, technology is leading to significant changes in early-stage investing opportunities for retail investors. The recently enacted JOBS Act will allow retail investors to participate via Internet portals in securities crowdfunding of startup and small businesses — a sector of the capital markets previously open only to institutional investors, venture capital firms, and angel investors. Moreover, electronic peer-to-peer lending platforms are enabling individuals to engage in an area traditionally occupied by banks and credit unions.

These technologically driven changes have been complemented by psychological ones. The financial crisis led many investors to lose confidence in traditional financial institutions, driving them to seek alternative investment strategies at lower cost. Record sums are being withdrawn from actively-managed mutual funds, to be placed in exchange-traded funds and other passive products with low fees. Meanwhile, those still interested in actively managing their portfolios have access to no-frills brokerage houses, which offer a variety of Web-based tools that enable internet-savvy individuals to perform market research and analysis on their own.

More Change Is Coming

So what does this decentralization and democratization of financial markets mean for firms, individuals and governments?

Unless traditional financial institutions adapt to the altered environment, they should expect continuing declines in sales and trading (for example, Morgan Stanley recently reported a 48 percent drop in trading revenues), as well as in managed assets. Projections from Cerulli Associates suggest that the total share of high-net-worth customer assets under management at the four largest full-service brokerage firms will drop to 42 percent by 2014 from a high of 56 percent in 2007. Firms that recognize the value of open, networked models of information exchange will likely thrive by offering investors access to that information, along with the Web-based tools to help them make sense of it. There may also be an opportunity for information clearinghouses that vet or filter the vast quantities of information available on the Internet to ensure some degree of quality control.

But It's Not All Good News

All of this may sound like unalloyed good news as investors will be able to make reasoned and informed investment decisions without paying hefty service and transaction fees. Upon closer inspection, however, the view is not quite as rosy. For individuals and regulators alike, this new world will create major headaches as trading platforms, services and opportunities are unbundled and decentralized. Retail investors now have access to complex investments and hybrid assets without necessarily understanding the risks to which they are exposed.

Consider, for example, the failure earlier this year of the VelocityShares Daily 2x VIX Short Term Exchange Traded Note (TVIX) — an ETN created by Credit Suisse to return two-times the movement in the VIX (the Chicago Board Options Exchange Market Volatility Index). When Credit Suisse ceased issuing and redeeming TVIX shares -- a process that helps to keep the share price in line with the share net asset value -- its price became unmoored from the underlying VIX index. The price of TVIX was cut in half.

Consider, too, that in a low-rate environment, many inexperienced investors empowered with new trading technologies are able with the click of a button to chase yield by investing in high-yield bonds, dabbling in volatile currency markets, trading options, assuming short positions, and (soon) investing in high-risk startups through securities crowdfunding. Meanwhile, the proliferation of algorithm-based, automated, and high-speed trading, which now accounts for more than half of all daily trading volume, pose additional risks to market stability and investment strategies that are not yet fully understood.

In the brave new world of electronic investing, those investors who understand the new risks will be the best positioned to capture new rewards.

Daniel S. Gorfine is the Washington-based Director of Special Projects & Legal Counsel for the Milken Institute.