Smaller Spreads, Less Revenue--Fewer Brokerages?

Some of the cheapest-commission deals available from deep-discount stock brokerages--indeed, some of the brokerages themselves--are under threat as a key source of the firms’ revenue begins to evaporate.

With commissions as low as $9.95 a trade, it may seem a wonder how the deep discounters make any money at all--especially considering what they spend advertising their rock-bottom fees in newspapers and on cable TV.

The not-so-secret fact is that the brokerages subsidize the cut-rate commissions with fees of a penny or two per share that they collect from market makers, the wholesale dealers who execute their trades.

Such “payment for order flow,” as it is known in the industry, can account for 20% or more of a discounter’s revenue, experts say.

“Take away payment for order flow and a lot of these firms are close to earning nothing,” Lehman Bros. analyst Michael W. Sears said.

But threatening those margins are recent changes in the Nasdaq Stock Market’s trading rules, as well as the move in all the major exchanges to quote stock prices in ever-smaller increments.

The exchanges now allow spreads in sixteenths of a dollar (6.25 cents), and when decimal pricing is adopted in the next few years, the minimum increment is expected to drop to a nickel or even lower. (Closing stock prices are sometimes in sixteenths, thirty-seconds or even as small as two-hundred-sixty-eighths, but the spread between buy and sell prices are no smaller than sixteenths.)

The new order-handling rules for Nasdaq, intended to help small investors, require market makers to display to the whole market any customer buy or sell offers they receive that are better than those they are currently quoting.

The result of these changes is smaller “spreads” between the bid and asked (that is, the buy and sell) prices of a stock. The spread is the dealer’s markup. Shrinking spreads can mean better prices for investors, but as dealers’ profit margins shrink, the dealers are less able to pay for order flow, and thus the discount brokerages’ subsidy for their low commissions dries up.

“We’re starting to see wholesalers scale back their rebates over the past month,” said Bernard L. Madoff, whose Bernard L. Madoff Investment Securities in New York is what’s known as a third-market firm--that is, it executes trades in competition with the New York and regional stock exchanges.

Payment for order flow will not disappear completely in the foreseeable future, Madoff said, but the amounts paid will come down, and there will be little or nothing paid for tougher-to-execute limit orders--orders to buy or sell stock at a specific price rather than at the best available price.

Payment for order flow has long been a controversial practice because of the potential for conflict of interest it poses for brokers. Their duty is to obtain the best possible price for their retail customers, but the obvious temptation is to send orders to the dealer offering the highest rebate.

However, the practice withstood a Supreme Court challenge earlier this year, and the Securities and Exchange Commission has declined to ban it, calling instead for a voluntary phaseout.

Defenders of the practice say it gives market makers a way to boost their trading volume and cut processing costs by bundling orders together. The cost savings ultimately can be passed on to investors through lower commissions and other fees, adherents say.

Madoff said he considers rebating a legitimate way for wholesalers to attract business, in much the manner retailers use advertising.

In any case, it is the economics of shrinking spreads--not opponents’ objections--that are putting the practice under pressure.

Palo Alto-based E-Trade Group, one of the fastest-growing deep discounters, has seen payment for order flow drop to 18% of revenue in the just-completed quarter from a peak of about 22% last year, according to Steve Richards, chief financial officer.

Some observers consider E-Trade, with its $14.95 commissions for trades executed by personal computer, to be one of the firms most vulnerable to a shortfall in rebate revenue.

But Richards, in an interview last week, said company management has long been aware of the potential shortfall and is making plans to add new sources of revenue, although he would not specify what they are.

Richards said that although sharp reductions in order flow payments will cut profit margins, E-Trade is growing so fast that earnings will keep rising. The company’s revenue more than doubled to $37 million for the quarter ended June 30, compared with the year-earlier period.

Other discount brokers are preparing for the change by diversifying.

Quick & Reilly Group, for example, earlier this year bought the prominent Nasdaq market-making firm of Nash, Weiss & Co. Both are based in New York. Although Q&R;’s discount brokerage operation will sacrifice rebates by placing orders through its sister unit, Nash Weiss will get a more dependable stream of business at lower cost, spokesman Charles G. Salmans said.

Jack White, founder of La Jolla-based Jack White & Co., one of the pioneering discount brokerages, said dwindling rebates will inevitably squeeze out some of the cheapest-commission deals, those in the $10-to-$15 range. White predicted that flat fees of $25 to $30 will become the norm.

For his part, White is diversifying into no-load mutual funds and other investments to reduce the firm’s dependence on individual stock trades.

Things have changed from the days when Charles Schwab, Jack White and a few other discount brokers were mavericks on the fringes of the brokerage community.

Stephen Rubenstein, chairman and chief executive of Beverly Hills-based J.B. Oxford Holdings, said in a recent interview that when his firm opened three years ago, it could count about 15 competitors. Now there are at least 85, he said.

Rubenstein believes that not only will market markers eventually stop paying for order flow, but also that the pendulum may swing to a point where they charge fees to execute limit orders or other transactions.

Oxford has seen its order flow payments shrink as much as 50% from the highs of 1996, he said.

Rubenstein said Oxford, too, is diversifying into market-making to make up for the money it loses on order flow rebates. It’s a matter of survival, he said.

“To the extent that they don’t have a means of offsetting the lost revenue, we’ll not only see the [low] prices evaporate, but the firms evaporate too,” he said.

Times staff writer Thomas S. Mulligan is based in New York. He can be reached by e-mail at thomas.mulligan@latimes.com