Soaring Stock Trades Fuel Debate Over Pricing
Two years after Wall Street stock dealers ended what many experts viewed as a long history of abusive trading practices, concern is mounting that millions of individual investors still aren’t getting a fair deal.
The government-mandated reforms narrowed the once-wide gulf between the prices at which Wall Street dealers buy stocks from, and sell them to, individual investors, particularly on the Nasdaq Stock Market. Today’s criticism centers on something more basic: how quickly and fairly dealers execute the soaring volume of stock orders from small investors.
Execution refers to the price at which a trade occurs once an investor puts in an order. For example, if an investor tries to buy a stock while its price is $30 a share, he may not have gotten the best execution if that order ends up being filled at $30.50 or $31. The same holds for someone trying to sell at $30 whose trade is done at $29.50 or $29.
Think of it as putting a gallon of milk into your grocery cart that supposedly costs $2.50, but paying $2.75 or $3 for it at the checkout counter a few seconds later.
Though the extra costs may be just a few cents a share, in aggregate Wall Street firms may be reaping substantial additional profit at small investors’ expense--and without justification, some experts say.
The execution issue isn’t considered anywhere near as severe a problem as the accusations of the mid-1990s, when the dealers who control the electronic Nasdaq market were investigated for allegedly colluding to rig the market against small investors.
But the order-execution controversy is increasingly relevant as the number of individuals trading stocks--especially Nasdaq issues--continues to rocket.
Questions about execution quality have increased as some small investors have discovered their trades being filled at prices far different than expected, especially in volatile Internet-related stocks.
Securities and Exchange Commission Chairman Arthur Levitt announced two weeks ago that he has ordered an “examination sweep” in which SEC investigators are reviewing the records of online brokerages for potential execution problems.
The New York attorney general’s office is conducting a similar investigation, according to one source.
Firms “have an obligation to ensure the best execution of their customers’ orders,” Levitt said. “That’s not just good business practice, it’s a legal obligation.”
Certainly, execution concerns haven’t deterred the growth of online trading. The number of online brokerage accounts, now about 8 million, is projected to surge to 14 million by next year, according to consulting firm Gomez Advisors.
The number of shares traded online--including Nasdaq trades and those directed to the New York Stock Exchange and other exchanges--surged a whopping 40% in April from the monthly average in the first quarter, according to Credit Suisse First Boston.
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Regulators worry, though, that novice investors don’t understand the costs or the risks involved in aggressive trading. And they’re particularly concerned that Wall Street dealers may in some cases take advantage of those unsophisticated investors with their trades.
Specifically, Levitt’s comments about execution revived debate over a long-standing practice known as payment for order flow, in which discount brokerages sell their customers’ orders to other firms that actually execute the trades.
Payment for order flow is primarily an issue for Nasdaq stocks, although Wall Street firms and traders on some regional stock exchanges also may pay for orders in an attempt to siphon business from the NYSE.
The concern is that discount brokerages may care more about the payments they get than about how well their customers’ orders are filled.
A parallel controversy centers on Nasdaq dealers’ use of “manual” execution, a method by which firms sometimes handle orders in fast-moving markets.
Critics say manual execution hurts individual investors because it slows the order-execution process at the very moments that stock prices are moving the fastest.
Individual investors have been trained to focus on commissions, the fee ranging from $5 to $30 that discount brokers charge per trade.
Yet “most individual investors don’t understand that the most significant cost of online trading is the slippage factor of the price they got executed at as opposed to the best price that was available at that moment,” said Philip Berber, chief executive of CyBerCorp, an Austin, Texas-based online brokerage and software firm.
To understand the controversies over payment for order flow and manual execution, it’s important to understand how individual investors’ orders are handled.
When customers place Nasdaq orders with discount brokerages such as E-Trade or Ameritrade, the brokers often ship the orders to a “wholesale” market-making firm that actually executes them.
Wholesalers frequently pay online firms a fee of one-quarter of a penny to one-third of a penny a share for the right to execute the orders. In other words, they’re paying for order flow.
The biggest wholesalers are Knight/Trimark Group, which is partly owned by several online brokerages, and Mayer & Schweitzer, owned by Charles Schwab Corp.
They’re willing to pay for orders because they stand to make a profit from the prevailing “spread” in Nasdaq stock prices. For example, a wholesaler willing to buy XYZ stock from one investor at $20 a share (the “bid”) normally quotes a higher price--say, $20.13--to sell the stock to another investor (the “ask”).
The wholesaler would pocket the 13 cents-a-share difference.
Such price spreads exist, and are perfectly legal, because wholesalers expect to earn a profit for being willing to risk their own capital to maintain an active market in Nasdaq stocks, in good times and bad.
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Moreover, those price spreads have narrowed since 1997, when Nasdaq adopted new order-handling rules--a response to investigations by the Justice Department and the SEC into allegations of dealer collusion to maintain wide spreads.
“Individual investors are definitely getting better deals than they used to,” said Paul Schultz, a Notre Dame University finance professor whose 1994 study on Nasdaq led to the reforms.
Even so, he said, Nasdaq trading is “certainly not perfect,” as the payment-for-order-flow debate demonstrates.
And even though per-share prices paid by wholesalers for orders have plunged since Nasdaq reforms took effect in 1997, the SEC still is concerned.
SEC examiners are studying online brokers’ order-routing practices, Levitt said, to make sure that orders are sent to wholesalers who give the best executions--not the biggest payments.
Online brokers “simply can’t let payment for order flow or other relationships or inducements determine where they do business,” Levitt said.
Online brokers maintain that customers do receive the best executions--because, under the Nasdaq system, dealers are always supposed to execute trades at the best market price, either in-house or via another dealer--and that payment for order flow lets them offer rock-bottom commissions.
Kurt Halvorson, president of Advanced Clearing Inc., a unit of Ameritrade, said his firm sends orders to wholesalers based on the quality of their executions regardless of how much they pay for order flow.
Advanced Clearing regularly reviews the execution performance of the other firms and would yank business if standards weren’t met, he said.
“We evaluate our order-routing on a constant basis,” Halvorson said. “The primary focus is finding the best execution vehicle for the customer.”
Wholesalers have another reason to pay for order flow.
“By purchasing order flow, they’re also getting information,” said David Whitcomb, a finance professor at Rutgers University and chief executive of Automated Trading Desk, a day-trading firm. The firms see “which way the market is crumbling,” a valuable insight for their own trading.
That can be of use to the wholesalers as they decide between either automatic or so-called manual execution of the trades they field.
Under normal conditions, wholesalers use powerful computers to automatically execute orders. Investors get confirmation of completed trades within a few seconds.
However, in volatile markets wholesalers sometimes turn off their automated--or “auto ex”--systems and go to manual execution, whereby a trader oversees how the heavy volume of orders is processed rather than allowing the computer to complete trades automatically.
The problem, critics say, is that this slows the process at moments when stock prices are moving the fastest. An investor trying to buy shares may not be able to do so until the price is significantly higher.
“It is in the self-interest of the dealer, when the market is running, to not fill orders,” Whitcomb said. If the price of a certain stock is rising, for example, a firm could benefit by waiting to fill orders from its own inventory at higher prices.
Conversely, if the stock price is falling, a firm might wait to buy near the low--and sellers thus would obtain lower values.
“The option to switch from automatic to manual execution allows market makers to make money at investors’ expense,” Schultz said.
The National Assn. of Securities Dealers, which runs Nasdaq, monitors wholesalers to make sure they use manual execution properly and don’t go to it “at the drop of a hat,” said Stephen Luparello, NASD head of market regulation.
“We don’t want firms to be turning on and off their automatic [systems] in a way that may be manipulative of the market or [that would] disadvantage customers,” he said. “We look at those types of situations very seriously.”
But in some cases, a wholesaler may decide not to do a trade in-house at all. It would typically send the order out to the broad market, often via a Nasdaq trading system known as SelectNet, where orders may be filled by other dealers.
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In the best-case scenario, that can be time-consuming. Even worse, other firms may be hesitant to fill orders, forcing an extended execution delay.
“If we lower the size [of automated orders] on our systems, we’re doing it for a reason,” said an official at one wholesaler who asked to remain anonymous. “Generally speaking, when that happens here, it’s happening at all the other places. That’s why stocks go up or down so much”--because the relative lack of liquidity pushes prices until more buyers, or sellers, emerge in the market.
Wholesalers say they use manual execution sparingly, and only to avoid large losses when Internet stocks or other shares are gyrating wildly.
“That is used as an absolute last resort,” said Marty Cunningham, head trader at Mayer & Schweitzer. “The instances are few and far between.”
Ken Pasternak, Knight/Trimark’s chief executive, said his firm executes 95% to 99% of all orders automatically.
Some experts defend wholesalers’ right to avoid risking too much of their capital via automated order-filling in volatile markets.
“Whenever there’s a stampede of everyone running to the left, you don’t want to be in their way,” said James Angel, a finance professor at Georgetown University’s business school.
The problem, wholesalers say, is there’s no easy way to handle a flood of individual-investor orders that hit at the same time.
If 10 investors each submit an order to buy 500 shares of a stock at the same moment, “one person gets 500 shares and the other nine are dissatisfied,” Pasternak said.
“Investors expect automatic execution when they send their orders through,” said Harold Bradley, a fund manager and former head of trading at American Century mutual funds. “They don’t understand that everybody else is watching CNBC at the same time.”
Even so, the NYSE and other exchanges face heavy trading as well. But exchanges, unlike Nasdaq, rely on individual specialists on the trading floor to maintain orderly markets and execute trades at the best possible prices--in full view of other traders.
Specialists also can halt all trading in individual stocks if prices get excessively volatile, something Nasdaq doesn’t allow. In fact, Nasdaq’s board recently rejected a proposal that would have given Nasdaq officials broad power to halt trading when prices fluctuate wildly.
Times staff writer Walter Hamilton can be reached at walter.hamilton@latimes.com.
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Paying for Trades
Wall Street’s stock “wholesalers” pay discount brokerages for their individual-investor orders, a practice known as payment for order flow. Those payments, per trade, have sunk in recent years, but the overall amount of revenue that discount brokerages receive has risen with the surge in trading volume. Here are order-flow payment data for one major discounter, E-Trade Group:
PAYMENT REVENUE (in millions)
2nd-quarter fiscal 1999: $9.9 million
PAYMENT PER TRADE
2nd-quarter fiscal 1999: $2.30
* Sources: E-Trade Group; Duetsche Bank Securities
* MORE SAY
Individuals may soon have more control over how their orders are handled. C14
