E-Trading a Bad Deal for Investors?
U.S. financial markets are supposed to be the envy of the world.
So why does the average investor still often have such a tough time getting a simple online stock order done right?
Brokerages are legally required to obtain the highest possible price when customers sell shares and the lowest price when they buy--and with good reason.
Poorly executed trades usually cost investors far more than they save with cut-rate commissions. Someone who pays as little as 1/16th more than necessary to buy 1,000 shares has forked over an additional $62.50.
The quality of the brokerage industry’s trade executions has been an issue for small investors seemingly forever, but especially in the last five years, as the ranks of individuals buying and selling stocks online has mushroomed.
Securities and Exchange Commission Chairman Arthur Levitt has harped on the execution issue more than any of his predecessors, even announcing to great fanfare 15 months ago a special “examination sweep” focusing on how brokerages treat customers’ orders.
Yet the evidence still strongly suggests that individual investors too often are victims of inferior trade executions--whether they know it or not.
Consider:
* The SEC found execution problems at 17 of 29 online brokerages, according to a General Accounting Office study released in May. Most firms routed orders to stock exchanges or dealers whose execution quality was “well below industry averages.” The SEC just announced a new “comprehensive study” of execution quality.
* A separate SEC investigation this year turned up a “pattern of serious neglect” in the handling of “limit” orders, which are investor requests to trade at specific prices or better, Levitt said in May.
In June, the National Assn. of Securities Dealers hit J.P. Morgan & Co. with a $200,000 fine, the biggest-ever penalty of its kind, for limit-order violations.
Ensuring the proper processing of limit orders was the keystone of major Nasdaq market reforms in 1997. The industry’s adherence to those reforms is considered essential in guaranteeing fair executions.
* Execution-related problems are the leading source of complaints by individuals about their online brokerages, SEC records show. In the first half of this year, small investors lodged 779 execution-related complaints against online brokers, compared with 868 in all of 1999 and 413 in 1998.
“It’s getting better, but [execution problems] still are certainly there,” said Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations. “A lot of firms need to do a lot more.”
Concerned that many investors still aren’t getting what’s formally known as best execution, the SEC recently proposed opening the industry’s dealings to more sunshine by having brokerages regularly disclose for all to see how they go about filling customers’ orders.
Online brokerages, the principal targets of execution complaints, dispute the criticisms, saying that they work hard to get their customers the best prices.
At Charles Schwab Corp., 92% of orders are executed instantaneously via an automated system, and 97% are done within five seconds, said Lon Gorman, Schwab vice chairman.
“At the forefront of everything we do, our clients’ best interests come first,” Gorman said. “Always have. They come before profitability. They come before anything.”
Even so, Schwab, the leading online firm, recently agreed to pay up to $20 million to settle a class-action suit alleging persistent quality-of-execution problems. The firm denied any wrongdoing, but agreed to spend that sum on investor education and the implementation of a new trading system giving customers better control over their orders.
Squeaky Wheel Gets the Grease--Sometimes
Eric Wells thinks he knows plenty about execution troubles.
In the nine months since the 38-year-old technology consultant opened an account at E-Trade Group Inc., he has complained to the firm about trade executions on 13 occasions. In each case, Wells said, the price at which his order was filled was “drastically different” from the price at the time he submitted the order.
Ten times, E-Trade acknowledged an error and gave him the better price, Wells said. But that’s little consolation to him.
“I’m probably much more likely than other people to pick up the phone and complain,” the San Francisco resident said. The repeated problems “tell me that there are quite a few investors out there who get bad fills, look at the screen and say, ‘I got unlucky that time,’ and don’t do anything about it.”
On July 26, Wells got what he said was one of his worst executions, which he says cost him almost $16,000. When trying to sell stock-option “call” contracts on fiber-optics firm JDS Uniphase Corp., he got no confirmation of his trade. He called E-Trade, where, Wells said, a broker assured him that his order was filled at the price he expected.
But the firm later reversed itself, he said, saying his execution was actually delayed about 45 minutes because of a volatile market--and that the real price was only two-thirds of what he was first told.
Instead of selling the contracts for $43,780, the trade was done at only $27,875--a whopping $15,905 difference, Wells said. In that case, E-Trade rejected his appeal.
An E-Trade spokesman said the firm doesn’t discuss individual cases, but that it strives to give customers good executions.
To be sure, some things have improved for individuals on Wall Street. After a government investigation into alleged price fixing among brokerages in the Nasdaq market, the SEC in 1997 adopted landmark reforms that ended what critics said was a long history of abusive trading practices.
The resulting changes have narrowed spreads--the difference between the prices at which firms buy stock from, and sell stock to, investors--by more than 30%.
Also, the SEC says that some of the complaints it receives from investors don’t reflect bad brokerage practices, but rather customers’ lack of understanding of how trading works.
Nevertheless, regulators say brokerages are partly responsible for the lack of awareness because they lure customers to trade with glossy advertising, yet don’t warn enough of the risks.
The term execution simply refers to the completion of a trade. Anything that prevents a trade from getting done--or getting done at the best price--can trigger investor complaints.
In the last two years, some of the most common execution grievances have been tied to online brokerage Web site outages or system slowdowns. Some customers have seen their orders simply not get done, or get done after lengthy delays and at wildly different prices.
But though the SEC is concerned about technology glitches, the deeper quality-of-execution issues are ongoing and systemic in nature.
The trade debate is muddied because there is no single definition of “best” execution. Rather, the best price is unique to each trade. And factors such as the volatility of a stock and its trading volume on a given day make it difficult for investors, brokerages and regulators to agree on what the best price was at any moment.
Some Troubled by Industry Practices
Still, there are two continuing industry practices that critics say all but guarantee that execution quality will remain suspect.
The first is what’s known as payment for order flow. It works like this: Third-party dealers, known as “wholesale” market makers, pay a quarter-penny to two pennies per share to online brokerages for the right to execute their customers’ orders.
The wholesalers often use their own capital to fill trades, meaning individuals end up buying from, and selling to, these firms.
The biggest wholesalers are Knight Trading Group Inc. (formerly Knight/Trimark Group) and Schwab Capital Markets, a unit of Charles Schwab.
Wholesalers make money by purchasing shares from some customers at one price while selling to others at a higher price, benefiting from the price spread. That is legal. But if a particular wholesaler wasn’t the best place to send an order to begin with, the execution may well be suspect, critics say.
Wholesalers shell out a lot of money to buy orders from online brokerages. Last year, for example, Knight forked over $139 million in such payments, up from $82 million the previous year.
The other common practice is “internalization”: Rather than sell orders to a wholesaler--or show the order to the market overall--a brokerage such as Schwab may internalize order flow by shipping it to an in-house market maker.
Payment for order flow and internalization are most prevalent in Nasdaq stocks, but also are commonplace in New York Stock Exchange stocks.
The trouble, regulators say, is that some online brokerages send orders to market makers that pay them the most--not those that provide customers the best execution at that moment.
Experts say it’s widely known that some market makers provide better trade executions than others--with superior firms often not getting the business they deserve.
“I don’t think there’s any question that some firms do a better job at best execution than other firms,” said Stephen Luparello, head of market regulation at the National Assn. of Securities Dealers’ regulatory arm.
Even some people on Wall Street are troubled by payment for order flow. A June survey by the Security Traders Assn. showed that 44% of professional traders think the practice should be banned outright. Another 22% say certain forms of payment for order flow should be eliminated.
The SEC’s Levitt, in a speech last month, may have stunned some investors when he said that about 85% of Nasdaq “market” orders--that is, orders to buy at the prevailing market price--are sent by brokerages to dealers that aren’t quoting the best price at that moment.
Online brokerages counter that it doesn’t matter where orders are sent because all firms are required by market regulation to execute orders at the best quoted price. The system is the equivalent of a retailer being required to match the best deal quoted by a competitor.
But that raises another key issue: Regulators and others say that simply matching the best quoted price for a stock isn’t enough. Rather, market makers should work to find better prices for customers, critics say.
Just as a consumer might get a better deal on a TV by negotiating at an electronics store, investors can sometimes do better when market makers aggressively seek “price improvement,” traders say.
“If you work your orders really hard you can find better prices than the [quoted price],” said David Whitcomb, chief of Automated Trading Desk, a boutique firm.
Yet by automatically internalizing orders, or by routing them to a handful of wholesalers that pay the most for such order flow, brokerages don’t “expose” individuals’ orders to a far larger number of investors in the broad market that might offer better prices--if only they knew the orders were there.
Market makers counter that price improvement is over-hyped, and that most customers are far more concerned with immediate execution of a trade. What’s more, the firms say, they provide a depth of liquidity--the ability to quickly trade big blocks of stock--that smaller competitors can’t.
“Some customers care about price improvement. Most of our customers don’t,” said Schwab’s Gorman. “Most of our customers care about certainty and speed of execution. Period. End of story.”
How often could small investors get price improvement? Industrywide, investors trading NYSE and other listed stocks received better prices on about 30% of trades in the second quarter, garnering an additional 9 cents a share, on average, according to Transaction Auditing Group Inc., a firm that monitors trade executions.
For Nasdaq stocks, prices were bettered only 9% of the time, by an average of 14.8 cents a share.
Though customers in some cases could get better prices, frequently the opposite would happen, Gorman argues: By the time his firm searched for a better price and realized there wasn’t one, the original price at which the customer could have traded would be gone, he said.
Then Schwab would have to explain why it didn’t, say, sell at $50 before the price fell to $49, he said.
“You know what my customer will do? He will scream and yell,” Gorman said. “When they see a price [on their computer screen], they expect to get that price. It’s great if they get more. But [they say], ‘Don’t give me less.’ ”
SEC Critical of Execution Quality
But the SEC, under Levitt, has found the brokerage industry’s answers regarding quality of execution to be wanting.
Indeed, the SEC has been angered that some brokerages simply can’t say if they’re getting customers good execution. Brokerages are required by law to do “regular and rigorous” analysis to ensure that they’re getting customers the best deal. But the GAO study said many online brokers do not evaluate whether they can get better executions for customers.
When regulators find apparent execution violations, they ask the firms for an explanation. If they aren’t satisfied with the answer, they launch a formal inquiry that can end with enforcement actions.
The NASD is conducting “a number of pending significant best-execution investigations,” Luparello said.
To tackle the overall execution problem, the SEC last month proposed a rule requiring brokerages and market makers to divulge their trade-execution records so that customers can compare firms.
Among other things, firms that route orders to dealers would have to reveal the payments they receive. The reports would give monthly and quarterly figures in the aggregate. But they wouldn’t provide data on each trade--thus preventing investors from assessing the quality of individual transactions.
Another partial solution may be coming within the next few years. Many brokerages are working on ways to let customers specify their preferred order-routing when they submit orders online. A small investor could theoretically instruct that his order be sent to a private trading network that competes with Nasdaq and the NYSE.
But for now, industry critics say the best advice for many small investors is simply to be vigilant in watching how orders are handled--and to be willing to complain if they believe a trade wasn’t handled fairly.
*
Times staff writer Walter Hamilton can be reached at walter.hamilton@latimes.com.
Next week: Do a handful of behind-the-scenes Wall Street firms have too much information about small investors’ online stock trades?
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Leading Complaints
Here are the top 10 grievances about online brokerages filed by individual investors with the Securities and Exchange Commission in the first half of 2000. Trade-execution issues are in bold:
Trades missed/delayed: 479
Margin position sellouts: 221
Can’t access account: 218
Errors in orders: 184
Account transfers: 173
Deposits, withdrawals: 162
Best-execution problems: 155
Orders not canceled: 145
Errors on statements: 142
Couldn’t open account: 117
Source: Securities and Exchange Commission
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Glossary of Trading Terms
* Best execution: Official term for the requirement that brokerages obtain the highest price for sellers and the lowest price for buyers.
* Internalization: A close corollary of “payment for order flow” (see below). Instead of selling orders to an outside firm, an online brokerage ships them to another division of its company for execution, thus keeping the profit in-house.
* Limit order: An instruction to a broker to execute a trade at a specified price or better.
* Market maker: A firm that executes trades on the Nasdaq Stock Market. Because they stand ready to buy or sell shares whenever investors want to trade, such firms are said to be making markets.
* Payment for order flow: A widespread practice in which online brokerages sell customer orders to outside firms that execute the trades. Brokers say the payments allow them to charge low commissions. Critics contend that many brokerages send orders to firms that pay them the most but that give poor executions to customers.
* Price improvement: The term for when a customer receives a better price than the quoted price.
* Quoted price: The best price being publicly quoted at any moment.
* Wholesale market maker: A market maker that caters to small-investor trades.
Source: Times research
