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Nov. 26 — O.K., stock investors, it’s 10 a.m. Do you know where your order is? Until now, you had virtually no way of knowing. But two new SEC rules, approved this week, should help shed some light on an area of investing that has long eluded individuals. Who’s executing my trade? And just how do I know I’m getting the best price?
WITH MORE and more individual investors taking on tasks they used to rely on their broker for, the Securities & Exchange Commission is trying to provide you with access to information that used to be reserved for Wall Street insiders. Regulation FD, which recently forced companies to open up their once-clubby conference calls with Wall Street analysts, is one example.
Two fairly obscure new SEC regulations approved this week and scheduled to go into effect next spring — Rules 11Ac1-5 and 11Ac1-6 — are another. The first regulation forces brokers and market makers to let you compare the price you paid with other concurrent trades for the same stock.
The second rule requires brokers disclose a widespread, legal but poorly understood practice known as “payment for order flow.” That’s where your broker gets paid to steer your trade to specific market maker — even if that’s not where you’ll get the best price. Together, the rules are designed to illuminate one of the darkest corners of stock trading for individual investors.
“It’s the black hole of investing,” said John Markese, president of the American Association of Individual Investors. “It’s very hard to judge” whether you’re getting the best execution, he said.
Until now, it’s been virtually impossible for an individual investor to follow the paper trail that begins after you click “buy” on a broker’s Web site or place an order by phone. That’s because your order can be routed to any of a number of so-called “market makers” that actually match buyers and sellers. In doing so, they pocket the “spread” — the difference between what the seller is willing to accept and the buyer is willing to pay.
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With the increasing fragmentation of Wall Street trading venues, spreads can vary widely from one market maker to another at any given moment. But investors have little way of knowing whether they’re getting the best price available.
What few investors realize is that many of those market makers pay brokers to steer your trade their way — whether or not that’s where you’ll get the best price. Brokers may also steer trades to their own firm’s trading desk. (That’s called “internalization.”)
TRUE COST OF A TRADE
The payments they get for order flow help discount brokerages subsidize low commissions. But while you may be saving money with that $8 commission, the total cost of your trade includes the spread. And for a 1,000-share trade, every extra 1/8 of a point costs you $125.
Critics say paying for order flow amounts to a conflict of interest — because market makers who pay to capture orders have no incentive to make the trade at the best price.
The SEC had considered a real-time solution, a so-called central limit order book that would have been a kind of gateway for all trades. But the securities industry successfully argued that such a system would stifle competition by, among other things, giving individual market makers little incentive to add new technology.
So when the new rules take effect in April, brokers and market makers will have to provide you with information about your trade retrospectively — for up to six months after its made. While the SEC is telling brokers and market makers that have to disclose the information, it’s not saying how.
For starters, it will probably look something like the monthly reports on time performance and baggage handling data the Transportation Department requires from airlines. Disclosing the information is no guarantee that your flight won’t be delayed. But over time, airlines with the most delays are punished by travelers who choose other carriers.
By comparing data on a broker or market maker’s overall order execution — especially the speed of execution and the average spread — investors will be able to chose brokers and market makers that provide the best trades.
“If nothing else it puts the brokerage industry on notice that someone is going to look at this execution data,” said Markese.
But the new rules go further by requiring disclosure of the specifics of individual trades — such as where it was routed and how the spread you paid compares to with other trades in that stock at the same time. Using the airline analogy, that’s like asking the airlines to look up Flight #325 from Cleveland to Albuquerque on August 14th and tell you how long it took to clear the gate.
“From the market maker’s perspective this is where they get down and dirty and are required to disclose specific information on a security by security basis,” said Russell Keene, an analyst who follows the online brokerage industry at Keefe, Bruyette and Woods.
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LOTS OF QUESTIONS
For some brokerage firms, especially those with outdated back-office systems, the new rules create a potential bookkeeping nightmare.
And the cost doesn’t end once they’ve figured out how to make the information available, according to Robert Schwartz, a professor of finance at Baruch College. “Part of the cost of providing the information is answering customer questions” after they receive the trade-execution reports, he said.
Though many analysts expect third parties to jump in to collect and analyze the data, it’s not clear yet just how the system will work. Companies like Gomez Advisors, which ranks brokers using over 250 criteria on its Web site, will likely include it in their ratings. Details on execution will likely have the most appeal for the most active traders, according to Gomez analyst Dan Burke.
“If one firm is getting a 16th [of a point] more than the other, for someone that doesn’t trade as much it’s not as much of an issue,” he said.
One thing investors won’t be able to do with the new data is hold their broker liable for trades that they believe weren’t handled properly. The SEC included language in the new rules saying they “don’t create a reliable basis to address whether a particular broker failed to meet its legal duty of best execution.”
That means you can’t sue if you think you didn’t get the best price. But you can go find another broker.
So will investors think twice about using with a broker that gets paid for steering their trades? Maybe. But the practice will likely continue even after the rules take effect, according the Greg Smith, an analyst who follow the online brokerages industry at Chase H&Q.
“Payment for order flow is not going to go away as long as there’s value in that order flow,” he said.
Defenders of the practice also note that market makers who pay for order flow are also generating a better market by accumulating more volume. More volume means more competition among buyers and sellers, which makes for better trades for both sides.
The new rules are clearly designed to narrow the spread you pay as much as possible — but only to a point. Without any spread, there would be no market makers. And without market makers to step in an commit their own capital, spreads on thinly traded stocks would widen — especially when there’s a big imbalance of buyers or sellers. That’s why some observers say the SEC stopped short of an outright ban on payment for order flow by market makers.
“If they got rid of it altogether it would have very painful side effects,” said Smith. “And it would hurt investors.” |
