November 22, 1999
Dow Jones Newswires
SMARTMONEY.COM: Don't Go With the Flow
By MATTHEW GOLDSTEIN
Smartmoney.com
(This story was originally published late Friday.)
NEW YORK -- Web Street (WEBS), a small online brokerage firm that went public Nov. 17. has a great marketing gimmick. The Deerbrook, Ill., brokerage doesn't charge any commission on large trades of most Nasdaq stocks.
How can Web Street, whose stock is trading 28% above its $11 offering price, do this?
Like many online brokers, a significant chunk of Web Street's revenues comes from payments it receives from other financial institutions that process and execute trades for its customers. In Web Street's case, this revenue, or 'payments for order flow,' is so large - roughly 40% of its total revenue - it can afford to entice investors with the unusual freebie.
But a close look at the prospectus for Web Street's initial public offering reveals that this gravy train, as well as the promise of free trading for big investors, may be nearing an end. The online broker expects payments for order flow to shrink next year, when a favorable deal it has with another financial institution expires. Web Street, which could lose more than $5 million this year, says it may start charging commissions on those larger trades to make up for any lost revenue.
A potentially bigger threat to the long-term viability of Web Street and other online brokers that rely on payments for order flow may come on the regulatory front. Just this month, Securities and Exchange Commission Chairman Arthur Levitt Jr. voiced concern about the impact that paying for order flow may have on stock transactions. In a speech before the Securities Industry Association, the nation's top securities regulator said brokerage firms have an obligation to ship their customers' transactions to the market-maker or electronic communications network that offers the best price for executing a trade. But it appears, he says, some brokers are making decisions based not on what constitutes the best execution price, but whether they can get payment for order flow.
While there's no indication the SEC is going to prohibit payments for order flow anytime soon, the online brokers clearly are worried. The footnotes to their financial filings are rife with comments saying that regulators may move to restrict payments for order flow. And make no mistake about it, eliminating payments for order flow would have a profound effect on the bottom line for most online brokers. E-Trade Group (EGRP), for instance, took in $39.1 million in payments for order flow, roughly 6% of its revenues in fiscal 1999. At Ameritrade Holding (AMTD), payments for order flow account for about 8% of the Omaha, Neb.-based online broker's revenues.
Paying for order flow is a win-win situation for online brokers. But it also has been a good arrangement for the market-maker firms that pay out those large sums of money and direct the trading on Nasdaq. Market-markers make their money on the spread between the bid and the ask price for a particular stock. In other words, if a market-maker buys a stock for $1 and resells it for $1.06, the six-cents spread is the profit. In a standard payment for order-flow arrangement, a market-maker will pay one half of a cent per share to the brokerage firm for each transaction routed its way. So the market maker is willing to shave a bit off its profit margin, in order to insure a steady stream of trades coming its way.
By contrast, ECNs generally don't pay for order flow. They are alternative trading platforms that match buy-and-sell orders almost instantaneously. Instead of making money off the spread, ECNs charge a fee for every stock trade they complete.
Naturally, online brokers and market-makers deny there's anything unsavory about paying for order flow and insist investors are not getting cheated in the process. The online brokers contend that by accepting payments for order flow, they can keep their basic commission fees low. Market-makers say the arrangement insures a steady flow of transactions, and that keeps the Nasdaq market moving smoothly. But online brokers seem reluctant to discuss the issue. Officials from E-Trade and Web Street, for instance, were unavailable for comment.
Kenneth Pasternack, chief executive for Knight/Trimark Group (NITE), one of the biggest Nasdaq market-makers, says paying for order flow has no impact on the way his firm executes transactions. He insists that by paying for order flow, Knight actually insures a better price for investors because the market is more liquid and subject to less price volatility. During the first nine months of 1999, Knight shelled out $98.9 million in order-flow payments to brokerage firms, up from $56.1 million during the same time last year. 'When our customers place an order through our Web site, they are expecting it to get executed as soon as they hit the button and to come back with the price that they saw on our screen, and that's our job,' he says.
But not all market-makers agree. Anthony Broy, president of Hill Thompson Magid, a Jersey City, N.J.-based market-maker firm, says paying for order flow can create a disincentive on the part of a market-maker to narrow the spread between the bid and ask price. Once a market-maker is assured of an order heading its way, there's no need to narrow the difference between the selling and buying price. In Nasdaq-speak, a wider spread means more money for the market-maker and generally less for the investor. Broy says he'd prefer to see the securities industry abolish the practice of paying for order flow.
Meanwhile, investor advocates and state regulators are cheering Levitt's speech. They say many investors largely are unaware that brokerage firms even receive payments from market-makers. Some regulators suspect that a good number of online investors may not even know that most online brokers are nothing more than middlemen in the stock-execution process. 'Few investors know about these behind-the-scenes arrangements that can cause them to pay too much when they buy a stock and get too little when they sell," says Bradley Skolnik, president of the North American Securities Administrators Association and Indiana's top state securities regulator. 'Payment for order flow reduces the incentive to better the customer's price."
So stay tuned, in the coming year, the big battle at the SEC could just be over how much money your online broker makes for shipping out your trades to another financial institution. |
