When Cheap Stock Trades Aren't Cheap
By GRETCHEN MORGENSON
he popularity of online stock trading has
exploded as individual investors have come to
believe that their computers put them on the
same level as the professionals, at a very low cost.
But it is becoming increasingly clear that online trading
is far costlier than most investors think. Moreover, it
does little to level the investment playing field. Instead,
judging from a report released last week by the General
Accounting Office, online brokerage firms are Wall
Street's latest incarnation of the Wild Wild West.
Government researchers collected data from 12 online
firms in 1999. They were not identified, but they accounted for almost 90 percent of online
trades.
Delays and breakdowns were a big problem -- so common at one firm that it said
management did not track them.
Online firms provide customers with little information, the G.A.O. found, on the risks of
margin trading -- that is, using borrowed money to buy stocks. Nearly half the companies did
not detail the risks for their customers opening margin accounts; only a third posted on their
Web sites such information as the list of stocks they would not allow customers to buy on
margin. One investor found he had bought such a stock only when his broker called to
demand $75,000.
But even these problems pale compared with the difficulties investors have getting online
trades executed at the best possible price. Good execution is crucial to improving investors'
profits. But because the way a firm handles a trade is not as apparent as the $8 commission it
charges, few investors understand how important execution is or how they can be victimized.
Included in the report was a review by the Securities and Exchange Commission of 29 online
brokerage firms. Last year, the S.E.C. found, more than half were not meeting their obligation
to provide the best execution for their customers' trades. A major reason is that most online
firms have other firms complete their customers' trades in exchange for payments of as much
as 1 or 2 cents a share. These payments, big surprise, determine where a customer's order is
sent, even if another market or trader is offering a better price. On a 1,000-share sale, a
customer would receive $62.50 more if he got a price one-sixteenth above the prevailing
market.
Of the 29 firms the S.E.C. investigated, 17 "improperly emphasized payment for order flow
in deciding where to send orders." The regulators said the firms did not even try to assess the
prices available from trading firms other than those that were paying them. Indeed, most
routed orders to traders whose execution quality was well below industry averages.
It is high time investors understand that payment for order flow is corrupting trade executions
at many online firms -- and costing investors a bundle.
Steve Galbraith, a senior analyst at Sanford Bernstein, an investment firm in New York, said
such conduct helped explain the outsized profitability of some online brokerage firms.
"Execution is the securities industry's best-kept secret, and payment for order flow is part of
that," Mr. Galbraith said. "You're seeing monopolistic-type returns in what really should be
structurally an economically competitive industry. I think it's one of the paradoxes of the
market today."
Senator Carl Levin, the Michigan Democrat who requested the G.A.O. study, agreed. "Pay
for order flow is a good deal for the broker but is too often a bad deal for their clients," he
said. "The S.E.C. needs to get after this problem quickly and aggressively." Until then,
investors are vulnerable to bad executions and the high costs associated with them.
The S.E.C. should require brokerage firms to monitor trade executions, tracking how many
trades are done at prices better than those specified by investors. This is the information age.
Why should investors be clueless about how much money they are losing when they trade
stocks? |
