Sunday, August 27, 2000
Do Wall Street Firms Know Too Much?
Some Are Taking Advantage of Clues From Online Trades, Critics
Say
By WALTER HAMILTON, Times Staff Writer
Wouldn't you love it if the stock market worked like this: Before
trading a stock, you could look at the orders of scores of other
investors to get a good idea whether the share price is heading up
or down.
Of course, individual investors don't have such an edge. But, say
some critics, a cluster of Wall Street firms do--and they're using it
to make huge profits at the expense of online investors.
The critics claim that some firms, because they execute a huge
number of online investor stock trades, get important clues about
the market that they use to boost their own trading success.
The flip side is that individuals lose big: Wall Street's profits come
directly out of their pockets by leaving them with inferior
executions or unfilled trades.
"It's a terrible shame that retail investors aren't getting the best
prices and everybody knows it," said Bill Burnham, a venture
capitalist who previously was an analyst tracking the online
brokerage industry. "The dark secret is that retail investors are
known as the 'dumb' money, and everybody on Wall Street thinks
it's OK to take advantage of the dumb money."
The Wall Street firms vigorously deny that they have a leg up or
that they hurt small traders.
Nevertheless, the National Assn. of Securities Dealers has
proposed a rule that could lessen some of Wall Street's trading
advantage.
The crux of the debate centers on the cold reality of the market:
If another investor knows that you're about to buy a stock, he'll try
to buy it first so that he can then sell it to you at a higher price.
Put another way, information is money. And you suffer if someone
else has information about what you're planning to do.
Each time a small investor submits a stock order, she sends Wall
Street a piece of information--her desire to buy or sell.
In isolation, an order to trade a few hundred shares isn't of much
value. But when bunched together, those orders can yield important
clues about the short-term direction of a stock's price.
Mutual funds and other big investors go to elaborate lengths to
prevent others from seeing their hands. They have trading desks
that monitor how Wall Street handles their orders. And they divvy
up big orders among brokerages to avoid leaks.
For years, individuals didn't have to worry about who saw their
orders. Most people were buy-and-hold types who cumulatively
accounted for only a fraction of market trading volume.
But with online investing surging in popularity since 1995, small
investors now wield the cumulative power to move stocks.
Market Makers' Dual Role
Growing along with small investors have been the behind-the-scenes
firms that execute their orders.
Though there are roughly 100 electronic brokerages, most online
investor trades are executed by just a handful of firms known as
"wholesale" market makers. Online investors zap an e-mail message
to an online brokerage, which in turn instructs a wholesaler to
execute the trade. Wholesalers often use their own capital to do
the trades--buying stock from a seller or selling to a buyer.
(By standing ready to buy and sell stocks, the firms are said to be
making markets. The term "wholesale" refers to firms that handle a
lot of small-investor orders.)
The biggest wholesalers, as well as the biggest Nasdaq market
makers, are Knight Trading Group Inc. and Schwab Capital Markets,
a unit of brokerage giant Charles Schwab Corp.
The important fact to understand about market makers is that they
have a dual role. While they execute trades for customers, they
also trade for their own accounts.
In theory, that's a potential conflict of interest. However, a
battery of rules is designed to ensure that firms work on behalf of
customers.
Still, each time a market maker uses its own capital to buy from, or
sell to, an investor, the firm is said to be trading "against" the
customer.
The emergence of wholesalers has altered the trading game in key
ways. Wall Street firms have always stood to benefit--at least
theoretically--from knowing what their clients were doing. But even
the biggest firms had no more than a tiny fraction of overall orders
and could only speculate as to where the market was going.
Wholesalers, by contrast, have enormous order flow. Knight has a
whopping 17% of Nasdaq market share, while Schwab is No. 2 with
12%, according to Autex/BlockData. Goldman Sachs Group, by
contrast, has less than 3%. The firms have larger market share in
some volatile technology stocks.
The fact that wholesalers get much of their order flow from
individuals helps them in at least three distinct ways.
First, most individuals are considered to be the least-informed and
least-savvy traders, and Wall Street has always liked to trade
"against" them. It's like playing poker against a novice rather than a
Las Vegas card counter.
Second, individuals can't employ the same tactics that big investors
use to cloak their orders from market makers.
Third, individuals are big players in the tech stocks on which
wholesalers can make the juiciest trading profits.
To critics, market makers exercise their informational advantage in
two key ways that harm online investors. Between the two, Burnham
estimates that about one-third of all online trades are affected.
The first is the way wholesalers trade at the opening of the Nasdaq
market each day. Because individuals submit a huge number of
orders overnight for execution the next morning, wholesalers can
get a good idea if a stock will open higher or lower.
Say, for example, that a stock closed Monday at $50. If a
wholesaler has overnight orders to buy 20,000 shares but orders
to sell only 5,000, the stock is likely to open higher Tuesday.
How does a market maker benefit from that knowledge? Typically,
critics say, the firm buys shares in informal pre-market trading
among dealers Tuesday morning. Say the firm pays between $50
and $51 a share. Then the firm can jockey with "bid" and "asked"
prices in a way that can influence the opening price--which becomes,
say, $52. The firm then unloads shares to its long line of buyers at
$52, guaranteeing itself a profit.
Profiting, Yes, but Unfairly?
To Burnham, that's nothing less than a violation of insider-trading
laws.
"It's clear that this kind of situation is exactly what the
insider-trading laws are supposed to prevent," he said. "It's
amazing to me that the biggest insider-trading racket on Wall
Street continues unabated and nobody seems to care."
Wholesalers scoff at that notion. "He's totally half-baked," said
Kenneth Pasternak, Knight Trading's chief executive. "He's totally
wrong."
Although Knight is a sizable wholesaler, it still has only a small
portion of overall orders, Pasternak said. His firm might know which
stocks some individuals are buying and selling, he said, but it doesn't
know what institutions are doing.
Thus, if Knight were to buy at the opening simply because individuals
were doing so, the firm could lose if heavy institutional selling drove
down the price.
"Even though we might have 10% of the information [on a given
stock], we don't have 90% . . . and that's a lot of information not to
have," Pasternak said.
In fact, he said, the opening is the only time of the day that Knight
consistently loses money.
Knight promises to execute at a single opening price most of the
overnight Nasdaq orders that it receives from online brokerages.
Knight claims its policy--which applies to the first 250,000 shares
of any Nasdaq stock--saves investors money because their trades
are done at the midpoint of a stock's bid-asked spread. Midpoint
pricing resulted in better prices for investors on 91% of Nasdaq
opening trades in June, Knight said.
Because the firm often uses its own capital to complete the trades,
it can lose money when stocks go the wrong way, Pasternak said.
Nevertheless, Knight has been enormously profitable. Its profit
more than tripled last year to almost $168 million. And Knight has a
"relatively low number" of days when it loses money regardless of
market conditions, Pasternak acknowledged.
To Burnham, that's proof that the firm has a knowledge advantage.
Without it, Knight would have fluctuating profit as it speculated
blindly on the market. "This is the major source of their profits,"
Burnham contends.
In fact, the surging profitability of wholesalers recently attracted
one of Wall Street's premier names: Merrill Lynch & Co. agreed in
June to pay more than $900 million to buy Herzog Heine Geduld
Inc., the No. 3 Nasdaq market maker.
Wholesalers acknowledge that professional traders have an edge
over individuals. But, they say, that's no different from a car dealer
knowing more about the auto market than a consumer, and they
argue that the firms don't have an unfair advantage.
"If you have a pro who trades Intel all day long and he's not
somewhat smarter than the aggregate of 5 million people who might
buy Intel here and there, then he should be fired, right?" Pasternak
said.
Knight makes money because it has superior technology and smart
traders who are better at assessing public information, he said.
"Our advantage is not around what we see. It's what we do with it."
Lon Gorman, head of Schwab Capital Markets, said wholesalers may
have had an informational advantage earlier this year when stocks
were soaring. But that was attributable to a brief market anomaly in
which shares were being powered by small investors rather than by
institutions.
"Although there was a period of time where one could argue that
this information advantage existed to some extent, I would argue
that the information advantage right now is totally meaningless,"
Gorman said.
Proposal Would Tighten the Rules
Nonetheless, the wholesalers' power has helped trigger calls for
tightened trading rules.
Last month the NASD proposed a change to Nasdaq pre-market
trading that could partially eliminate the wholesalers' information
edge. The proposed rule, which would require Securities and
Exchange Commission approval, would bar a market maker from
trading for its own account at prices that are better than what a
customer gets.
Thus, if a customer submits a "limit" order to buy a stock at $20 or
better, and the firm buys at $19, the customer's order would have
to be filled at $19.
The rule would apply only to customer limit orders--requests to
trade at specific prices--designated to be filled between 8:40 a.m.
EST and the formal market opening of 9:30 a.m. It would not apply
to overnight "market" orders, which are filled at the prevailing
market price, or to pre-market trades before 8:40.
Officially, however, the NASD says it doesn't believe that
wholesalers have an informational advantage.
Though they have a larger share of orders, wholesalers don't have
enough to guarantee they know the market's direction, said Bill
Broka, NASD senior vice president of trading and market services.
"If the overwhelming majority of retail people are in a sell mood in a
particular stock, they may collectively represent 200,000 shares,"
he said. "But you can have several institutions who may be buyers
and collectively they represent 2 million shares. If you're handling
all those retail orders, you got one view of the market, and the real
one may be something entirely different."
Annette Nazareth, SEC market regulation director, also doubts
that small investors are being hurt.
Though they may have suffered from wholesalers' pre-market
trading habits, that should be rectified by the NASD proposal, she
said.
As for the overall issue, Nazareth acknowledges that market
makers may have a leg up by seeing order flow. But that is an innate
part of their business and is not necessarily unfair to investors, she
said.
"Not all informational advantages are illegal," she said.
Price Improvement, but Buyers Shut Out
Which brings us to the second way critics see wholesalers
exercising their informational advantage to the detriment of online
investors. Ironically, it can stem from the firms' efforts to give
small investors what regulators want--"price improvement,"
meaning a better price on a trade than the prevailing market price.
To understand how, consider this scenario: A small investor decides
to sell a stock when it's trading at $20 a share. A market maker has
a standing order from another individual to buy at that price.
But rather than matching the two orders, the market maker buys
from the seller at $20.06. The firm has "price improved" the seller
by 6 cents a share.
Why? Because the firm has a pretty good idea from observing its
order flow that the stock is heading up, critics say.
"People aren't price-improving people out of the goodness of their
heart," Burnham said. "They're doing it to make money. And they're
usually doing it simply because they have a great certainty that they
can make even more money by offering a slightly better price."
Though the seller has gotten a better price, a would-be buyer has
been shut out as the market maker "stepped ahead" of him.
Market makers "actually trumpet their act of stepping ahead as
price improvement," said Ed Nicoll, chief executive of brokerage
Datek Online Holdings. "They say, 'Look at this terrific thing that I
did. I price-improved.' But they never talk about the fact that they
step ahead of a buyer who would have bought it at that price, and
they're disadvantaging the buyer. They always forget to mention
that."
The problem, critics concede, is that the advantages wholesalers
have in handling small investors' orders aren't easily proved, and
the cost to investors, taken individually, isn't enough to trigger a
public outcry. "You're not screwing anybody dramatically," Burnham
said. "You're not kicking an old lady out of her home. You're just
nicking her for a dollar or two on every trade she does."
Part One of this series and related stories are at
latimes.com.
* * *
The Pre-Market Trading Game
Here's how critics say wholesale market makers can profit at the
expense of small investors in pre-market trading:
* * *
Step 1: After the stock closes at $50 on Monday, small investors
send a flood of overnight orders to buy shares of UXYZ Corp. The
orders are routed by online brokers to a wholesale market maker
to be executed when the Nasdaq market opens Tuesday at 9:30
a.m. Eastern time.
* * *
Step 2: By 8:30 a.m. Tuesday, the wholesaler has orders to buy
20,000 shares but to sell only 5,000--a sign that the stock price
will open higher. Using electronic networks on which institutions
swap shares in pre-market hours, the firm buys 15,000 UXYZ
shares at $50 to $51 each, adding them to the 5,000 shares it buys
from Monday's sellers so it has 20,000 to fill the buy orders.
* * *
Step 3: A few minutes before the market opens, the wholesaler
often uses legal, though controversial, trading techniques to push up
UXYZ's price. The goal is to guarantee that UXYZ opens at the
price the wholesaler wants.
* * *
Step 4: The stock opens at $52, thus turning a profit for the
wholesaler, which sells to individuals the shares it bought at lower
prices.
Trading Glossary
* Informational advantage: A situation, critics say, in which a market
maker gains an edge in trading stocks for its own account by
observing the trading patterns of its customers.
* 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.
* Stepping ahead: A situation in which a market maker offers a
slightly higher price to buy a stock, thus "stepping ahead" of a
customer who otherwise would have bought it. If, for example, a
buyer and a seller place simultaneous orders to trade a stock at
$20, a market maker would step ahead by offering to pay $20.06.
The would-be buyer would suffer if the stock subsequently rose.
* Wholesale market maker: A market maker that caters to
small-investor trades.
Copyright 2000 Los Angeles Times
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