JD,
Good point about the ISLAND problem. But your axe to grind is better done else where FWIW.
March 28, 1999
Hidden Costs in Online Trading
The New York Times: Your Money
Forum
By GRETCHEN MORGENSON
illions of Americans have rushed into the brave new world of electronic stock trading. Armed with fast computers and sophisticated software, they see themselves not only at the market's epicenter but also on the same plain as professional traders. For extra enticement, there are low commissions, sometimes less than $10 a trade.
What many investors may not realize is that their trades -- particularly in the sizzling Internet stocks with which online traders are infatuated -- are not finding their way to the market through traditional channels.
Instead, much of that trading is being piped through new types of electronic networks -- systems that, in theory, are ideal marketplaces, where buyers and sellers can trade stocks without paying a markup to the professional traders who have long served as middlemen in the NASDAQ market.
The new trading systems, called electronic communications networks, or ECNs, are pitched as a way for investors to gain instant access to the markets and to compete head to head with professional traders.
Yet for all their promise, the ECNs have distinct downsides. They and the investors who use them -- including the growing numbers of rapid-fire day traders -- are contributing to the wild ricocheting of prices in Internet stocks.
Moreover, although commissions to trade online are indeed rock bottom, there are hidden costs in using the networks. Prices on these networks are inferior on 8 out of 10 stocks they trade, according to the National Association of Securities Dealers. In large part, that is because investors are trading only with other investors who are using the same network, rather than "meeting" all other investors in the broader NASDAQ marketplace.
Frustrations over poor prices or trades that were not executed at all have led some experienced investors to wonder whether something is amiss between the time orders are placed and the time they show up on an ECN.
"The upside is that investors are getting that meeting possibility," said Richard G. Ketchum, president of the NASD. "The downside is that they are not getting any execution guarantee."
The networks now account for about 20 percent of trading in NASDAQ stocks -- more than the volume on the American Stock Exchange and all the nation's regional stock exchanges combined. But even investors who are not using the networks have reason to be concerned, as volatility jumps and total trading costs increase.
"We're in a period of disequilibrium right now," said Bruce Weber, assistant professor of information systems at New York University's Stern School of Business. "Anybody that's trading a NASDAQ stock these days has to work harder to find the best price and ideal counterparties than they did maybe three or four years ago."
With the NASDAQ composite index up 10 percent so far this year, the problems have been largely papered over by investor profits. Not until a full-fledged market dive will investors find out whether the fragmented marketplace created by the rise of the ECNs will make it harder to sell -- or harder to sell at a good price. Such difficulties could make jittery investors panic, turning a trickle of selling into a flood and pulling down more established stocks, too.
Regulators opened the door wide to the new networks after they found in the mid-1990s that traders in NASDAQ stocks were profiting from artificially wide spreads -- the difference between the price at which traders buy shares from sellers and the price at which they will resell them to buyers.
In the most important change, regulators forced NASDAQ traders to display customers' orders that fell at prices within the spread. They also encouraged the creation of new networks that would allow investors to meet. Rather than taking a markup on trades, the networks profit by charging a small fee for each transaction.
Most of the electronic networks operate today for institutional investors. The oldest is Instinet, a unit of Reuters Group PLC. But two fast-growing services cater to individual investors: Island, a two-year-old network owned by Datek Holdings, a discount brokerage firm in Iselin, N.J., and Archipelago, a Chicago company whose owners include Goldman, Sachs and E(star)Trade Group. The 200,000 customers of Datek Online have trades funneled to Island.
"ECNs are one of the most dramatic forces reshaping the equity markets," said David Cushing, director of research at ITG Inc., a research and trading company that runs a trade-matching service for institutional investors called ITG Posit. "I think ECNs have a very valuable role in improving the efficiency of the market. The downside is, many of the benefits of ECNs have been co-opted by the professional day trader. Some of the ways they are being used right now are not in the market's best interest."
Wide and Wild Swings
CNs play a significant role in the increasing volatility in many NASDAQ stocks. A growing number of day traders, who buy and sell furiously all day long, hoping to capture tiny per-share profits on large trades, execute their orders on the networks. Their lemming-like behavior in stocks that are already moving has made 15-point single-day swings common.
Even the occasional trader who uses an ECN can add to volatility. If a customer offers to buy shares at a price well above the market -- something that happens increasingly, with so many online traders eager to buy hot stocks at any price -- the offer is flashed on other investors' screens, helping push the market higher. At a brokerage firm, that order would probably be executed at the lower price.
The day traders and the price-is-no-object investors are creating wild price swings in Internet stocks, which trade widely on ECNs. According to ITG, daily swings in an index of Internet stocks have been running at more than twice the rate of the Standard & Poor's 500-stock index. Such volatility increases investors' anxieties and raises their costs by making it more difficult to get in and out of positions.
"People take pride in the fact that spreads in stocks have narrowed, but intraday price changes are bigger than they've ever been," said Andrew M. Brooks, vice president in charge of equity trading at T. Rowe Price in Baltimore. "I don't think we've ever had an environment like that."
More Fragments, Fewer Matches
he biggest problem posed by ECNs is the fragmentation of the market for NASDAQ stocks. The NASDAQ has always been fragmented because it has no central trading floor. The ECNs split up the market even more. When fewer trades are posted in one place, it is less likely that orders to buy and sell at the same price will find each other.
Robert Colby, deputy director of the Securities and Exchange Commission's division of market regulation, said that although the changes after the NASDAQ investigation have helped investors, "it's still a dispersed market."
"If the volume is going on in one place, and you are at another, you won't get executed," he said.
An investor can also wind up with an inferior price. Say a stock is quoted on ECN. "A" at $10.25 (the "bid" price) and at $10.3825 (the "offered" price), while ECN "B" has prices of $10.25 bid, $10.3125 offered. An investor interested in buying the shares at the prevailing price would pay more to trade on "A."
Or say an investor has placed a limit order -- an order to buy stock at a set price -- on an ECN. If there is no seller willing to take the other side of the trade at that price, his order remains unfilled.
After it becomes evident that the trade cannot be matched at the ECN, the investor, if he understands how NASDAQ trading works, can cancel his order and route it to another system, or to a big market maker like Merrill Lynch or Knight Securities.
Even then, this time lapse -- maybe just a few seconds -- can be costly. The price the investor wanted to pay may be vastly different from the new one. If the market price is much higher, the order is not executed. If the market price has fallen significantly, the order is executed -- but the investor pays more for the stock.
If ECNs were all linked into a central order book, that problem would disappear. The NASD wants to knit the marketplace together but has encountered resistance from some members. Until it does, the greater the volume on an ECN, the more likely that a customer's order will be matched quickly.
For that reason, clients of Island, which traded 813 million shares for customers in January, are more apt to get their trades matched in-house than are customers of Archipelago, whose volume for the month was 90.5 million shares.
But even on a populous ECN like Island, it is unlikely that an investor will get the best price for his trade. According to a study last year by the NASD, in 81 percent of all NASDAQ stocks actively quoted, traditional market makers had better prices than any ECN. In only 11 percent of the stocks did ECNs have superior prices. In the remainder, both ECNs and traditional market makers offered the best prices.
The Cost Catches
hen it comes to costs, most investors focus only on their brokerage commissions. But explicit costs like commissions make up only 10 percent of an investor's total costs, according to Salomon Smith Barney. Implicit costs -- such as what an investor pays for a volatile stock or when trades are badly executed -- make up the rest.
Eugene Noser of the Abel/Noser Corp. in New York, who tracks trading costs, says that implicit factors -- including those driven by the rise of ECNs -- are very high for popular Internet stocks.
"If you take the trading costs of a Yahoo or Ebay or Excite, they are astronomical," he said. "It is very difficult and expensive to try to execute orders in these stocks." According to Abel/Noser, while the average cost of trading New York Stock Exchange, American Stock Exchange and NASDAQ stocks is about 0.16 percent of the transaction amount, the average cost to trade Ebay in the last six months of 1998 was roughly 0.4 percent; for Yahoo, it was 0.22 percent.
ECNs, unlike market makers, charge other dealers to execute on their networks, increasing costs.
And these stocks may be costly to trade because the size of the typical trade is small: 1,000 shares or less. When smaller orders dominate trading, it is more likely that a single order will move the price of the stock, increasing investors' costs.
In February, more than three out of four trades in both Amazon.com and Yahoo were for 1,000 shares or less. Almost 80 percent of Ebay's trades fell into this category. Dell, which has been trading far longer than these young Internet enterprises, had 67 percent of its trades move in small orders last year, up from 31 percent in 1994.
Expense and Execution
here may be other reasons it is so costly to trade these stocks online.
A few experienced traders who say they have received bad executions on stock trades at both Datek Online and Terra Nova Trading, the brokerage firm affiliated with Archipelago, are wondering whether people who work for these firms have been jumping in to take better prices for themselves.
Gerald D. Putnam, owner of Terra Nova and part-owner of Archipelago, says none of his employees trade against customers' orders. The practice, which is against securities regulations, was rampant on the NASDAQ stock market before the SEC's crackdown in 1996.
Matt Andresen, president of Island ECN, did not respond to a reporter's questions.
The potential for such improper trading at ECNs affiliated with a brokerage firm -- like both Island and Archipelago -- remains a concern of regulators. In a statement last fall, the SEC instructed ECNs and their affiliates to set up procedures to prevent employees from using confidential information in trading.
The temptation to trade ahead of a customer is greatest when investors place market orders, meaning that they will buy or sell at the prevailing price.
A brokerage employee who receives a market order for 1,000 shares of Yahoo is supposed to complete the trade at the market price within 30 seconds. But given the rapid price changes in these stocks, the trader could easily complete the customer's trade at a price fractionally higher than the market and take the lower price for himself.
As long as the investor's price is in the range, the brokerage firm can argue that it gave its customer the "market" at the time. Only a study of each transaction, second by second, would reveal the truth.
Furthermore, the NASD has stated that during fast or exceedingly volatile markets, traders can be excused from this 30-second rule, giving them even more flexibility.
Troubled by Some Trades
mong the experienced investors to raise questions about the quality of executions on some ECNs is Greg F. Mazzeo, who traded over-the-counter stocks professionally for 15 years and now trades for himself. In documents he has compiled meticulously, Mazzeo points to numerous examples of market orders that he placed with Datek Online and Island ECN that were not executed for minutes at a time, or were executed at prices that to him were suspiciously off the prevailing market levels.
"I'm not accusing them of front-running orders or holding orders for their own benefit," he said. "But the time it takes to execute and the price of execution on market orders at times are highly suspect."
Over the seven months that he was trading through Datek, until March, Mazzeo made numerous complaints to the firm. Datek's policy is to rescind commission charges if a customer's "marketable" order is not executed within 90 seconds. Mazzeo said he paid no commission on roughly a third of his orders.
Using sophisticated software, Mazzeo can watch all the action in a stock. And what he saw on one trade early this year troubled him. On Jan. 15, Mazzeo put in an order to sell 500 shares of Network Event Theatre, a small NASDAQ stock that rarely trades. The bid price on the stock was $13.8125 when he placed his market order on Datek Online.
For minutes, no offers to buy were posted on the network. Then a 500-share lot traded, and the bid price began to fall. Still, Mazzeo's shares were not sold until the bid fell to $13.4375.
A computer glitch? An old order suddenly processed? Perhaps, but with Mazzeo's market order in hand, the firm's traders could have sold 500 shares that they did not yet own at $13.8125. Such a "short" sale in a thinly traded stock could easily have lowered the bid price to $13.4375, at which time a trader could have bought Mazzeo's 500 shares and covered his short position at a profit of $187.50.
Datek did not respond to written questions about these trades.
Fair-Weather Friends
hile ECNs have contributed to rising stock prices, no one knows for sure what their role will be in a market crash.
Unlike the NASDAQ market makers they hope to replace, ECNs do not commit any capital to maintain orderly markets in the stocks they trade. While most large, reputable market makers stand ready to buy or sell 1,000 shares of the stocks they trade -- they are required to handle 100-share trades -- ECNs do not.
Moreover, according to NASDAQ, the average block of stock available at the best bid or offer on an electronic network last year was only 340 shares. So an investor with more than 340 shares to sell or buy may well have his offer only partly filled. By comparison, the average block available from a market maker was 1,741 shares.
What does all this mean? If the online traders' favorite stocks start to fall from the sky, the people who trade on ECNs may not be able to get out.
"You get to a point of uncertainty and no one is going to sit out there and say they are a buyer during a market break," said Ketchum of the NASD. "If markets drop, ECNs have a harder time providing liquidity."
In other words, for ECNs, the resulting stampede for the exits could make the 1987 crash look like a day at the beach.
DrRisk
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