Hidden Costs in Online Trading
By GRETCHEN MORGENSON
Millions 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
ECNs 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
The 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
When 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
There 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
Among 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
While 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. |
