Couple more articles. Good reading.
The future of ECNs
A report finds they're headed for extinction. They'll fight to survive.
By Alex Frew McMillan
September 01, 1999: 12:32 p.m. ET
cnnfn.com
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And this one from Dow Jones New Service today mentions NITE:
September 1, 1999
Dow Jones Newswires
TALES OF THE TAPE:Do Order-Flow Payments Aid Investors?
By SEAN DAVIS
NEW YORK -- Some day-trading firms think the brokerage industry has a dirty little secret.
Online brokers sell customer orders to middlemen who, day-trading firms allege, don't always fill these orders at the best possible price for the customer. Some academic research supports this. Brokerages that accept payment for order flow, as the practice is known, typically rate worst in executing customer orders at the best possible price. Thus, Web brokers make money selling orders at the expense of their customers, say critics of the practice.
But the real secret may be that payment for order flow is a boon to investors because it reduces their overall cost of buying and selling stocks. Online brokerages that receive order-flow payment pass it on to customers in the form of lower commissions. In fact, without payment for order flow, the online brokerage industry, which has lowered trading commissions for millions of investors, probably wouldn't exist, says Robert Battalio, assistant professor of finance at Georgia State University in Atlanta.
Day Traders' Rallying Cry
The debate over payment for order flow isn't new - the practice has been around for decades - but it has picked up steam lately because day trading is a burgeoning industry, and many day-trading firms use payment for order flow as a rallying cry to attract customers who might otherwise opt for online brokerages. Day-trading firms, which provide individual investors sophisticated trading systems similar to those used by professionals, charge about $20 a trade, while most online brokerages, with less sophisticated tools aimed at less-active investors, charge $15 or less.
"The fact is, the payment-for-order-flow model practiced throughout the industry is a chain around a day trader's neck," Mark Brandon, principal of Daylight Trading in Glendale, Calif., says in a letter, entitled "The Brokerage Industry's Dirty Little Secret," posted on the firm's Web site.
Here's a hypothetical example of how payment for order flow works. Web brokerage E*Trade Group Inc. (EGRP) receives a customer order to sell 1,000 shares of WXYZ when the stock is trading for $10 each. But E*Trade typically doesn't execute customer orders. Instead, it sends them to a wholesale market-maker such as Knight/Trimark Group Inc. (NITE). Knight buys the 1,000 shares for $10 each in hopes of selling them for $10.13 and pocketing the difference. To get this crack at a trading profit of $130, Knight pays E*Trade about $2.50. That is payment for order flow.
Daylight's Brandon says, in so many words, that if someone out there is willing to buy 1,000 shares of WXYZ for $10.13 each, the customer should be able to sell them directly to the buyer at that price. For that to happen, the customer's order would have to go to an electronic communications network, or ECN, which matches buyers and sellers for a fee. By sending orders to a market maker instead of an ECN, online brokerages deprive their customers of the opportunity to sell at the best possible price, Brandon says, taking money out of their pockets.
Some day-trading firms go so far as to suggest market makers aren't playing fair. Because they guarantee liquidity in the stocks they trade, market makers sometimes must take a position against the market, raising their risk of a trading loss. Day-trading firms accuse market makers of holding up orders until the market turns in their favor. They do this, the day-trading firms contend, by switching to manual execution of orders in stocks that are going up or down extremely fast - the very stocks day traders favor.
But there's no evidence market makers aren't filling customer orders at the best possible price, and regulators haven't found anything wrong with payment for order flow.
Knight/Trimark gives investors favorable order execution because it guarantees liquidity, even for orders than can be hard to fill at the prevailing price, says Chief Executive Kenneth Pasternak. In fact, most day-trading firms have asked to avail themselves of Knight/Trimark's liquidity guarantee, but in most cases have been turned down, Pasternak says.
Moreover, Knight/Trimark automatically executes more than 99% of incoming orders, Pasternak says. The instances when it switches to manual execution - that is, filling orders only when it has actual shares to deliver - are rare.
An E*Trade spokesman wasn't available for comment in time for this article.
Battalio says payment for order flow is a good deal for small investors. There is no guarantee a brokerage that doesn't accept order flow is going to obtain a better price for the customer than one that does. The size and type of an order can influence the price at which it is executed. In Nasdaq stocks, price improvement is available less than half the time. So investors are better off taking the sure savings of lower commissions rather than the less-than-50% chance of executing their trades at a better price, Battalio says.
Knight's Second-Largest Expense
Payment for order flow seems to be working well for online brokers and market makers. Knight, for instance, paid $35.4 million for order flow in the three months ended June 30. That was its second-largest expenditure, after employee compensation and benefits. Was it a worthwhile expense? Knight had average net revenue of $10.09 a trade in the second quarter, up 13.4% from a year before.
On the other side of the transaction, E*Trade received $11.1 million in payment for order flow in the three months ended June 30. That was 10% of its transaction revenue. Another way of looking at it is this: Without payment for order flow, E*Trade would have had to charge 10% more a trade - $21.95 for a Nasdaq stock instead of $19.95 - to book the same transaction revenue.
Some online brokerages that don't take payment for order flow benefit in other ways from steering business to affiliated market makers . Charles Schwab Corp. (SCH), for example, sends orders to its wholly owned market-making unit, Mayer & Schweitzer, and presumably benefits from the trading profits the unit is able to make on the orders.
In a working paper published last year under the auspices of the National Association of Securities Dealers, Battalio and co-authors Robert Jennings and James P. Selway III set out to determine whether payment for order flow hurts investors. But they found only one small online brokerage that didn't have some kind of order-flow arrangement. That leads Battalio to conclude that without payment for order flow, low-cost online trading wouldn't exist.
Nevertheless, the online brokerage industry has been forecasting the decline of payment for order flow for some time. There is some evidence that such a decline is taking place. Although Knight's payment for order flow rose 81.4% in the second quarter from the year-earlier period, as a percentage of net trading revenue it declined to 16.3% from 24.3%. One reason is that Knight is wringing more profit from each trade. Another is that trading for institutions - which don't take payment for order flow - is a growing part of Knight's business.
Likewise, E*Trade depends less and less on payment for order flow. The $11.1 million of order flow in the three months ended June 30 was 10% of transaction revenue. A year before, the $8.1 million of payment for order flow was 18.7% of transaction revenue.
Indeed, the profound changes now under way in the securities markets could end payment for order flow, whether the online brokerages like it or not. Since changes in order-handling rules earlier this decade, ECNs have flourished, capturing 30% of Nasdaq volume. The major stock exchanges and many big Wall Street firms now are jockeying to affiliate with ECNs, a sign that ECN market share could expand. That means investors would have an easier time finding matching orders. That could relegate market makers to stocks that trade infrequently and thus are harder to match.
Knight's Pasternak says he wouldn't mind seeing payment for order flow go away. "It's a custom on Wall Street. If it were discontinued, Knight/Trimark wouldn't be upset."
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