A useful article copied from the NY Times:
March 28, 1999
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. |
