This article from the WSJ, 4/23/99 is worth reading for anyone with an account at a deep discount broker.
Regulators Worry That Online Investors
May Be Getting Poor Trade Executions
By GREG IP and REBECCA BUCKMAN
Staff Reporters of THE WALL STREET JOURNAL
It costs just a few bucks to make an online stock trade. The growing
concern is that investors are getting what they pay for.
Regulators and industry participants worry that online investors, without
knowing it, are sometimes getting poor trade executions in return for low
commissions.
Attention is focusing on the practice by which some major market-maker
firms pay online brokers for their orders. The concern is that in order to
get those payments, online brokers may be directing their orders to
particular wholesalers without regard to the quality of execution they give.
For example, a customer may pay $10 in commission to send a "market"
order to buy 100 shares in a fast-rising stock on which the lowest offer
price at the moment is $20. But because of the way that the broker
handles the order, the order doesn't get executed until the offer price has
risen to $21. The customer, in effect, paid $100 more than he might have,
wiping out the benefit of the lower commission.
SEC Looks at Payment
Both the U.S. Securities and Exchange Commission and the New York
attorney general's office are looking at payment for order flow as part of
separate inquiries into online trading, say people familiar with those
inquiries. The state's questionnaire to online brokers asks for "current
contracts or agreements relating to directed order flow and payments
thereon" and documents on "problems with recipients of your directed
order flow."
Most online brokers, such as E*Trade Group Inc., Ameritrade Holding
Corp. and Toronto-Dominion Bank's Waterhouse Securities Inc., don't
execute orders they receive. Instead, they send an order to a market
maker, who executes it, or to a stock exchange in the case of some listed
stocks.
The largest online broker, Charles Schwab Corp., generally doesn't accept
payment for order flow. But it does send most of its Nasdaq orders to its
wholly owned market maker, Mayer & Schweitzer, thereby benefiting
from any profit that unit earns executing the orders.
While most discount firms accept payment for order flow, the payments
are most important to online brokers because their commissions are so
low. Full-service firms generally don't accept such payments.
"Anytime you have a middleman in front of your trade, you have to wonder
if you're getting the best deal," says Bill Burnham, an analyst who follows
online brokers for Credit Suisse First Boston. The middlemen -- the
wholesale market makers -- "are making money off those orders, and that
money is not being created out of thin air. Wholesalers ... are essentially
using the information provided by retail order flow to become very
informed speculators."
Wholesale Firms Reject Notion
But wholesale firms reject that notion. "The kind of executions wholesalers
are providing to online discounters in general are the best executions in the
business," says Kenneth Pasternak, president and chief executive of
Knight/Trimark Group Inc., the largest wholesaler, which claims a
market-leading 15% share of the Nasdaq market. A substantial share of
Knight's business comes from online brokers. E*Trade, Waterhouse and
Ameritrade all have equity stakes in Knight/Trimark.
Online brokers also adamantly deny they send trade orders to the market
makers that pay the highest rebates, or those in which they have financial
interests. Bill Yates, vice president and controller of Advanced Clearing
Inc., which is owned by Ameritrade Holding and clears trades for that
firm's fast-growing online-brokerage unit, says, "You'd get skewered in the
marketplace for that. Your customers would scream."
An E*Trade spokeswoman didn't return a call seeking comment. A
Waterhouse spokeswoman declined comment, citing the "quiet period"
surrounding the initial public offering of its parent's global
discount-brokerage business, which includes Waterhouse and Canada's
Green Line Investor Services. A Schwab spokeswoman says, "Schwab
holds Mayer & Schweitzer to the strictest standards of best execution."
Market makers are willing to pay for orders because they make money
trading them. For example, the market maker may buy 100 shares from
one customer at its bid price of $21 while selling the same 100 to another
at its ask price of $21.125, pocketing the spread, $12.50 in this case, in
the process.
Controversy Isn't New
Controversy over payment for order flow isn't new. Earlier this decade,
the SEC said the practice was all right, as long as brokers disclose it to
their customers. New order-handling rules and the reduction in the
minimum bid-ask spread to 1/16 from 1/8 of a dollar recently have cut
what market makers can pay for order flow. Mr. Burnham estimates
E*Trade's average payment received per order has dropped from $12 in
1996 to $2.90 now, while Ameritrade's has fallen from $8.51 to $2.18.
But growing trade volume has offset that decline.
Mr. Yates says his staffers divvy up Nasdaq orders among six to eight
trading firms, based mainly on their speed and quality of execution records,
he said. Advanced Clearing examines monthly reports from each firm, "but
the guys in our trading room are monitoring this stuff on a day-by-day
basis," Mr. Yates adds. Advanced Clearing usually sends all orders for
one stock, such as Microsoft Corp., to the same market maker, according
to Mr. Yates.
The size of the rebate varies according to the size of the order (more
money for larger orders), the time it is placed (less for orders placed near
the busy market open) and the type of order. Many market makers, for
instance, don't pay anything for limit orders, or orders to buy or sell a
stock at a certain price.
Mr. Pasternak says customers benefit from such payments through lower
commissions, but he nonetheless wouldn't mind if such payments were
abolished. Like most wholesalers, Knight/Trimark promises top execution
quality through sophisticated automated-execution systems. They promise
to execute customer orders up to a certain size at the best bid or offer any
market maker is then displaying in the country. Mr. Pasternak boasts that
his firm's typical turnaround time is five seconds.
There Is a Catch
But critics note there is a catch. Wholesalers reserve the right in volatile
conditions to switch from automated to manual execution. James Lee,
principal in Houston-based Momentum Securities Inc., which caters to day
traders, says that can slow order execution and investors may discover
that market orders are executed far away from the prices they expect.
(There is less risk with limit orders.)
Mr. Lee says if the dealer senses the stock is rising, it might switch to
manual execution, slowing down the filling of orders until the stock has
risen sharply. At that point, it can then begin selling stock out of its own
inventory. The dealer can then try to buy it back later at a lower price.
Mr. Pasternak said his firm executes more than 90% of orders
automatically. He noted it is unrealistic to expect any firm to accept
"unlimited liability" by guaranteeing a particular price during volatile
conditions. Bernard Madoff, head of wholesale firm Bernard L. Madoff
Investment Securities, says, in fast markets, "you can't [be confident] the
price on your screen is the accurate price, either to the benefit or detriment
of your customer."
Critics don't question the right of wholesalers to go from automated to
manual execution, particularly as rocketing Internet stocks have set new
parameters for volatility. But some do question whether online investors
are aware that it can happen to them -- or have any choice in the matter.
The NASD advised wholesalers in February that if they deviate from
automated execution during "turbulent market conditions ... they should
consider disclosing such altered procedures" and the reason to customers
sending them orders.
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