From today's WSJ Interactive:
>>An E*Trade spokeswoman didn't return a call seeking comment.<<
I'm shocked!!!!
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April 23, 1999
Money & Investing
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.
Copyright © 1999 Dow Jones & Company, Inc. All Rights Reserved.
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