April 23, 1999
 
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 for Order Flow

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.