Doesn’t it seem reasonable that when you buy or sell a stock at the market price, you should actually pay or receive the market price? Yet the latest evidence on this issue provides troubling evidence that price may not, in fact, be the only factor involved. Other considerations may impact the final amount to be paid or received as well. Savvy market insiders and professional traders are aware of the various trade-offs involved and willingly settle for less than optimum market prices when other factors are more important. Occasional traders and those unaware of recent major changes in stock trading mechanics, however, may be surprised to learn that the stock price shown on brokerage invoices may not have been the best price available when the trade was made.
The Past and the Present
A recent speech by Fed Chairman Alan Greenspan highlighted the changes and challenges due to the growing influence of electronic finance (“e-finance”) on the operation of the securities markets. He expressed hope that policymakers would heed the advice offered to the medical profession and “First, do no harm.” Excellent advice, but difficult to implement.
Historically, one of the major functions of a stock exchange has been to provide a marketplace to match up buyer and seller at a price determined by arm’s length, or unbiased, negotiation. Ideally, there would be one clearing house where all orders to buy and sell securities would have the opportunity to interact with one another. While that does not exist, for many years the New York Stock Exchange (NYSE) has been the closest thing to it. The NYSE has been the predominant securities trading exchange because it has continuously provided all six basic functions that an exchange can potentially offer, while many newer exchanges provide only two or three. These basic functions are to:
- Facilitate the search for a counter-party, or the opposite side to a trade.
- Disseminate market intelligence before trades occur, either as formal quotations or as other soft, but valuable, information.
- Consummate trades, determining the price and quantity that clears the market. (This is the classic function of an exchange.)
- Disseminate post-trade information, such as the price and quantity of the trade.
- Clear and settle the trade. This involves comparing and matching the various parties to a trade so that everyone agrees on the cash and shares to change hands;
- Certify, both implicitly and explicitly, the quality of the issuers whose shares trade on the exchange and the quality of the trading counterparties who transact on the exchange. At a minimum, this involves listing requirements, self-regulation, market-watch and surveillance.
The third (price determination) and sixth (certifying participants) functions comprise the fundamental activities of the traditional exchange system. Most players have historically considered the price determined on the NYSE to be the “market price.” The same is now true for securities listed on the NASDAQ. Many newer exchanges, however, (for example, POSIT and Crossing Network) do not independently determine a price. They simply look up the price on the NYSE or NASDAQ and then cross match buy-and-sell orders. Moreover, a new type of exchange, known variously as an ECN (Electronic Communication Network) or ATS (Alternative Trading System), does no certification of issuers. These exchanges simply trade shares that are listed on another exchange, free-riding on the certification process of the other exchange.
In essence, the changes that have occurred, primarily in the 1990s, have involved a fragmenting of the marketplace, with new entrants focused on one or a few parts of the process in order to operate efficiently and economically. For example, POSIT outsources the clearing function to a large broker-dealer that is better able to process the paperwork and assume the risk in the trades. Because the certification function is one of the most expensive, in terms of manpower and contingent liabilities, all of the new entities have outsourced this function.
What’s the impact on your trading?
Fed Chairman Greenspan has stated the key issue as follows: “Fragmentation thus raises both questions about the quality and completeness of the price discovery process and concerns that investors’ orders to buy and sell securities may not be executed at the best price or the lowest cost.” In simple terms, the problem is that when you trade securities, you may not be getting the best price. To understand why, it will be helpful to briefly explain how the Securities and Exchange Commission had hoped markets would evolve and compare it with where we are today.
The SEC’s Goal: In 1975, amendments to the Securities Exchange Act of 1934 set a national goal that all securities should be traded in a national market system. This involved linking “all markets for qualified securities through communication and data processing facilities to foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors’ orders, and contribute to the best execution of such orders.” It included the idea of price priority over all markets and required that no market execute a trade at a worse price than was available on another market. Thus, if one market posted an offer to sell a share of ABC for $20.00, no investor should pay more than $20.00 in another market. There was, however, no guidance on the issue of time priority within price. Time priority requires that in the presence of two of more offers to sell at the same price, the offers be executed in the time order in which they are submitted. Similar time priority applies to bids.
At the time, some observers like Morris Mendelson, R. T. Williams, and Jay Peake took it for granted that a national market system would include time priority. In response to an SEC request for proposals in 1976, they outlined the major components of a consolidated limit-order book, or CLOB. A CLOB works as follows: Some investors submit limit orders to a centralized book. The orders in this book are executed according to price-time priority. Other investors submit market orders to be executed against these limit orders. To provide strict price-time priority, all trades must take place through this CLOB; no orders can be executed outside the CLOB. In their model, all orders are anonymous.
On the surface, this system appears to be eminently fair. Any investor who submitted a limit order would be assured that his or her order would be executed according to price-time priority. Any investor who submitted a market order would receive the best price available at the time. No one would have an unfair advantage. At the time, many commentators, especially institutional investors, supported a nationwide system of price/time priority. Further, these commentators expressed serious concern about market fragmentation. In fact, a national market system abhors fragmentation, as fragmentation limits interaction among order flow.
Yet, fragmentation is at the heart of competition in today’s economy. New competition creates fragmentation, but significant fragmentation will only occur if the competition is successful. If it is successful, it will likely drive out existing markets.
This is exactly what is happening. Specialized broker-dealers, such as Pershing Securities and Madoff Securities, focus on simply generating orders to buy or sell, receiving a payment from a particular dealer for directing all order flow to that dealer. Alternatively, some broker-dealers, notably Schwab and Merrill Lynch, trade retail orders against their own account, in essence acting as both the order-taker and the counter-party. Finally, a broker-dealer may vertically integrate and buy a specialist or market-making operation. Fidelity Investments is a good example. They are the largest specialist operation on the Boston Stock Exchange, trading not only their own customers’ order flow, but that of other parties as well. As a result of all of this, it will be noted that many orders may never have the chance to be part of a consolidated limit order book.
Consequences for the Non-Professional Trader
Consequence #1: There are three primary consequences for the average, non-professional trader. First, while the broker-dealer accepting a customer order to trade has a duty of “best execution” toward the order, this does not automatically mean “best price.” Although best execution has a strong connotation of best price, the SEC has been explicit that “a broker-dealer must consider several other factors affecting the quality of execution, including, for example, the opportunity for price improvement, the likelihood of execution (which is particularly important for customer limit orders), the speed of execution, the trading characteristics of the security, and any guaranteed minimum size of execution.” Thus, two investors might prefer two different convex combinations of the traits that constitute best execution, based on their own preferences for trade. In particular, some investors may be willing to trade off unbiasedness of price discovery in favor of other traits such as speed of execution. In other words, two investors with the same order might have two different views of what constitutes a “good execution.”
This is not just a hypothetical example. Regional exchanges such as the Pacific Coast Stock Exchange have specialized in providing rapid executions to brokerage firms that, as part of their business model, demand very rapid turn around times for their customers’ orders. These investors are willing to sacrifice some amount of price to obtain a rapid execution. In fact, a survey conducted by Sanford C. Bernstein & Co., Inc., found that 58 percent of online traders rate immediacy of execution as more important than a favorable price in evaluating the quality of a trade execution. It should be noted, however, that contemporary prices on different exchanges can’t differ by a large amount, otherwise a risk-free arbitrage situation would exist for alert traders.
Consequence #2: Second, focusing solely on price, the equilibrium price for a trade is a function of how smart or informed the trader is. “Uninformed” investors are assumed not to know anything unique or material about the firm and have little information about future prices. “Informed” investors, however, are assumed to be willing buyers or sellers only if they have reason to believe that share prices will rise or fall, respectively. Therefore, a rational seller would demand more for a share offered to an informed trader than to an uninformed one, since he or she may have an increased risk of giving up future profits. In other words, if an informed buyer is willing to trade at the informed seller’s quoted price, the seller is running the risk that he or she is quoting the “wrong” price because fully informed traders should not enter into losing transactions.
When all orders are funneled to one point, this may be of limited importance because gains and losses to market makers balance out over time. However, if different types of traders can be segmented in the market, it stands to reason that the competitive price for trade in each of these venues will not be the same. That is, shares may be bought or sold at different prices at the same time even if the market is functioning well. A given stock, therefore, has more than one correct price at the same time, an apparent violation of the “law of one price.” For example, index funds and passive/quantitative portfolio managers may choose to trade shares among themselves at prices near the midpoint of a bid-ask spread, while at the same time, active managers are trading similar size large blocks of stock at significant price concessions, and small order-oriented broker-dealers are trading small retail orders at existing bid-ask prices.
Consequence #3: Third, since some broker-dealers are simply in the business to generate order flow for a profit, it is theoretically possible to trade at zero cost or even be paid to trade. In essence, if an investor is dealing with an order-generating firm that sells order flow to an executing broker, it seems reasonable to ask why the investor should also have to pay a fee. Moreover, depending on the magnitude of the payment received by the order-generating broker, the economics of operating such a firm, and the level of competition, investors could be solicited to trade with a particular firm and receive a fee for doing so. In fact, as reported in the February 21, 2001 issue of the Wall Street Journal, online brokerage firm Tradescape Corp. is rolling out just such a plan, titled “Get Paid to Trade.” Customers will pay a fixed commission of $7.95 to trade any amount of shares but be given a rebate of a penny per share, with no cap on rebate amount. Therefore, any trade over 7,950 shares will result in a net payment to the trader. While this will not nullify the bid-ask spread difference, trading at the bid or ask price at zero or negative cost may soon be commonplace.
How Should You Respond?
Since “best execution” can mean trading at the best price or trading with the fastest execution, you first need to decide which is most important to you. In a slow moving market, it probably doesn’t matter much. For example, both the NASDAQ and NYSE execute trades fairly quickly, although the NASDAQ is faster: 3.4 to 7.8 seconds for trades of 100-499 shares compared to 15.8 to 26.5 seconds on the NYSE. In a fast-moving market, however, where prices are either dropping like a rock due to bad news or zooming to the sky as new IPOs often do, this difference can be a big deal. If execution speed is of utmost importance – as it is with most day traders – use of exchanges specializing in rapid execution would be called for.
Iif price is the main concern, the evidence points to dealing solely with NYSE-listed stocks, since each NYSE-listed stock is assigned to a single specialist. Therefore, currently there is very little fragmentation of trading in these stocks. Moreover, numerous studies have documented that the bid-ask spread is often 50% smaller on the NYSE than on NASDAQ.
New SEC Rules
How will you know if you are getting the “best execution,” regardless of the element on which you are focusing? In a move to help investors answer that very question, the Securities and Exchange Commission recently approved two new rules that take effect in April, 2001. These rules will require Wall Street to disclose how well their orders to trade stock are filled. They were in response to concerns of regulators and industry executives that the widely-touted benefits of low online-trading commissions were being wiped out by sloppy execution of the trades themselves.
Specifically, the first rule requires any entity that fills an order to publish each month detailed information on its quality of execution, including price and time to execute. The second rule requires brokerage firms that take investors’ orders to disclose quarterly how those orders are routed (i.e., executed internally or externally) and whether it received payment from an external executing broker. The SEC is, in essence, now trying to regulate a very fragmented, but highly competitive, market,. It has all but given up on a unified national market system. E-finance represents an acceleration of the process that the noted economist, Joseph Schumpeter, termed “creative destruction” – the continuous shift in which emerging technologies push out the old.
Commenting on this concept, Fed Chairman Greenspan provides an appropriate summary, “The process of creative destruction no doubt poses challenges for market participants and policymakers in the short run. But I expect our institutions and markets to be more resilient in the long run because of the use of new information processing and telecommunications technologies. Policymakers should not, and cannot, forestall this process. They should and can facilitate it.”
 Greenspan, A., Speech at the 2000 Financial Markets Conference of the Federal Reserve Bank of Atlanta, Sea Island, Georgia, October 16, 2000
 Sec. 11 A.(a) (2) of the 1975 Amendments
 Sec. 11 A. (a) (1) (D) of the 1975 Amendments
 Mendelson, M., Williams, R. T., and Peake, J. (1976) The National Book System: An Electronically Assisted Auction Market, April 30, 1976 (proposal to the SEC).
 It is not generally pointed out that in a CLOB market, orders themselves would never cross within the best bid and offer as there is zero probability that two market orders would arrive simultaneously in such an electronic market. The cross of two market orders within the bid and offer as occurs on the NYSE happens because market orders are often not executed immediately.
 Disclosure of Order Routing and Execution Practices, Release No. 34-43084; File No. S7-16-00, pg. 39
 “Weekly Notes,” Bernstein Research, NY: Sanford C. Bernstein & Co, Inc., May 12, 2000.
 Greenspan, op. cit.
See also the following article from a previous issue of GBR . . .