Ever wonder how your online or discount broker can make money charging $14.95 for a stock trade that would cost $100 at a full-service firm? A big part of the difference is you're not the only one paying your broker for the order.
Most discount or online brokers don't execute orders--find a seller or buyer to take the other side of your trade. Instead, your broker sends the order to an exchange or a dealer, a trading firm that makes a market in the stock you're ordering. Correction: It sells your order--for a neat profit of 1 cents to 2 cents a share.
Smells fishy? In most businesses, an agent isn't allowed to collect from both sides: A real-estate agent can't represent the seller and the buyer. But in stocks, payment for order flow is common and legal. The Securities & Exchange Commission says it's not harmful. And economists say the system even cuts individual investors' overall costs. Order-flow payment is a rare case of a kickback that benefits the customer.
UNINFORMED. Here's how it works. Dealers and exchanges profit on the spread between the bid and ask prices--what a dealer will pay and charge for a stock it trades. The more trades they process, the bigger their profits. So dealers pay brokers for order flow. The payments determine where your broker sends your orders.
Dealers want to execute your trades because, frankly, they don't think you know very much. "Everyone wants to deal with the uninformed investor," says Georgetown University finance professor James Angel. The dealer figures your trade isn't a signal of impending news or other factors that will rapidly move the stock price--and jeopardize his spread, usually 6.25 cents to 25 cents a share.
Dealers' actual costs to make a trade run about 3 cents a share. Since the least possible spread for most shares is 6.25 cents (the equivalent of one tick, the smallest price increment that can be quoted), a dealer can afford to spend 1 cents to 2 cents a share to buy profitable order flow. Virtually all brokers sell their orders for Nasdaq stocks, and many sell orders for New York Stock Exchange-listed shares to regional exchanges and "third-market" dealers such as Bernard L. Madoff Investment Securities in New York. The NYSE floor is the only market where order flow isn't explicitly sold.
The saving grace is that order-flow rebates are passed on to clients via lower commissions. "Deep-discount brokers couldn't exist without order-flow payments," says Stephen Franco, an E-commerce analyst at U.S. Bancorp Piper Jaffray. In a study for Nasdaq, Georgia State University finance professor Robert Battalio found that "many trades routed based on order-flow inducements enjoy lower costs." Indeed, some experts say these payments are the best way to share trading profits with small investors (table).
But what about getting the best price for shares? Order-flow routing means dealers are less likely to vie on "price improvement"--giving clients a price between the dealers' bid and ask. Chances of getting a price break are less than 50-50 on the NYSE--and worse on Nasdaq. So for most investors, "the certainty of a lower commission is better than playing the odds" of a price improvement," says Battalio. Clients of full-service brokers take note: They also farm out some trades, so you pay more but may still get poor execution. The SEC requires brokers to monitor dealers' executions; clients can ask how often a dealer's trades get price improvements.
If you're a purist, you can avoid deals that include order-flow payments. You can place limit orders, in which you set the price you're willing to pay--but you risk having the trade delayed or not executed at all. Also, a client who orders by phone can direct a broker to send trades to the NYSE. (Traders who order online may not get that choice.) On Nasdaq, one broker offers
a choice of rout-ing: Delta Trader (www.deltatrader.-com, 800 949-0205), a unit of San Francisco's Preferred Capital Markets, charges 2 cents a share ($15 minimum for the whole order) to execute trades, vs. $7.75 for a trade that's sold.
Economists' stats show the payoff of choosing how your trade is executed doesn't justify the extra expense. The idea of rewards for your broker may not be appealing. But if your concern is the bottom line, you shouldn't worry about payment for order flow.