Commentary: Let Investors Know What They Really Pay

Can information, technology, and competition fix problems in stock trading that regulators haven't been able to crack? Securities & Exchange Commission Chairman Arthur Levitt Jr. is betting that they can--and that the result will be cheaper, faster trades for individual investors.

On July 25, the SEC proposed rules that would force brokers, stock exchanges, and new electronic markets to spell out how well they execute stock trades. They would also have to disclose their all-too-common hidden conflicts (table). Levitt figures that when the data are available, an army of eager analysts--in the press, in online services that rate brokers, and market players themselves--will spotlight poor trades faster than the securities cops could.

FIERCE FRACTIONS. Critics charge that the SEC is shirking its job: Brokers already have a duty to deliver "best execution" of trades, and if they don't, the SEC should lower the boom. But best execution is a slippery concept. Some investors want the fastest trade while others are willing to wait for a better price. The SEC--long known for its heavy-handed rulemaking--has finally figured out that brokers can play games around any regulation that the agency prescribes. Better instead to expose brokers' records, so they'll be forced to scrap for every penny and millisecond or lose customers. "This will harness the power of the Internet to help investors demand better trades," says Dan Burke of Gomez Advisors, which will use the data in its broker rankings.

For investors, the new data will highlight the true cost of buying stocks. The $29.95, $14.95, or $9.95 commission an investor pays a broker is only a small and shrinking part of that cost. A bad price can far outweigh the broker's fee: Miss by just one-sixteenth of a dollar on a 1,000-share order, and you're out $62.50.

Securities firms point out that 99% of retail stock orders get filled at the best posted quote. But the listed price contains plenty of profit for the dealers who specialize in New York Stock Exchange or Nasdaq trading. Many stocks trade with a 12.5 cents spread, so a dealer who buys 1,000 shares from one customer and sells them to another pockets an instant $125. Dealers compete by claiming to provide "price improvement"--a price inside the spread. But investors are hard-pressed to check those claims, since fewer than half of all orders get improved.

More important, customers don't know what their brokers' side deals are costing them. Online brokers in particular depend heavily on "payment for order flow"--legal kickbacks to brokers from exchanges and market-makers of about $2.25 per order--to help hold down commissions. One result, Levitt says, is that 85% of orders for Nasdaq stocks go to dealers who haven't posted the best bid or offer. Those dealers usually match the best price. But with a guaranteed flow of orders, they have little incentive to improve it.

Payment for order flow was a key issue in a suit brought by investors against Charles Schwab & Co. The discount broker agreed on July 24 to spend $20 million improving its order routing. But outlawing such payments wouldn't end brokers' conflicts of interest: Schwab routes many Nasdaq trades to its Schwab Capital Markets subsidiary. "Reciprocal arrangements come in so many forms that it's impossible to ban them all," says Annette L. Nazareth, director of the SEC's Market Regulation Div.

Instead, the SEC is telling brokers to 'fess up--and produce evidence. Plenty of players will help translate the data. "Intelligent order routing" computer programs--now offered mainly to day traders--are likely to spread as online brokers give customers more control over how their orders are handled. The attention will bring enormous pressure to bear: "No market wants to be singled out as the worst place for trades," says Robert Greifeld, senior vice-president of SunGard Data Systems Inc., which measures trade quality for 250 dealers.

"Sunshine is the best disinfectant," said William O. Douglas, who served as the SEC's first chairman in the 1930s before moving to the U.S. Supreme Court. Levitt is putting that principle to work. Investors who discover exactly what their stock trades are costing them will be healthier for it.

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