SEC Prepares for a New World of Stock Trading
What should our securities markets look like to serve today's investor best? Congress addressed this very question a generation ago, when markets were threatened with fragmentation from an increasing number of competing dealers and exchanges. This led the SEC to establish the national market system, which enabled investors to obtain the best quotes on stocks from any of the major exchanges.
Today it is the proliferation of electronic exchanges and after-hours trading venues that threatens to fragment the market. But the solution is simple, and would take the intermarket trading system devised by the SEC a quarter century ago to its next logical step. The highest bid and the lowest offer for every stock, no matter where they originate, should be displayed on a screen that would be available to all investors, 24 hours a day, seven days a week.
If the SEC mandated this centralization of order flow, competition would significantly enhance investor choice and the quality of the trading environment.
Would brokerage houses or even exchanges exist, as we now know them? I believe so, but electronic communication networks would provide the crucial links between buyers and sellers. ECNs would compete by providing far more sophisticated services to the investor than are currently available—not only the entering and execution of standard limit and market orders, but the execution of contingent orders, buys and sells dependent on the levels of other stocks, bonds, commodities, even indexes.
The services of brokerage houses would still be in much demand, but their transformation from commission-based to flat-fee or asset-based pricing would be accelerated. Although ECNs will offer almost costless processing of the basic investor transactions, brokerages would aid investors in placing more sophisticated orders. More importantly, brokers would provide investment advice. Although today's investor has access to more and more information, this does not mean that he has more understanding of the forces that rule the market or the principles of constructing the best portfolio.
As the spread between the best bid and offer price has collapsed, some traditional concerns of regulators are less pressing than they once were. Whether to allow dealers to step in front of customers to buy or sell, or allow brokerages to cross their orders internally at the best price, regardless of other orders at the price on the book, have traditionally been burning regulatory issues. But with spreads so small and getting smaller, these issues are of virtually no consequence to the average investor as long as the integrity of the order flow information is maintained.
None of this means that the SEC can disappear once it establishes the central order-flow system. A regulatory authority is needed to monitor the functioning of the new systems and ensure that participants live up to their promises. The rise of technology threatens many established power centers and has prompted some to call for more controls and a go-slow approach. By making clear that the commission's role is to encourage competition to best serve investors, not to impose or dictate the ultimate structure of the markets, the SEC is poised to take stock trading into the new millennium.
SOURCE: Abridged from Jeremy J. Siegel, "The SEC Prepares for a New World of Stock Trading," The Wall Street Journal, September 27, 1999. Reprinted by permission of Dow Jones & Company, Inc. via Copyright Clearance Center, Inc. © 1999 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
Moreover, these e-brokers are beginning to provide some of the same services offered by full-service brokers such as online company research and, to a lesser extent, the opportunity to participate in IPOs. The traditional full-service brokerage firms have responded to this competitive challenge by introducing online trading for their own customers. Some of these firms are charging by the trade; others charge for such trading through fee-based accounts, in which the customer pays a percentage of assets in the account for the right to trade online.
An ongoing controversy between the NYSE and its competitors is the extent to which better execution on the NYSE offsets the generally lower explicit costs of trading in other markets. Execution refers to the size of the effective bid-ask spread and the amount of price impact in a market. The NYSE believes that many investors focus too intently on the costs they can see, despite the fact that quality of execution can be a far more important determinant of total costs. Many NYSE trades are executed at a price inside the quoted spread. This can happen because floor brokers at the specialist's post can bid above or sell below the specialist's quote. In this way, two public orders can cross without incurring the specialist's spread.
In contrast, in a dealer market, all trades go through the dealer, and all trades, therefore, are subject to a bid-ask spread. The client never sees the spread as an explicit cost, however. The price at which the trade is executed incorporates the dealer's spread, but this part of the price is never reported to the investor. Similarly, regional markets are disadvantaged in terms of execution because their lower trading volume means that fewer brokers congregate at a specialist's post, resulting in a lower probability of two public orders crossing.
A controversial practice related to the bid-ask spread and the quality of trade execution is "paying for order flow." This entails paying a broker a rebate for directing the trade to a particular dealer rather than to the NYSE. By bringing the trade to a dealer instead of to the exchange, however, the broker eliminates the possibility that the trade could have been executed without incurring a spread. In fact, the opportunity to profit from the bid-ask spread is the major reason that the dealer is willing to pay the broker for the order flow. Moreover, a broker that is paid for order flow might direct a trade to a dealer that does not even offer the most competitive price. (Indeed, the fact that dealers can afford to pay for order flow suggests that they are able to lay off the trade at better prices elsewhere and, possibly, that the broker also could have found a better price with some additional effort.) Many of the online brokerage firms rely heavily on payment for order flow, since their explicit commissions are so minimal. They typically do not actually execute orders, instead sending an order either to a market maker or to a stock exchange for listed stocks.
Such practices raise serious ethical questions, because the broker's primary obligation is to obtain the best deal for the client. Payment for order flow might be justified if the rebate is passed along to the client either directly or through lower commissions, but it is not clear that such rebates are passed through.
Online trading and electronic communications networks have already changed the landscape of the financial markets, and this trend can only be expected to continue. The nearby box considers some of the implications of these new technologies for the future structure of financial markets.
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