Before we continue with the sorry state of competition and order execution in the options industry, we should review the recent history of order execution on and off the stock exchanges. In a previous article we discussed the theories behind and the differences between the traditional stock exchanges and the Nasdaq market system. What we did not cover was how collusion and off exchange trading, along with rather imaginative ideas on fiduciary responsibilities by many stock firms, worked to erode the customer safeguards thought to be present in both systems.

           
The theoretical strength of the Nasdaq system was that any Nasdaq member could become a market maker in any stock, but without the necessary order handling rules that would provide customer protection, the actual performance of the system fell short.

For instance, there were no specific rules that forced the firm holding the order to represent that order. If the best market on a stock was, for example, $10 bid - $10 ½ offer, the firm holding an order to buy 500 shares at $10 3/8 was under no obligation to reflect that bid, meaning the composite market would not necessarily change to $10 3/8 bid, $10 ½ offer. Worse than that, the firm could bid for its own account at $10 ¼ ahead of the order, and if filled could sell it immediately to the customer at the higher price. A different firm holding an order to sell 1000 shares at $10 also was not required to trade with the $10 ¼ bid for 500, and could trade the whole 1000 shares at $10, where maybe 1000 shares were bid. The fact that it was easy for a firm to become a competitive market maker should have been a plus for competitive markets, but the fact that the best bid or offer did not necessarily get the trade was a huge disincentive to actually compete.

           
Partially because of these “order handling” issues the increased competition designed into the system did not fully manifest itself. In fact, the system deteriorated into a rather closely held system with nowhere near the expected number of participants. It also appears that over time many of the participants used the system to collude and fix prices to the detriment of the investing public.  A huge lawsuit and lengthy government investigations in the early 1990’s resulted in many firms paying serious fines and reparations for collusive activities. The embarrassing mess also resulting in the SEC mandating newer and more customer friendly order handling rules. The cynical might add that the fines and reparations did not come close to the amount of money actually stolen.

           
Another addition to this mix of non-customer service was the payment for order flow phenomenon. The natural economic reaction to a price being too high, or in this case the bid-ask spread being wider than competitively justified, is for other players to enter the market and lower the price. If that is impossible, people will find ways to erode the price or spread. In fact, a cottage industry appeared that, instead of narrowing the market from the disseminated $10 bid, $10 ½ offer, would pay cash rebates to firms that directed the order to pay $10 ½ or sell at $10 to them. The brokerage firm essentially began to receive kickbacks for trading the order at the disseminated price, rather than using their best efforts to find the best price. This practice also made it less likely that the spread would narrow, as a kickback was received for paying $10 ½, not necessarily for posting a $10 3/8 bid.

           
Amazingly enough, this practice also became prevalent in stocks traded on the listed exchanges. For example, if IBM were quoted at $120 bid, $120 ¼ offer, people began to pay rebates (a nicer word than kickback) for orders that paid the offer or sold on the bid. This either took place by having the orders sent to a regional exchange like the Cincinnati Stock Exchange, or essentially to an off exchange payment for order flow firm, which sprouted like weeds in the early and mid 1990’s. As the firms using this practice and receiving rebates began to lower stock commissions to increase their order flow and rebate income it became popular to say that these practices were not inherently slimy, but necessary for the firm to remain “competitive.” Especially interesting was the use of the practice by the old-line “high-brow” firms that still charged full commissions as if they were sending the trades to the NYSE. 

           
Where were the SEC and that supreme watchdog, Arthur Levitt? They ignored the practice long enough that it became too widespread to “put back in the barn.” Some firms did become nervous about flat out internalization, where you charged commission and traded against the order yourself, and formed separate firms that received the order flow (why would that fool anyone but a government regulator). Although late, the SEC essentially attacked the problem on two fronts. The first was in requiring disclosure to the customer. You or I might think that would mean telling the customer as you solicited the account that this was the firms practice, and that you would be required to identify specific orders on which you received a “rebate.” To the SEC, some mumbo jumbo on the back of the order confirmation (after you became a customer) in the fine print about “We may from time to time internalize or take rebates” was perfectly acceptable. When I was lecturing to groups of customers at the time, I can safely say that it was the rare individual who had any idea how his stock trade was actually executed.

           
The second idea by the SEC, and one that actually worked pretty well, was to require that the minimum bid-ask spreads on the exchanges narrow first to 1/16 from 1/8, then to as low as $.01. The narrower the spread on the exchanges the less “room” for rebates, although it may have created other problems we will address later. The SEC’s success at minimizing the problem through the narrower spreads and decimalization is commendable, but it is still not the same as coming out strong against the practice. I believe that the firm bears a responsibility to the person from whom they took the order to do the best job possible, and that would rarely coincide with getting the biggest kickback possible on the back end. Firms now are still free to shirk their fiduciary responsibility for “rebates” whenever able, and most customers still have no idea when or if it happens. As a regulator it is hard to really come down on nefarious deeds by some firms when you might see yourself as a future employee of that industry, or if your party is awash in political contributions from those you are trying to regulate. The answer to the problem: Stop the kickbacks.

Have a comment about today’s article or any previous article?  Feel free to e-mail me at tph@ptihedge.com.
     

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