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Tim Quast
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August 31, 1998

A $13 Billion Wealth Transfer?

By Jeffrey L. Winograd

Two well-known finance professors, Robert Wood of the University of Memphis and Rutgers University's David Whitcomb, have locked horns over the Small Order Execution System. During a hearing of the House Commerce Subcommittee on Finance and Hazardous Materials last month, Wood spoke of a huge wealth transfer effected by SOES. Whitcomb countered, saying the best academic research suggests the effect of SOES usage is essentially neutral.

The most common practice of SOES day traders, testified Wood, is watching for the onset of large institutional buy or sell programs, and then stepping in front of them.

For example, he said, if there are ten market makers on the offer side of a stock, day traders seek to identify a particular broker who takes out two of those market makers. At that moment, day traders might take out the remaining market makers, hitting their "monster buttons" to execute all transactions at the same time, using technology not available to other traders. Finally, they offer the stock back at a higher price.

"To a significant extent, SOES represents a wealth transfer from mutual-fund and pension-fund holders, and retail investors, to SOES day traders," said Wood, who is a member of the National Association of Securities Dealers Economic Advisory Board.

This activity neither adds market liquidity nor assists in the price-discovery process, claimed Wood. "Instead, in my opinion, it is a parasitic activity," he said. Wood cited his joint research with Professor George Benston of Emory University, which contends that SOES day trading cost individual investors perhaps $13 billion from 1988 to 1996.

"Yet potentially far greater costs frontrunning of pension-fund and mutual-fund buy-and-sell programs, and the results of the increased cost of capital cannot be measured with data available to us," the research report states.

Competition

According to Whitcomb, the many retail brokers who either sell their customers' limit orders to the highest bidder or execute them on the broker's account are responsible for the lack of quote-price competition on Nasdaq (with the exception of electronic communications networks).

These practices have reduced SOES use among retail traders, whose market participation SOES was initially designed to encourage, Whitcomb said. "As a result, most SOES use is by active day traders who employ public information available to anybody willing to pay for it to observe market-maker quotation behavior and other signals that may predict very-short-term price movements," he testified.

Whitcomb said the best academic evidence suggests that SOES day trading has "an essentially neutral effect." He said it is "a game played between two classes of what are essentially day traders market makers and active individual investors and it does no measurable harm to the general investing public or institutional investors."

Day trading has some "subtle" benefits, he added, such as narrowing the bid and asked spreads, and creating the market discipline that keeps market makers "on their toes."

Whitcomb is the founder and chief executive of Automated Trading Desk (ATD) in Charleston, which developed the first expert system for automated limit-order trading. In 1997, ATD traded over $20 billion of New York Stock Exchange and Nasdaq stocks. "A fraction of that volume, about 30 percent, was executed on SOES," Whitcomb said. "As of July 1998, the fraction of ATD clients' volume traded on SOES has diminished further, probably to about 20 percent."