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January 1, 2002

Quality of Executions

By Brett Redfearn

Several months after Rule 11Ac1-5 was introduced, the industry had data on the quality of executions in more than 3,700 listed stocks.

Rule 11Ac1-5, which establishes a common methodology for measuring quality across all market centers, is a positive step for investors. Order flow providers are able to make more informed decisions on where orders are sent. Firms are using the data to make meaningful order routing switches.

After including all order types, order sizes and measures of best execution, there are 292 data points for each security. There are over one million new data points to work with each month, combining the 3,700 listed securities (and the 292 data points per security). On Nasdaq stocks, where the rule kicked in later, comprehensive data should soon provide more perspective. So it would seem, finally, that the best execution debate is over, the order routing puzzle is solved for listed stocks. But is it?

Despite consistent methodologies, formats and data points, there is still a wide range of interpretations and uses of the 11Ac1-5 data. After numerous discussions with industry participants, several conclusions are worth sharing. To begin with, top line market center comparisons have proven themselves meaningless for these reasons:

* Different market centers are trading substantially different sets of securities with different trading characteristics, e.g., trading volumes and prices. These varying characteristics affect Rule 11Ac1-5 results. Hence, accurate inter-market comparisons can only be made at a stock specific level, or, possibly, among stocks with similar trading characteristics.

* Different market centers have different average order sizes. Smaller retail orders will certainly execute faster and will have lower effective spreads than larger institutional orders. Hence, accurate comparisons of market centers must control for order size and also, needless to say, order type.

* Different market centers have different customers. Primary markets accept all customers, be they day-traders, hedge funds or competing dealers. Others can pick and choose at will who to turn on or to shut off. Market center comparisons must account for the nature of the customer base.

Another looming 11Ac1-5 question continues to be: Does the customer care? Is John Q Retail Investor calling his broker dealer screaming, Hey, why are effective spreads in XYZ better on market center A, and you're sending my orders to market center B!' This is probably not a frequent occurrence for the typical broker dealer.

However, with the recently released Rule 11Ac1-6 data, we have taken another step down that road. This rule requires broker dealers to make quarterly reports publicly available, describing their order routing practices, disclosing the venues to which customer orders are routed for execution.

Assuming the retail customer, at some level, does (or will) cares about execution quality, the real question becomes what specifically does the customer care about?' The biggest debate on this issue usually boils down to price versus speed. True, individual investors want a fast execution.

That leaves less time for dealers to play around with the order, right? Oddly, much of the data shows that quicker executions often take place at a greater cost. What will happen if an investor finds out that, if he waited another 10 seconds for his order to be executed, he could have saved $50? These types of analyses are only beginning to surface.

Bottom Line

Finally, for order routers there is always the reality of the P&L. Especially in tight times, profit is the bottom line. Execution quality data has and will continue to be meaningful only in the context of the complete economic picture, such as in areas relative to trading costs and various forms of payment-for-order flow.

In discussing Rule 11Ac1-5 data with order routing customers, a fairly common view is: "All else being equal (trading costs, payment-for-order-flow, etc.)..." effective spreads and net price improvement begin to assume more significance.

Recent developments such as decimalization, the narrowing of spreads, and reduction in payment-for-order flow have leveled the economics across market centers. As a result, execution quality data is beginning to have a more meaningful impact, even though the debate over best execution is certainly not over.

Brett Redfearn is senior vice president of equity business strategy and equity order flow at the American Stock Exchange.