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April 1, 2002

Sunlight on Executions

By Denis P. Kelleher

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  • Sunlight on Executions
  • Page 2

No more mysteries about how and why broker dealers route orders. At least that's the hope of regulators who put new order routing and disclosure rules into effect late last year. Regulators believe that in order to encourage best execution, it is important to show investors exactly how brokerages are routing trades.

There is no consensus on what it all means, no agreement on how investors should interpret the data. Still, some brokers are acting as if the information required by SEC Rules 11Ac1-5 and 11Ac1-6, isn't important. I think they couldn't be more wrong. In 1999, the Securities and Exchange Commission found that payment for order flow was affecting execution quality in over half the brokerage firms the agency surveyed. The problem remains. Although some progress has been made, trade execution woes are an open secret.

Take a look at the new data - provided by the brokerages themselves. Currently, many firms simply route the majority of their orders to affiliates. In theory, brokerages have a choice when executing NYSE and Nasdaq listed trades and can choose a variety of venues. Many vertically integrated firms route the majority of their orders to affiliates. The recent data shows some firms were routing as much as 95 percent of their orders to affiliated market centers.

On the other hand, firms not affiliated with particular market centers spread their orders around much more evenly, which is what you would expect among firms actually shopping for the best price. The question for investors is whether or not there could ever be a good reason to route all trades to the same ECN or market maker. It is easy to conclude that brokerages funneling all trades in one direction are not really "working" their customer's orders.

It is not too difficult for investors to do simple comparisons for themselves. The new information can be accessed online on brokerage firms' websites. (To check on your broker's website, look for one of these: "order routing, "SEC Rule 11Ac1-5," "SEC Rule 11Ac1-6," or "order execution." There should be information, in a table or other form, on how Nasdaq and NYSE-listed stocks are routed.)

If a firm consistently routes large numbers of trades to an affiliate, investors might want to know whether or not the affiliate venue always provides the best price for their trades. Investors should remain in contact with their brokers to determine if they are getting the best execution on their trades. Some of the questions they might want to ask:

* How many POEs, or points of execution, does the trading desk use for listed securities and Nasdaq?

* Do brokers on the desk have discretion to override the order routing table in order to obtain better execution?

* Are more than 60 percent of orders routed to any one point?

* Does the brokerage effectively internalize order flow? Does the brokerage own the market maker?