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January 1, 2003

A Decade Later for Order Executions Are Investors Getting a Better Shake?

By Bill Tanem

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  • A Decade Later for Order Executions Are Investors Getting a Better Shake?
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In a speech two years ago, SEC Chairman Arthur Levitt claimed, in effect, that most OTC investors were being rooked.

He said 85 percent of market orders then executed on the Nasdaq were not going to the markets with the best price. Investors were overpaying for executions, Levitt charged.

Beginning in the early 1990s, the Securities and Exchange Commission started analyzing what improvements in the securities markets could be made to benefit small investors. It eventually drafted new rules that would dramatically affect how broker dealers conduct business on behalf of their customers.

These included the order handling rules, transaction reporting rules, disclosure and best execution rules. Among the most recently enacted are the "disclosure rules." These affect how a broker dealer - a so-called market center - executes or routes customer orders.

Two disclosure rules have been applied for more than a year: SEC Rules 11Ac1-5 (Rule 5) and 11Ac1-6 (Rule 6), which require the disclosure of order execution and routing practices. The objective is to make execution quality on certain stock orders more visible and to expose how firms route these orders.

Some 60 percent of the Rule 5 reporting broker dealers, according to NASD statistics, have used the services of market data analysis firms like Market Systems, Inc. (MSI) and The Transaction Auditing Group (TAG). These firms capture order execution, compare against market data and post a publicly available analysis report for customers to view on the Internet.

Rule 5 reports require firms to analyze execution quality for market and limit orders. Rule 6 requires quarterly reports of routing of non-directed orders and information about receipt of payment for order flow. (Non-directed orders, as the name implies, are not directed to a specific market center. For example, a firm paying for research through commissions, or order flow, might request that a specific market center be used.)

Are the rules improving market quality? "Absolutely, yes," Mark Madoff, the co-director of trading at Bernard L. Madoff Investment Securities told a reporter for Traders Magazine. He said the rules force firms to show how good a job they're doing in execution quality. "The disclosure of execution quality has had a direct benefit to the end user," Madoff said. He added that, "just the mere fact that one now needs to publish execution quality statistics has improved the market." Bernard L. Madoff has ranked among the top firms on quality of executions statistics.

On the other hand, the rules have critics. In an early batch of stats, an execution analysis prepared by Market Systems made the execution quality of discounters Charles Schwab and Fidelity seem inferior when compared to full-service firms. Schwab disputed the results. "It's an old saw that if you torture statistics long enough you can make them say anything you want," wrote Charles Schwab and David Pottruck, co-CEOs of Schwab.

Officials at another firm interviewed for this story said they changed order routing for a group of stocks, soon after the rules were enacted, in response to data analyzed by the firm's best execution committee. This apparently surprised regulators who had not anticipated such a change in practices so quickly.