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January 1, 2003

Price Improvement Belongs to Dealers, Professor Says

By John A. Byrne

The most important information in order routing arrrangements may be overlooked by investors, according to a Harvard University academic.

Frequently warned by regulators about the hidden costs in payment for order flow arrangements, it could pay investors to start placing a higher premium on the "price improvement" opportunities a broker is receiving, he says. That's because these order flow payments, which are disclosed under Rule 11Ac1-6, can mislead investors and sow confusion.

The "functional equivalent" of order flow payments can, in fact, occur in fully-integrated broker dealers - even though no cash is exchanged.

These controversial rebates - abandoned by some dealers since the introduction of penny pricing, but still paid legally by others - have been misunderstood by regulators, argues Allen Ferrell, an assistant professor of law at Harvard University. He is also a member of the National Association of Securities Dealers' Economic Advisory Board.

Legal Requirement

Ferrell has a new but controversial twist on the order flow payment debate. He advocates the removal of the legal requirement that brokers credit investors' orders with the actual price received. "Brokers could then fill investors orders at the NBBO [National Best Bid and Offer] and keep any price improvement realized on the order floor themselves. Let us call this the NBBO pricing option," Ferrell said.

Ferrell contends that a broker who uses the NBBO pricing option would have a vested interest in finding the best possible price. Investors should benefit from this in the form of lower commissions as competitive brokers pass along some of the "price improvement" savings to customers, he says.

"With an efficient allocation of investors' orders, brokers would no longer reward securities markets for merely offering side payments [payment for order flow] in lieu of better prices. Auction markets such as the NYSE would no longer be disadvantaged just because they are institutionally incapable of offering order flow payments," Ferrell contended.

"Indeed, to the extent that price can adjust more quickly and at less cost than side payments, markets will have a new reason to compete on the basis of posting competitive prices," he added.

Ferrell's proposal is not supported by all his fellow academics in the field of market structure. "He seems to presume that the money paid for order flow goes somehow to each investor and reduces their transaction costs. It doesn't," according to Professor Junius Peake, a finance professor at the University of Northern Colorado. "It goes to the broker dealer."

"If his plan was adopted, spreads would widen so the NBBO (as it is presently constituted) would have the potential to increase the price improvement, and therefore increase the paybacks to brokers," Peake added.