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November 29, 2005

Dash-5 Stats Headed for Extinction?

By Peter Chapman

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Retail brokerages, charged with identifying the best trading venues to route their orders, are turning to new execution analysis technology for guidance. The trend could spell an end to the practice of basing routing decisions on the much-maligned "dash-5" reports.

Penson Financial Services and JP Morgan Invest/BrownCo. are among a number of order-sending shops using the market monitoring and trade quality analysis technology of Austin, Texas-based vendor Quantum 5.

"If your order was filled on Archipelago," says Ben Brown, Quantum 5's chief scientist, "we will tell you if, on average, for like orders, INET would've been a better venue."

Quantum 5's technology, originally designed for the telecommunications industry, performs two tasks. First, it judges the quality of the order-senders' fills in light of the liquidity conditions existing when the orders were filled. Second, it assigns a score to an execution or group of executions that can be compared against an average as well against other individual scores. Those scores may represent orders sent to competing execution venues.

Quantum 5's offering is a response to the Securities and Exchange Commission's four-year old effort to bring transparency to and promote competition in the retail order execution business.

In 2001, the SEC promulgated two rules designed to shed light on the murky world of retail order executions: Rule 11Ac1-5 and Rule 11Ac1-6.

Best Execution Clarification

Rule 11Ac1-5, the more important of the two, requires market centers market makers, exchanges and ECNs to publish monthly certain execution quality statistics. These metrics would result, the SEC hoped, in some sort of mathematical definition of "best execution," a heretofore nebulous concept enshrined in 1930s-era SEC laws.

Rule 11Ac1-6 requires order-sending firms to publish quarterly the names of the market centers executing their orders and the percentages of their flow each venue received. Both rules contend strictly with market and marketable limit orders of fewer than 10,000 shares.

The Rule 11Ac1-5 stats, the dash-5 stats, are not universally liked, but they have impacted the business of retail order execution. Those market centers with better stats have seen an uptick in their business. Those market centers with inferior numbers have suffered.

The stats have their critics. "Dash-5 statistics don't measure best execution," Matt Lavicka, a senior trading official at Goldman Sachs, said at an industry gathering earlier this year.

The dash-5 stats include such metrics as effective spread', which compares the execution price to the market's best quote at the time of the fill; speed; and amount of price improvement an order received.

Indeed, the numbers provided by the trading venues may not even be accurate. The NASD recently fined Instinet and its INET ECN division $700,000 for "publication of inaccurate [dash-5] reports" and "related supervisory violations." Only weeks earlier, at the stock trading industry's annual conference in Boca Raton, NASD market regulation chief compliance official Richard Wallace promised an investigation into firms' compliance with Rule 11Ac1-5.

Brown, the architect of Quantum 5's market surveillance engine, claims the dash-5 methodology has two major defects. First, it doesn't take into account the complete array of order types. It includes only market and marketable limit orders.