Discount brokers offer cheap trades, but are they really saving you money?
Investors will be able to answer that question soon, thanks to a new rule that will force brokerage firms to disclose whether they are getting the best prices for their customers.
Many investment experts praised the changes as among the most significant in recent years for individuals who buy and sell stocks.
“I think it’s an excellent ruling,” said Douglas Schulz of Westcliffe, Colo., who works as an expert witness in securities disputes. “Eventually it will be an incredible value to investors.”
The new rules, which will take effect in April, aim to shed light on an issue unfamiliar to many individual investors. Discount brokers offer low commissions, but commissions aren’t the only costs involved in completing a trade. A good broker will also get the best price available on the market: the highest price if you’re a seller and the lowest if you’re a buyer.
Because many discount brokers route trades to networks that consist of only a portion of the market’s total buyers and sellers, you may not get the best price.
Let’s say you place an order to buy 1,000 shares of a stock at the market price. Your broker buys it for you at $100, even though it is trading on another network for $99.9375. The 6.25-cent difference sounds small, but on 1,000 shares, it adds $62.50 to the cost.
“Too few investors recognize that an order executed just pennies away from the best price can dwarf the commissions charged by most discount firms,” said Securities and Exchange Commision chairman Arthur Levitt.
A 1999 SEC study of 29 online brokerage firms found that more than half failed to execute trades at the best prices for customers.
Concern about quality of pricing has grown because more and more stocks, especially Nasdaq stocks, are traded on electronic communications networks, or ECNs.
When trades are executed on an ECN, an investor can buy or sell only at the prices available on that particular network. That means investors may never learn of a better price available in the broader market.
The new rules are designed to shed light on the quality of trades in two ways. The first requires market centers — which include ECNs, exchanges and any other organization that executes a trade — to publish monthly performance data. The data would include how fast a market center fills orders and how much the price investors overall receive differs from the best available price.
The second forces brokerages to tell investors how their orders are routed. The second report also must tell investors whether a brokerage receives any compensation from the company or person who completes the trade. Often, companies that complete trades pay brokerages to send orders their way. This form of compensation, known as payment for order flow, makes the SEC worry that brokers are not getting the best prices for their customers.
Brokers also must disclose whether they execute the order themselves, which allows them to keep the profit on the trade. The SEC fears that this also prevents customers from getting the best prices.
The SEC says these problems occur most often with Nasdaq stocks because they are more likely to be traded on fragmented networks. The SEC estimates that, if the new rules simply make all Nasdaq firms deliver average pricing, investors will save $160 million in the first year.
New York Stock Exchange stocks, in contrast, tend to have fewer pricing problems because that exchange’s central trading floor makes it easier to see all the prices in the market at once.
The SEC says brokers will post the new reports on the Web in the spring, but the data may be hard for investors to interpret.
