Reuters: Regulatory News: Pennies add up when brokers choose wrong exchange

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Pennies add up when brokers choose wrong exchange May 7th 2012, 04:00 Mon May 7, 2012 12:00am EDT * Poor trade execution can cause big client losses -study * Order routing costs investors $4.5 bln a year By Herbert Lash and Jonathan Spicer NEW YORK, May 7 (Reuters) - Investors spend a lot of time and money on stock selection when trying to get that extra edge to build a winning portfolio, but a bigger concern in these days of high-speed electronic markets may be the money lost in trade execution. Poor order routing and cost differences account for billions of dollars of losses a year, according to a study by consulting firm Woodbine Associates. Exchanges charge different trading fees, which can lead to sizable losses over the long run. For example, when executing a 50-million share order, the difference in cost among U.S. stock exchanges can be $45,000, said Stamford, Connecticut-based Woodbine. Such an order is unusually large, almost 1 percent of daily volume. "Sub-optimal order routing decisions" cost traders and investors as much as $4.5 billion per year, Woodbine found in a study of the order-routing practices of brokers and the quality of stock prices on the 13 competing U.S. exchanges. "That is a large amount of return given away by traders who overlook the critical importance of seemingly insignificant differences in execution quality and price reversion tendencies at exchanges in the displayed markets," concluded the study, released on M ond ay. Too many institutional investors - or the "buyside" - are unaware of how or even where their orders are routed, said Lionel Mellul, co-founder of brokerage Momentum Trading Partners LLC in New York. This includes even their head traders. That lack of knowledge can lead brokers to route orders where the execution cost is less than optimal or the trade can cause too much impact, leading the share price to move away from the client, Mellul said. "Unfortunately, if I tell you the amount of time that we pitch clients - with the head trader, not the portfolio manager, not the guy that is only on research, but the head trader - and we explain to them the market structure, the way the system works, they're lost," he said. "Those guys don't even know what we're talking about. It's like a different language," Mellul said. MARKET BASICS The survey results could raise questions over how closely brokers adhere to so-called "best execution" requirements in which they must, by law, seek out the best trade for clients based on price, time and the likelihood of execution. It also shines a light on the very complex structure of today's stock markets, where dozens of electronic trading venues use an array of pricing schemes to attract high-frequency and Main Street traders alike. Regulators at the Securities and Exchange Commission have expressed some concern that high-frequency trading, and the way exchange operators like NYSE Euronext and NASDAQ OMX Group compete for business, could undermine market stability and fairness. A major reason money can be lost depends on whether the trader is a "maker" or a "taker" of liquidity. Makers, who earn a rebate, are those whose order was already at the exchange; takers, who pay a fee, execute against that standing order. While the difference may be fractions of a cent on 1,000 shares, it can add up on a large trade. Brokers - or the "sellside" - are likely basing their order-routing decisions in part on which exchanges offer lower trading fees, including better prices for member brokers, said Matthew Samelson, principal at Woodbine. "These brokers are meeting their fiduciary responsibility but are likely conflicted by the benefits of the pricing," he said. The study's overall finding "is a screaming message to both the buyside and the sellside that we really need to decide what we want the market to be," Samelson added. "Because for the buyside, you can't pay brokers nothing and expect everything from them." The complexity of order execution is another reason why institutional investors might not fully understand how trading occurs in the electronic marketplace, said David Mechner, chief executive at Pragma Securities LLC, a New York firm that designs algorithms and serves as an execution consultant. A client can demand better information, but it's hard to know what to ask. Pragma often will provide "tutorials" or walk clients through how their algorithms work. There are cost benefits to knowing how to route an order, Mechner said. "It's unreasonable to expect buyside firms to stay on top of all the nuances (of order execution), the market structure is so complex," he said. "That's the reality. Whether that should be the case, it's harder to say." Link this Share this Digg this Email Reprints

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