Trading Costs

Part of the cost of trading a security is obvious and explicit. Your broker must be paid a commission. Individuals may choose from two kinds of brokers: full-service or discount. Full-service brokers, who provide a variety of services, often are referred to as account

4 The Economist, June 17, 2000. This issue has an extensive discussion of globalization of stock markets. At that time, the most likely partner for Nasdaq was the iX exchange, which was to be the name of an exchange formed from a proposed merger between London and Frankfurt. However, the London-Frankfurt merger fell through. Many observers believe that Nasdaq is now contemplating an alliance with the London Stock Exchange.

84 PART I Introduction

Table 3.7 Choosing Partners: The Global Market Dance

Recent alliances between stock exchanges and their status

Market(s)

Action/Partner

Status

NYSE/Tokyo Stock Exchange

Cooperation agreement

Discussion of common listing standards

Osaka Securities Exchange (OSE), Nasdaq Japan Planning Co.*

Joint venture

Trading expected to begin June 30, 2000

Nasdaq, Stock Exchange of Hong Kong

Co-listing agreement

Starts trading end of May 2000

Nasdaq Canada

Co-listing agreement with Quebec Government

Announced April 26, 2000

Euronext

Alliance between Paris, Amsterdam and Brussels exchanges

Announced March 20; trading expected to begin year end 2000

LSE/Deutsche Boerse

London Stock Exchange, Deutsche Boerse

Deal fell through

Nordic Exchanges (Norex)

Alliance between Copenhagen Stock Exchange and OM Stockholm Exchange

Trading began June 21, 1999

Baltic Exchanges: Lithuania's Tallinn, Latvia's Riga and Lithuania's National exchanges

Signed a letter of intent to participate in Norex

Announced May 2, 2000

Iceland Stock Exchange; Oslo Exchange

Separately signed letters of intent to participate in Norex

Announced spring 2000

NYSE/Toronto/Euronext/ Mexico/Santiago

Linked trading in shared listings

Early discussions

Joint-venture between the NASD and Softbank established June 1999.

Source: The Wall Street Journal, May 10, 2000, and May 15, 2000.

Joint-venture between the NASD and Softbank established June 1999.

Source: The Wall Street Journal, May 10, 2000, and May 15, 2000.

executives or financial consultants. Besides carrying out the basic services of executing orders, holding securities for safekeeping, extending margin loans, and facilitating short sales, normally they provide information and advice relating to investment alternatives. Full-service brokers usually are supported by a research staff that issues analyses and forecasts of general economic, industry, and company conditions and often makes specific buy or sell recommendations.

Some customers take the ultimate leap of faith and allow a full-service broker to make buy and sell decisions for them by establishing a discretionary account. This step requires an unusual degree of trust on the part of the customer, because an unscrupulous broker can "churn" an account, that is, trade securities excessively, in order to generate commissions.

Discount brokers, on the other hand, provide "no-frills" services. They buy and sell securities, hold them for safekeeping, offer margin loans, and facilitate short sales, and that is all. The only information they provide about the securities they handle consists of price quotations. Increasingly, the line between full-service and discount brokers can be blurred. Some brokers are purely no-frill, some offer limited services, and others charge for specific services.

In recent years, discount brokerage services have become increasingly available. Today, many banks, thrift institutions, and mutual fund management companies offer such services to the investing public as part of a general trend toward the creation of one-stop financial "supermarkets."

CHAPTER 3 How Securities Are Traded 85

The commission schedule for trades in common stocks for one prominent discount broker is as follows:

Transaction Method

Commission

Online trading

$20 or $0.02 per share, whichever is greater

Automated telephone trading

$40 or $0.02 per share, whichever is greater

Orders desk (through an associate)

$45 + $0.03 per share

Notice that there is a minimum charge regardless of trade size and that cost as a fraction of the value of traded shares falls as trade size increases.

In addition to the explicit part of trading costs—the broker's commission—there is an implicit part—the dealer's bid-asked spread. Sometimes the broker is a dealer in the security being traded and will charge no commission but will collect the fee entirely in the form of the bid-asked spread.

Another implicit cost of trading that some observers would distinguish is the price concession an investor may be forced to make for trading in any quantity that exceeds the quantity the dealer is willing to trade at the posted bid or asked price.

One continuing trend is toward online trading either through the Internet or through software that connects a customer directly to a brokerage firm. In 1994, there were no online brokerage accounts; by 1999, there were around 7 million such accounts at "e-bro-kers" such as Ameritrade, Charles Schwab, Fidelity, and E*Trade, and roughly one in five trades were initiated over the Internet. Table 3.8 provides a brief guide to some major online brokers.

While there is little conceptual difference between placing your order using a phone call versus through a computer link, online brokerage firms can process trades more cheaply since they do not have to pay as many brokers. The average commission for an online trade is now less than $20, compared to perhaps $100-$300 at full-service brokers.

Moreover, these e-brokers are beginning to compete with some of the same services offered by full-service broker such as online company research and, to a lesser extent, the opportunity to participate in IPOs. The traditional full-service brokerage firms are responding to this competitive challenge by introducing online trading for their own customers. Some of these firms are charging by the trade; others plan to charge for such trading through fee-based accounts, in which the customer pays a percentage of assets in the account for the right to trade online.

An ongoing controversy between the NYSE and its competitors is the extent to which better execution on the NYSE offsets the generally lower explicit costs of trading in other markets. Execution refers to the size of the effective bid-asked spread and the amount of price impact in a market. The NYSE believes that many investors focus too intently on the costs they can see, despite the fact that quality of execution can be a far more important determinant of total costs. Many trades on the NYSE are executed at a price inside the quoted spread. This can happen because floor brokers at the specialist's post can bid above or sell below the specialist's quote. In this way, two public orders cross without incurring the specialist's spread.

In contrast, in a dealer market such as Nasdaq, all trades go through the dealer, and all trades, therefore, are subject to a bid-asked spread. The client never sees the spread as an explicit cost, however. The price at which the trade is executed incorporates the dealer's spread, but this part of the trading cost is never reported to the investor. Similarly, regional markets are disadvantaged in terms of execution because their lower trading volume means

86 PART I Introduction

Table 3.8 Online Brokers

Homepage

Market

Reliability*

Download

Order

Share of

(4-point

Time

Commission

Online

Best for . . .

Broker

max.)

Accessibility-

(seconds)

Rate

Market

Beginners:

These firms charge

more but let you

Schwab

3.3

98.8%

15.24

$29.95

27%

speak to a broker.

Focus is on

Fidelity

3.21

97

9.19

25

9

customer service

over price.

Serious traders:

These clients have

E*Trade

3

95.8

3

14.95

12

some online

experience and a

Waterhouse

2.99

86

2

12

12

self-directed

approach toward

DLJDirect

3.16

98.9

7

20

4

investing. Most

online brokers

Quick & Reilly}:

NA

95.2

8

14.95

3

target this group.

Here the focus is on

Discover

3.31

97.8

9

14.95

3

providing analytical

tools, research, and

Web Street

NA

99.7

10

14.95

2

convenience.

Frequent traders:

These firms focus

on keeping costs

Datek

3.27

98.6

4

9.99

10

down, which

generally means

Ameritrade

2.65

99.8

6

8

8

fewer customer

service and

Suretrade}

2.72

92.8

8

7.95

3

research options.

*Based on a satisfaction survey by the American Association of Individual Investors. Members were asked to rate—from unsatisfied (1) to very satisfied (4)—how reliably their online-broker site could be accessed for an electronic trade. The responses were then averaged.

fAccessibility was measured by Keynote Systems, an e-commerce performance-rating firm. These percentages measure how consistently a website's homepage can be called up from 48 locations across the United States. The ratings reveal how well online brokers cope with heavy traffic. }Suretrade and Quick & Reilly are both owned by Fleet Financial and share market-share results.

Market share figures are from the fourth quarter 1998. These were calculated by Bill Burnham, Credit Suisse First Boston analyst. Source: Kiplinger.com. ©1999 The Kiplinger Washington Editors, Inc.

*Based on a satisfaction survey by the American Association of Individual Investors. Members were asked to rate—from unsatisfied (1) to very satisfied (4)—how reliably their online-broker site could be accessed for an electronic trade. The responses were then averaged.

fAccessibility was measured by Keynote Systems, an e-commerce performance-rating firm. These percentages measure how consistently a website's homepage can be called up from 48 locations across the United States. The ratings reveal how well online brokers cope with heavy traffic. }Suretrade and Quick & Reilly are both owned by Fleet Financial and share market-share results.

Market share figures are from the fourth quarter 1998. These were calculated by Bill Burnham, Credit Suisse First Boston analyst. Source: Kiplinger.com. ©1999 The Kiplinger Washington Editors, Inc.

that fewer brokers congregate at a specialist's post, resulting in a lower probability of two public orders crossing.

A controversial practice related to the bid-asked spread and the quality of trade execution is "paying for order flow." This entails paying a broker a rebate for directing the trade to a particular dealer rather than to the NYSE. By bringing the trade to a dealer instead of to the exchange, however, the broker eliminates the possibility that the trade could have been executed without incurring a spread. Moreover, a broker that is paid for order flow might direct a trade to a dealer that does not even offer the most competitive price. (Indeed, the fact that dealers can afford to pay for order flow suggests that they are able to lay off the trade at better prices elsewhere and, therefore, that the broker also could have found a better price with some additional effort.) Many of the online brokerage firms rely heavily on payment for order flow, since their explicit commissions are so minimal. They typically

SEC PREPARES FOR A NEW WORLD OF STOCK TRADING

What should our securities markets look like to serve today's investor best? Arthur Levitt, chairman of the Securities and Exchange Commission, recently addressed this question at Columbia Law School. He acknowledged that the costs of stock trading have declined dramatically, but expressed fears that technological developments may also lead to market fragmentation, so that investors are not sure they are getting the best price when they buy and sell.

Congress addressed this very question a generation ago, when markets were threatened with fragmentation from an increasing number of competing dealers and exchanges. This led the SEC to establish the national market system, which enabled investors to obtain the best quotes on stocks from any of the major exchanges.

Today it is the proliferation of electronic exchanges and after-hours trading venues that threatens to fragment the market. But the solution is simple, and would take the intermarket trading system devised by the SEC a quarter century ago to its next logical step. The highest bid and the lowest offer for every stock, no matter where they originate, should be displayed on a screen that would be available to all investors, 24 hours a day, seven days a week.

If the SEC mandated this centralization of order flow, competition would significantly enhance investor choice and the quality of the trading environment.

Would brokerage houses or even exchanges exist, as we now know them? I believe so, but electronic communication networks would provide the crucial links between buyers and sellers. ECNs would compete by providing far more sophisticated services to the investor than are currently available—not only the entering and execution of standard limit and market orders, but the execution of contingent orders, buys and sells dependent on the levels of other stocks, bonds, commodities, even indexes.

The services of brokerage houses would still be in much demand, but their transformation from commission-based to flat-fee or asset-based pricing would be accelerated. Although ECNs will offer almost costless processing of the basic investor transactions, brokerages would aid investors in placing more sophisticated orders. More importantly, brokers would provide investment advice. Although today's investor has access to more and more information, this does not mean that he has more understanding of the forces that rule the market or the principles of constructing the best portfolio.

As the spread between the best bid and offer price has collapsed to 1/16th of a point in many cases—decimalization of prices promises to reduce the spread even further—some traditional concerns of regulators are less pressing than they once were. Whether to allow dealers to step in front of customers to buy or sell, or allow brokerages to cross their orders internally at the best price, regardless of other orders at the price on the book, have traditionally been burning regulatory issues. But with spreads so small and getting smaller, these issues are of virtually no consequence to the average investor as long as the integrity of the order flow information is maintained.

None of this means that the SEC can disappear once it establishes the central order-flow system. A regulatory authority is needed to monitor the functioning of the new systems and ensure that participants live up to their promises. But Mr. Levitt's speech was a breath of fresh air in an increasingly anxious marketplace. The rise of technology threatens many established power centers and has prompted some to call for more controls and a go-slow approach. By making clear that the commission's role is to encourage competition to best serve investors, not to impose or dictate the ultimate structure of the markets, the chairman has poised the SEC to take stock trading into the new millennium.

Source: Jeremy J. Siegel, "The SEC Prepares for a New World of Stock Trading," The Wall Street Journal, September 27, 1999. Reprinted by permission of Dow Jones & Company, Inc. via Copyright Clearance Center, Inc. © 1999 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

do not actually execute orders, instead sending an order either to a market maker or to a stock exchange for some listed stocks.

Such practices raise serious ethical questions, because the broker's primary obligation is to obtain the best deal for the client. Payment for order flow might be justified if the rebate were passed along to the client either directly or through lower commissions, but it is not clear that such rebates are passed through.

Online trading and electronic communications networks have already changed the landscape of the financial markets, and this trend can only be expected to continue. The accompanying box considers some of the implications of these new technologies for the future structure of financial markets.

88 PART I Introduction

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook


Post a comment