Small investors do not get the best price for stocks because brokerage firms and New York Stock Exchange professionals emphasize holding down their own costs at the expense of investors, according to a study by Midwest Stock Exchange specialist William Finerman.
Finerman submitted his sweeping condemnation of the system used to execute small stock orders to Securities and Exchange Commission officials. Michael J. Simon, assistant director of market regulation for the commission, said the study "raises important questions" about how small orders are being handled.
Simon said the SEC is examining the problems caused by the system. He said the positive aspect of the system is that it holds down transaction costs for brokers and investors. But Finerman is convinced the costs to the investors outweigh the benefits.
"The quality of execution of small, retail orders is being sacrificed to the profit and cost control of the retail brokerages," Finerman said in a study signed by dozens of his Midwest Stock Exchange colleagues. "The retail brokerages are shopping for the cheapest execution costs. No effort is being extended to obtain the best price for the customer. The result is that all of the great strides of communication and computerization of the past decade benefit only the broker. The general public is not being served."
One New York Stock Exchange specialist said Finerman and his colleagues are making the allegations because they are trying to find a way to increase the flow of orders to the Chicago-based Midwest Exchange. The SEC's Simon said that while the problems and solutions outlined in Finerman's study could lead to additional orders being executed on regional exchanges, including the Midwest, that does not necessarily mean the study lacks merit.
Finerman said the basic problem is that retail brokerage firms send their orders to the New York Stock Exchange even if better prices are offered on the regional exchanges. He said they do this to control their costs.
Finerman said the brokerage firms allow NYSE specialists, who work on the Big Board's floor buying and selling shares to maintain an orderly market in each stock, to match the best price being offered on regional exchanges.
While it appears that this system would still give the investor the best price, he said that, over time, it does not. Finerman said the regional stock exchanges do not continue to bid as aggressively, because orders will be diverted to the NYSE floor anyway. As a result, competition diminishes and the investor does not get the most competitive price. In addition, the NYSE specialist makes a bigger profit on the transactions he handles, because less competition means there is a bigger spread between the price bid and asked on stocks. Most brokerage firms, eager to control costs, favor this system because it allows them to keep most of their trading on one floor.
"They have fashioned a two-tiered exchange structure that excludes the public and is run exclusively for the benefit of the professional trader," Finerman said. "This revision has resulted in greatly increased profits for floor traders and brokerage firms. As usual, the public has been asked to foot the bill for this windfall. The profit is levied through artificially wide trading spreads, against which the automated public orders are priced without attempting to better them."
Finerman's study, which was the topic of an article in this week's Wall Street Letter, a weekly financial newsletter, discusses small stock trades in the 100-share range. Institutional orders are handled by a separate system, he said.
The Intermarket Trading System condemned by Finerman links the NYSE and the Philadelphia, Boston, Cincinnati, Midwest and Pacific Exchanges. He said the system enables NYSE specialists to take business away from the regional exchanges while decreasing pricing competition.
"At present, the exchange auction has been converted to an arena for the exclusive use of professionals. The general public has been excluded," Finerman said. He said the problem should be solved by adopting a competitive system that automatically directs small orders to the exchange offering the best price. His opponents charge that such a system would greatly increase transaction costs.