Do Wall Street Firms Know Too Much?

Wouldn’t you love it if the stock market worked like this: Before trading a stock, you could look at the orders of scores of other investors to get a good idea whether the share price is heading up or down.

Of course, individual investors don’t have such an edge. But, say some critics, a cluster of Wall Street firms do--and they’re using it to make huge profits at the expense of online investors.

The critics claim that some firms, because they execute a huge number of online investor stock trades, get important clues about the market that they use to boost their own trading success.

The flip side is that individuals lose big: Wall Street’s profits come directly out of their pockets by leaving them with inferior executions or unfilled trades.

“It’s a terrible shame that retail investors aren’t getting the best prices and everybody knows it,” said Bill Burnham, a venture capitalist who previously was an analyst tracking the online brokerage industry. “The dark secret is that retail investors are known as the ‘dumb’ money, and everybody on Wall Street thinks it’s OK to take advantage of the dumb money.”

The Wall Street firms vigorously deny that they have a leg up or that they hurt small traders.

Nevertheless, the National Assn. of Securities Dealers has proposed a rule that could lessen some of Wall Street’s trading advantage.

The crux of the debate centers on the cold reality of the market: If another investor knows that you’re about to buy a stock, he’ll try to buy it first so that he can then sell it to you at a higher price.

Put another way, information is money. And you suffer if someone else has information about what you’re planning to do.

Each time a small investor submits a stock order, she sends Wall Street a piece of information--her desire to buy or sell.

In isolation, an order to trade a few hundred shares isn’t of much value. But when bunched together, those orders can yield important clues about the short-term direction of a stock’s price.

Mutual funds and other big investors go to elaborate lengths to prevent others from seeing their hands. They have trading desks that monitor how Wall Street handles their orders. And they divvy up big orders among brokerages to avoid leaks.

For years, individuals didn’t have to worry about who saw their orders. Most people were buy-and-hold types who cumulatively accounted for only a fraction of market trading volume.

But with online investing surging in popularity since 1995, small investors now wield the cumulative power to move stocks.

Market Makers’ Dual Role

Growing along with small investors have been the behind-the-scenes firms that execute their orders.

Though there are roughly 100 electronic brokerages, most online investor trades are executed by just a handful of firms known as “wholesale” market makers. Online investors zap an e-mail message to an online brokerage, which in turn instructs a wholesaler to execute the trade. Wholesalers often use their own capital to do the trades--buying stock from a seller or selling to a buyer.

(By standing ready to buy and sell stocks, the firms are said to be making markets. The term “wholesale” refers to firms that handle a lot of small-investor orders.)

The biggest wholesalers, as well as the biggest Nasdaq market makers, are Knight Trading Group Inc. and Schwab Capital Markets, a unit of brokerage giant Charles Schwab Corp.

The important fact to understand about market makers is that they have a dual role. While they execute trades for customers, they also trade for their own accounts.

In theory, that’s a potential conflict of interest. However, a battery of rules is designed to ensure that firms work on behalf of customers.

Still, each time a market maker uses its own capital to buy from, or sell to, an investor, the firm is said to be trading “against” the customer.

The emergence of wholesalers has altered the trading game in key ways. Wall Street firms have always stood to benefit--at least theoretically--from knowing what their clients were doing. But even the biggest firms had no more than a tiny fraction of overall orders and could only speculate as to where the market was going.

Wholesalers, by contrast, have enormous order flow. Knight has a whopping 17% of Nasdaq market share, while Schwab is No. 2 with 12%, according to Autex/BlockData. Goldman Sachs Group, by contrast, has less than 3%. The firms have larger market share in some volatile technology stocks.

The fact that wholesalers get much of their order flow from individuals helps them in at least three distinct ways.

First, most individuals are considered to be the least-informed and least-savvy traders, and Wall Street has always liked to trade “against” them. It’s like playing poker against a novice rather than a Las Vegas card counter.

Second, individuals can’t employ the same tactics that big investors use to cloak their orders from market makers.

Third, individuals are big players in the tech stocks on which wholesalers can make the juiciest trading profits.

To critics, market makers exercise their informational advantage in two key ways that harm online investors. Between the two, Burnham estimates that about one-third of all online trades are affected.

The first is the way wholesalers trade at the opening of the Nasdaq market each day. Because individuals submit a huge number of orders overnight for execution the next morning, wholesalers can get a good idea if a stock will open higher or lower.

Say, for example, that a stock closed Monday at $50. If a wholesaler has overnight orders to buy 20,000 shares but orders to sell only 5,000, the stock is likely to open higher Tuesday.

How does a market maker benefit from that knowledge? Typically, critics say, the firm buys shares in informal pre-market trading among dealers Tuesday morning. Say the firm pays between $50 and $51 a share. Then the firm can jockey with “bid” and “asked” prices in a way that can influence the opening price--which becomes, say, $52. The firm then unloads shares to its long line of buyers at $52, guaranteeing itself a profit.

Profiting, Yes, but Unfairly?

To Burnham, that’s nothing less than a violation of insider-trading laws.

“It’s clear that this kind of situation is exactly what the insider-trading laws are supposed to prevent,” he said. “It’s amazing to me that the biggest insider-trading racket on Wall Street continues unabated and nobody seems to care.”

Wholesalers scoff at that notion. “He’s totally half-baked,” said Kenneth Pasternak, Knight Trading’s chief executive. “He’s totally wrong.”

Although Knight is a sizable wholesaler, it still has only a small portion of overall orders, Pasternak said. His firm might know which stocks some individuals are buying and selling, he said, but it doesn’t know what institutions are doing.

Thus, if Knight were to buy at the opening simply because individuals were doing so, the firm could lose if heavy institutional selling drove down the price.

“Even though we might have 10% of the information [on a given stock], we don’t have 90% . . . and that’s a lot of information not to have,” Pasternak said.

In fact, he said, the opening is the only time of the day that Knight consistently loses money.

Knight promises to execute at a single opening price most of the overnight Nasdaq orders that it receives from online brokerages. Knight claims its policy--which applies to the first 250,000 shares of any Nasdaq stock--saves investors money because their trades are done at the midpoint of a stock’s bid-asked spread. Midpoint pricing resulted in better prices for investors on 91% of Nasdaq opening trades in June, Knight said.

Because the firm often uses its own capital to complete the trades, it can lose money when stocks go the wrong way, Pasternak said.

Nevertheless, Knight has been enormously profitable. Its profit more than tripled last year to almost $168 million. And Knight has a “relatively low number” of days when it loses money regardless of market conditions, Pasternak acknowledged.

To Burnham, that’s proof that the firm has a knowledge advantage. Without it, Knight would have fluctuating profit as it speculated blindly on the market. “This is the major source of their profits,” Burnham contends.

In fact, the surging profitability of wholesalers recently attracted one of Wall Street’s premier names: Merrill Lynch & Co. agreed in June to pay more than $900 million to buy Herzog Heine Geduld Inc., the No. 3 Nasdaq market maker.

Wholesalers acknowledge that professional traders have an edge over individuals. But, they say, that’s no different from a car dealer knowing more about the auto market than a consumer, and they argue that the firms don’t have an unfair advantage.

“If you have a pro who trades Intel all day long and he’s not somewhat smarter than the aggregate of 5 million people who might buy Intel here and there, then he should be fired, right?” Pasternak said.

Knight makes money because it has superior technology and smart traders who are better at assessing public information, he said. “Our advantage is not around what we see. It’s what we do with it.”

Lon Gorman, head of Schwab Capital Markets, said wholesalers may have had an informational advantage earlier this year when stocks were soaring. But that was attributable to a brief market anomaly in which shares were being powered by small investors rather than by institutions.

“Although there was a period of time where one could argue that this information advantage existed to some extent, I would argue that the information advantage right now is totally meaningless,” Gorman said.

Proposal Would Tighten the Rules

Nonetheless, the wholesalers’ power has helped trigger calls for tightened trading rules.

Last month the NASD proposed a change to Nasdaq pre-market trading that could partially eliminate the wholesalers’ information edge. The proposed rule, which would require Securities and Exchange Commission approval, would bar a market maker from trading for its own account at prices that are better than what a customer gets.

Thus, if a customer submits a “limit” order to buy a stock at $20 or better, and the firm buys at $19, the customer’s order would have to be filled at $19.

The rule would apply only to customer limit orders--requests to trade at specific prices--designated to be filled between 8:40 a.m. EST and the formal market opening of 9:30 a.m. It would not apply to overnight “market” orders, which are filled at the prevailing market price, or to pre-market trades before 8:40.

Officially, however, the NASD says it doesn’t believe that wholesalers have an informational advantage.

Though they have a larger share of orders, wholesalers don’t have enough to guarantee they know the market’s direction, said Bill Broka, NASD senior vice president of trading and market services.

“If the overwhelming majority of retail people are in a sell mood in a particular stock, they may collectively represent 200,000 shares,” he said. “But you can have several institutions who may be buyers and collectively they represent 2 million shares. If you’re handling all those retail orders, you got one view of the market, and the real one may be something entirely different.”

Annette Nazareth, SEC market regulation director, also doubts that small investors are being hurt.

Though they may have suffered from wholesalers’ pre-market trading habits, that should be rectified by the NASD proposal, she said.

As for the overall issue, Nazareth acknowledges that market makers may have a leg up by seeing order flow. But that is an innate part of their business and is not necessarily unfair to investors, she said.

“Not all informational advantages are illegal,” she said.

Price Improvement, but Buyers Shut Out

Which brings us to the second way critics see wholesalers exercising their informational advantage to the detriment of online investors. Ironically, it can stem from the firms’ efforts to give small investors what regulators want--”price improvement,” meaning a better price on a trade than the prevailing market price.

To understand how, consider this scenario: A small investor decides to sell a stock when it’s trading at $20 a share. A market maker has a standing order from another individual to buy at that price.

But rather than matching the two orders, the market maker buys from the seller at $20.06. The firm has “price improved” the seller by 6 cents a share.

Why? Because the firm has a pretty good idea from observing its order flow that the stock is heading up, critics say.

“People aren’t price-improving people out of the goodness of their heart,” Burnham said. “They’re doing it to make money. And they’re usually doing it simply because they have a great certainty that they can make even more money by offering a slightly better price.”

Though the seller has gotten a better price, a would-be buyer has been shut out as the market maker “stepped ahead” of him.

Market makers “actually trumpet their act of stepping ahead as price improvement,” said Ed Nicoll, chief executive of brokerage Datek Online Holdings. “They say, ‘Look at this terrific thing that I did. I price-improved.’ But they never talk about the fact that they step ahead of a buyer who would have bought it at that price, and they’re disadvantaging the buyer. They always forget to mention that.”

The problem, critics concede, is that the advantages wholesalers have in handling small investors’ orders aren’t easily proved, and the cost to investors, taken individually, isn’t enough to trigger a public outcry. “You’re not screwing anybody dramatically,” Burnham said. “You’re not kicking an old lady out of her home. You’re just nicking her for a dollar or two on every trade she does.”

Part One of this series and related stories are at http://ukobiw.net./etrading.

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The Pre-Market Trading Game

Here’s how critics say wholesale market makers can profit at the expense of small investors in pre-market trading:

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Step 1:

After the stock closes at $50 on Monday, small investors send a flood of overnight orders to buy shares of UXYZ Corp. The orders are routed by online brokers to a wholesale market maker to be executed when the Nasdaq market opens Tuesday at 9:30 a.m. Eastern time.

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Step 2:

By 8:30 a.m. Tuesday, the wholesaler has orders to buy 20,000 shares but to sell only 5,000--a sign that the stock price will open higher. Using electronic networks on which institutions swap shares in pre-market hours, the firm buys 15,000 UXYZ shares at $50 to $51 each, adding them to the 5,000 shares it buys from Monday’s sellers so it has 20,000 to fill the buy orders.

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Step 3: A few minutes before the market opens, the wholesaler often uses legal, though controversial, trading techniques to push up UXYZ’s price. The goal is to guarantee that UXYZ opens at the price the wholesaler wants.

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Step 4:

The stock opens at $52, thus turning a profit for the wholesaler, which sells to individuals the shares it bought at lower prices.

Trading Glossary

* Informational advantage: A situation, critics say, in which a market maker gains an edge in trading stocks for its own account by observing the trading patterns of its customers.

* Market maker: A firm that executes trades on the Nasdaq Stock Market. Because they stand ready to buy or sell shares whenever investors want to trade, such firms are said to be making markets.

* Stepping ahead: A situation in which a market maker offers a slightly higher price to buy a stock, thus “stepping ahead” of a customer who otherwise would have bought it. If, for example, a buyer and a seller place simultaneous orders to trade a stock at $20, a market maker would step ahead by offering to pay $20.06. The would-be buyer would suffer if the stock subsequently rose.

* Wholesale market maker: A market maker that caters to small-investor trades.