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01/01/2004

Ripping Off The Little Guy, One Trade At a Time

I first wrote this piece in 2000, but I think most of my advice for retail investors still applies. Thanks to the growing popularity of ECN's as well as renewed attention from regulators, wholesalers are not finding it as easy to screw retail investors, but it still happens every day.


How Retail Investors, Especially Internet Investors, are having their own trades used against them

Every working day, hundreds of thousands of retail investors enter orders to buy and sell stocks and then put their faith in a system that they believe is set up to get them the best price. However, the dark secret of Wall Street is that retail investors are getting far from the best prices and almost everyone on Wall Street knows it.

While this issue affects almost all retail investors, it affects Internet investors in particular as they trade in some of the most active and volatile stocks on the market and this activity provides ample room for Wall Street middlemen to make plenty of money, often at the expense of their own customers.

As a former Wall Street analyst who actively covered the growth of the Online Trading industry, I saw the emergence of these questionable trading practices first hand and now have watched them grow to the point where it seems as though they have become an accepted way of doing business, even though these practices are fundamentally unfair to individual investors and highly questionable from both a legal and moral perspective.

The Rise of the Wholesaler
While there are a number of trends that have pushed these practices to the forefront, the most important has been the rise of the so-called “wholesalers”. Wholesalers are large trading firms that aggregate orders from retail brokers and then execute those orders on behalf of the brokers and, by extension, their retail clients. Indeed, many retail investors are often surprised to learn that their trade is not completed by their own brokerage, but instead is “outsourced” to one of a handful of powerful wholesalers.

Today these wholesalers have become the primary means by which almost all retail investor orders are executed in the market. Many of the largest wholesalers now account for 30, 40, even greater than 50% of the trading volume in particular stocks and wholesalers often dominate trading in the hottest Internet stocks.

Orders = Information
When brokerages send their customers’ orders to a wholesaler, they are sending them valuable information. That’s because these orders represent intentions to buy or sell stocks at specific prices.

Professional investors, such as mutual fund managers, guard such intentions to buy and sell stocks very carefully. After all, if anyone in the market were to find out that a large mutual fund, such as Fidelity or Janus, was trying to sell a big position in a stock, the stock’s price could fall dramatically.

While professional investors take strong precautions to ensure that no one in general finds out about their intentions, they take particular care to prevent their own brokerage firm from finding out their true intentions. That’s because professional investors realize that if the trader at their brokerage firm knew that they wanted to sell a large amount of stock, the trader would likely try to make a profit for their firm by buying or selling stock in advance of completing the investor’s order.

Thus, in the professional investing world, if an investor planned on selling 10,000,000 shares they would, in all likelihood, never tell their broker their true intentions, but instead would “ parcel out” the trade in smaller increments, while always trying to keep the brokerage firm’s trader guessing as to whether or not there was more to come.

The Power of AggregationAt first blush it seems as though retail investors don’t have the same problem. After all, a decision to sell 100 or 1000 shares in most cases isn’t going to move the market.

However, with the rise of the wholesalers it’s become possible for one firm to aggregate tens of thousands of orders in a particular stock. By aggregating all of the individual retail investor orders, wholesalers are able to get some pretty valuable information, information that is often better than anything they can learn from professional investors.

As the wholesalers get more and more orders, in many cases over 50% of the orders in a particular stock, it gets easier and easier for them to determine whether or not a stock might go up or down.

Just imagine the stock market as a giant jig-saw puzzle. If you have 5% of a puzzle’s pieces it’s tough to guess what the picture is, but if you have 40 or 50% of the pieces, it’s a no-brainer.

In a similar way, once an experienced wholesaler controls 30-50% of the order flow in a particular stock, taking advantage of this information to make money for their own account is like shooting fish in a barrel.

The most disturbing part of all this is that the information that wholesaler is using to make money for themselves is coming from retail customers who have no idea that the their information is being used to make someone else rich and often at their expense!

Indeed, there are now a whole series of widely accepted trading techniques used on Wall Street that are explicitly based on supposedly confidential customer information.

Good Morning, You’re Screwed
One of the most basic examples of such techniques occurs just before a stock opens for trading in the morning. Let’s say a major wholesaler, one that typically is the #1 trader in a stock, has a large number of market orders to buy the stock at the open.

Based on this information, the wholesaler can be reasonably certain that the stock is going to open at a higher price than it closed the day before. Given this, the wholesaler can buy as much stock as possible on “after hours” markets, such as Instinet and the Island ECN, prior to the general market open. Then, just prior to the market opening, they would signal to the rest of the market that they had a lot of stock to buy by raising the quote that they publicly display to the rest of the market. (The most blatant way to accomplish is to do what’s called “crossing & locking” the market, which essentially means aggressively moving a quote up or down so fast that the whole market has to reset.)

Given that this particular wholesaler is the #1 trader in the stock, the other traders in the market are likely to stand aside and let him continue raising the quote as the other firms can only assume that he has a lot of orders buy the stock.

The wholesaler’s goal is to increase the opening price of the stock to the point where it is significantly higher than the price of the stock that they just bought on the after hours market. This way they can easily flip the stock they just bought on the after hours market to the individual investors for a significantly higher price than they just paid for it. Not bad for a few minutes work.

Of course, the wholesaler will claim they are merely doing what the retail investors wanted, which is selling them stock at the opening market price, but it’s probably safe to say that 100% of the retail investors would have preferred to get the cheaper “after hours” price.

What’s more, the opening price would never have been higher if the wholesaler hadn’t acted on the information provided to it by the retail investors. Talk about paying for your own participation!

Beware of Price Improvement
It gets worse. Examples like “managing” the open price are common knowledge on Wall Street, but they still entail some risk. In the pursuit of almost riskless arbitrage profits, many wholesalers are now using a tactic called “price improvement”.

“Price improvement” results when a wholesaler actually pays more for a stock than the current market price. This means that if a stock is being quoted at a $30 bid (buy) and a $30 1/2 ask (sell) and a customer wants to sell a stock, the wholesaler will actually “price improve” their order and allow them to sell for $30 1/16. For the seller, this seems like great news as they appear to have gotten an even better price than the best offer to buy (or bid) in the market.

The reality of the situation is a lot less rosy, for both the seller AND the buyer in the transaction. What typically happens in “price improvement” is that the wholesaler currently has a limit order on its book that is “at the market”. Limit orders are instructions from customers to buy or sell only at a specific price. In this case, that would mean that the wholesaler has a limit order from a retail investor to buy the stock at $30.

You might ask yourself, if the wholesaler had an “at the market” limit order to buy at $30 from a customer, why didn’t they just match the limit order to buy with the original market order to sell? That’s a good question and the tip-off that “price improvement” is not what it’s cracked up to be.

Rather than match the orders, what wholesalers typically do is that they unilaterally increase the bid by 1/16 (the minimum allowed by law) and then they execute the trade, not on behalf of a customer, but on behalf of their own account. In our example, it means that the wholesaler would buy the stock being sold at 30 1/16, rather than simply crossing the order with the open limit order at $30.

At first look, this strategy makes no sense: Why would the market maker buy the stock at $30 1/16 for their own account and take on the risk that the stock would fall, when they could simply do a riskless cross of the trades? It seems like wild speculation. But in reality, the market maker is not speculating at all, and in fact they are executing the trading equivalent of a “slam dunk”.

How could this be? First off, the market maker’s maximum loss on the stock is actually limited to 1/16, that’s because they still have a valid limit order at $30. If the price ever started to fall, they would simply sell their stock to the customer who has the limit order.

While their downside is limited to 1/16, the market maker never would have made the trade in the first place if they didn’t have a very good idea that the stock was in fact going up.

How would they know that? Once again, given that they control a large portion of the trading volume in the stock and have been given hundreds, perhaps thousands, of open orders to buy or sell at specific prices, the market maker has at their disposal a virtual treasure trove of information that only they can look at. For example, if the market maker saw a huge number of open buy orders and a decreasing amount of open sell orders, they might be reasonably confident that the stock was going up.

Thus in our “price improvement” example, the seller didn’t really get the best price, because in all likelihood the market was about to move sharply higher, while the customer with the open limit order to buy never even got a chance to buy as the market maker simply “stepped in front” of their order and then used them as a backstop in case the market turned. How’s that for a customer friendly trading strategy?

I could go on and on with more examples of how wholesalers routinely use customer information to improve their own trading profits, but suffice it to say that this is a widespread practice throughout Wall Street today that is generally accepted as part of the business.

Online Brokers to the Rescue?
One would think that if Individual investors were really being taken advantage of so badly, that their brokerages would come to the rescue. After all, they do have a moral and legal responsibility to see that customers get the best execution possible.

Problem is, the online brokers are in on the action. In return for directing their trades to these wholesalers, Online Brokers receive “payments for order flow” (also know as rebates). These rebates are little more than kickbacks of the excess profits that wholesalers are able to achieve by using the information unwittingly provided to them by retail investors.

Thus, the online brokerages have very little incentive to cry foul because many of them are getting millions of dollars in payments a month from the wholesalers. Unwilling to shoot themselves in foot by questioning the legality or morality of the current gravy train, the online brokers prefer to look the other way and collect their checks.

Indeed, several of the largest online brokers actually own major wholesalers. By owning the wholesalers, these brokers capture 100% of the profits from the “information arbitrage” that is, disturbingly, perpetrated on their own customers. This strategy in essence enables them to secretly “charge” far more per trade than their publicly quoted prices.

What Retail Investors Can Do
Given that almost all of the established interests on Wall Street don’t seem to care that much of the market has degenerated into what appears to be an organized front-running operation, what can individual investors do to protect themselves?

Unfortunately, as long as wholesalers and traders in general are allowed to use customer order information to benefit their own trading activities, retail investors will be still be at their mercy. There are however a few things that investors can do to protect themselves, short of getting the SEC and Congress to ban the current practices. These include:

1. Don’t Enter a Market Order To be Executed at the Open: As we covered earlier, market orders at the open are like a license to steal for wholesalers because the wholesalers can trade for their own account prior to the opening and then influence the opening price.
2. Don’t Trade Within The First Hour of The Open: Given the tremendous games that go on during the open, I would recommend that, if they can help it, most investors not trade at all within the first hour or so of trading as it takes that long for much of the market open gamesmanship to play itself out.
3. Always Enter Limit Orders Whenever Practical: Given that market orders are far more malleable in the hands of a wholesaler than a limit order, its wise to use limits as much as possible. Limit orders won’t protect you from being used in “price improvement” schemes, but they are better than nothing.
4. Move to a Broker That Uses ECNs: Outside of using limit orders the best thing for retail investors to do is to use a broker which books their limit orders on one of the major Electronic Communications Networks or ECNs. ECNs are computers that dispassionately match orders between buyers and sellers. ECNs do not trade for their own account so they have no profit motive on the trade. As a result you can expect them to handle your order in as unbiased and as efficient a manner as possible. Of the major online brokers only one, Datek Online, routinely uses an ECN to book limit orders. While no broker is perfect, Datek’s execution is about as good as you are going to get. Outside of Datek, there are a few other firms, such as Tradescape (which SOFTBANK has an investment in) and CyberCorp (now owned by Schwab) that provide access to multiple ECNs, but they are generally targeted at the most active traders and thus may not appropriate for all investors.

Someday, We Won’t Get Screwed This Way
Someday soon the government or the markets themselves may take a close look at these issues and maybe they will make some changes. Some of the possible changes they could make would be to either require market makers to book their limit orders to a third party ECN or establish a Chinese wall between their customer order book and their traders.

There’s a slim chance that the wholesalers, and other market makers like them, will realize the tenuous ethical and legal ground they are standing on and proactively change their practices, but given that this is the same crowd that routinely fixed prices on the NASDAQ for decades, its hard to see how they could have a sudden attack of conscience.

So until such time that either the government wakes up or hell freezes over, it’s “investor beware” for retail investors. Never assume that your order in being held in confidence and always assume that someone else may use your order to improve their own trading decisions. It’s a sad fact that Wall Street has come to this, but if you factor this into your trades you’ll be a better investor for it.

January 1, 2004 in Stocks, Wall Street | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.