Online Broker Survey: Some Brokers Have a Side Business -- Selling Your Trade Orders

An order to buy or sell a stock may be worth a lot more than most investors know.

That's because of payment for order flow -- a common practice in which the firms that actually make the trades pay brokers to send orders their way. Insiders say it's one of the brokerage business' worst-kept secrets.

Or maybe not. Turns out the ones most in the dark about it are customers.

A wide majority of participants in TheStreet.com's Online Broker Survey say they don't know whether their broker has anything to do with this practice. And nearly half say they don't know whether their broker is getting them the best possible price.

Payment for order flow is exactly as it sounds. Brokers like E*Trade receive money from the Nasdaq market makers -- the trading houses that execute trades -- in return for sending the market makers a certain amount of their market orders and some limit orders . (TSC has examined this practice before.)

Regulators are well aware of this practice. Securities and Exchange Commission Chairman Arthur Levitt has proposed a rule that would require brokerages to disclose where they send their orders and how they fared in getting the best execution price.

Levitt and others are concerned that this practice of buying order flow could affect a broker's ability to fulfill its responsibility to get the best possible price for the customer.

Market orders are orders customers place with their broker to buy or sell a stock at the market price. This is a valuable order to a market maker in the middle, who can usually step in and profit from the difference between the price for which the stock is sold and the price at which it can be bought. (This is called the spread.) Limit orders, in contrast, are orders to buy a stock at a certain price. A market maker can't profit on this type of order, so firms usually don't pay for them.

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Here's how a market order works: An investor sends his broker an order to buy 100 shares of, say, Cisco (CSCO Quote). The broker sees that three market makers are all showing Cisco with the same spread, $55 bid and $55.125 ask . That's typical.

If one offers a better price, the broker is obligated to take it. Otherwise, the broker sends the order to the market maker with whom he has an agreement. The market maker then buys Cisco at $55 and sells it to the broker for $55.125. The market maker makes a profit of 12 1/2 cents a share on the transaction and then pays the broker a fraction of a penny per share for having sent it the order.

The question that SEC's Levitt has asked is whom this system serves. If there were no order flow agreement, could the broker have gotten a better price -- say, $55.0625 -- in a more competitive environment? That would be a better trade and less expensive for the investor.

Some market makers that pay for order flow include Schwab Capital Markets, a unit of Charles Schwab (SCH Quote), and Knight Trading Group (NITE Quote). Knight, for instance, spent $37.3 million in the quarter ended Sept. 30 paying for orders. Despite continuing talk that payment for order flow is on its way out because of SEC pressure, Knight's expenditures for such payments last quarter represented an increase from $31 million in the year-earlier quarter.

And Knight is paying that money to some of the largest online brokerages out there: E*Trade, Ameritrade and TD Waterhouse. In fact, the practice of payment for order flow is going strong enough that Ameritrade started a free trading site called Freetrade.com, where investors can place free market orders -- it uses payment for order flow to offset its costs.

Not all online brokerages partake in -- or like -- this arrangement. In fact, Datek Online -- the top-ranked broker in TSC's survey -- makes quite a point out of the fact that in most cases it doesn't get paid for order flow. Instead, it sends most Nasdaq orders to an electronic trading network called Island, of which it is the majority owner.

These electronic networks, known as ECNs, don't have the same payment-for-order-flow structure. In fact, many charge brokers for using their services. But Datek can't execute most non-Nasdaq orders on Island, so it sometimes receives payment for orders that it sends elsewhere. For instance, trading firms not located at the New York Stock Exchange, like Bernard L. Madoff Investment Securities, pay for order flow of Big Board-listed stocks. Datek says that at the end of September, it had rebated the nearly $1.5 million of these payments to customers on an order-by-order basis.

That's something that caught the eye of Kevin Allen, a 32-year-old accountant from Phoenix. Allen is working on closing out his account at E*Trade -- he disagrees with E*Trade about a promotional reimbursement he thinks he is entitled to -- and is moving his funds to Datek for a long list of reasons, he says. It has after-hours trading, the commissions are half those of E*Trade, he'll get 10 free trades when he opens the account and "it offers the rebate on the market makers' money."

Allen said he didn't know how much the rebates could be, but it sounded like a good idea to him.

Brokers as Bargain Hunters

Just as payment for order flow is a mystery to investors, so is best execution. No wonder. The two go hand-in-hand.

It's every broker's duty to give customers the best execution possible -- and in many cases that means not only finding the price the customer asks for but trying to improve upon it.

But many survey participants say they don't know whether they're getting the best execution.

That could change by the time TheStreet.com does its next survey. The SEC recently concluded the comment period on a rule that would require broker dealers to reveal their order routing and execution practices, which means the rule should move forward in the next several months. Another rule would require market makers and others to report execution data.

The end result could be to create a type of report card -- available to the public -- that would gauge each broker's effectiveness when it comes to order execution. That's one way to choose an online broker.

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Editor's Note: One of the payment-for-order-flow questions in the survey was misstated. It asked, "Is your broker paid to send orders to a particular exchange?" It should have asked whether the broker received payments from a particular exchange or market maker that executes Nasdaq stock trades. While regional exchanges do pay for orders involving stocks typically traded on the New York Stock Exchange, that practice accounts for only a small part of listed trading and is not as important among online investors who largely trade Nasdaq issues.