Seeking to keep orders for its popular Nasdaq 100 (QQQ) and S&P 500 (SPY) index shares away from competitors, the American Stock Exchange is considering paying brokerage firms to trade those products on its floor.
The exchange has seen an increasing amount of orders on those two listings routed to the rival
Chicago Stock Exchange
or executed internally by "upstairs firms" like
Salomon Smith Barney
Morgan Stanley Dean Witter
"We're going to look at all practical means available to protect ourselves," says an Amex spokesman who acknowledges that the exchange is prepared to respond "in-kind" to competitive efforts by other exchanges to pay for orders, called order flow by industry insiders.
But there's an industry-wide debate over both payment for order flow and internal executions of orders. Critics of payment for order flow say the rebates brokers receive create a conflict between finding the best price for their customers and directing trades to exchanges paying for the orders. Internalization also raises questions about whether investors are losing out.
Where the Orders Go
The payment issue looms large. The Chicago Stock Exchange, which pays for order flow through an independent specialists' association fund, has seen its QQQ volume grow to 121.3 million shares a month from 23 million in January 2000, while its S&P 500 volume has stayed even at around 8 million during the same period.
Both individual and institutional investors have flocked to the Nasdaq 100 index shares, making them Amex's busiest listing. On Feb. 9, for instance, the Nasdaq 100 index shares traded more than 25 million shares, while the busiest equity,
, traded just 700,000 shares.
If increasing payment for order flow wasn't a contentious enough issue, in-house trading also carries the risk customers aren't getting the best execution, while raising the possibility that firms are using customer information to trade ahead of those orders.
Since January, some floor traders and trading firm executives say, brokers have routinely been completing up to 50% of QQQ and S&P 500 trades internally, and sending other pieces of orders to Chicago, taking more business from the Amex.
Making More Money
Eliminating exchange floor traders from the action makes the trades more profitable because brokers save some floor commissions and pocket the spread -- the difference between the price at which someone is willing to buy the stock and the price at which someone is willing to sell.
"There's a lot of internalization in the QQQ. It's a very lucrative product," says a senior trading executive at a major New York securities firm.
To address that situation, the Amex board passed a rule in January that would allow firms to keep as much as 30% of orders executed at the current market price and 40% if they better it. The rule hasn't been approved by its membership or the
Securities and Exchange Commission
Although most large brokerage firms take pieces of customer orders, Goldman (which also owns floor trading giant
Spear Leeds & Kellogg
) currently is catching some heat for this kind of trading.
In a letter to a judge presiding over an investor lawsuit in the
U.S. Court for the Southern District of New York
alleging price fixing in the Amex options market, former Amex trader and exchange gadfly Ed Manfredonia outlined several such occasions when Goldman took 30% to 50% of its customer orders in the S&P 500 and QQQ index shares. A Goldman spokeswoman declined to comment on the issue.
According to other traders, a typical problem trade follows this pattern: A floor broker representing Goldman will enter the trading crowd for the Nasdaq 100 or the S&P 500 unit trusts at the Amex and say he has a customer who wants to buy 100,000 shares, and that Goldman wants to sell 50,000 of those. If the market for those shares is a bid (the current price at which someone will buy the shares) of $70.38 and an offer (the current price at which someone will sell) of $70.63, the order will get executed at $70.63. That, however, means Goldman's customer is paying $70.63 instead of $70.38 to buy half that order.
Two floor traders contend that if the entire order came to the floor, the customer would get a better price than what the brokerage firm offered. Institutional investors, however, are often more interested in speed of execution than in small differences in price.
Floor traders are also inherently suspicious that the upstairs firms are front-running their customer orders by simultaneously buying or selling ahead of S&P 500 or QQQ orders depending on their potential impact on the market.
"If you know someone's coming in to sell 100,000 Spiders
S&P 500 shares," says one floor trading firm executive who requested anonymity, "you can sell stock or futures ahead of that trade." At this point, however, no evidence of front-running has turned up.
Brandon Becker, a securities attorney at
Wilmer Cutler & Pickering
and former SEC head of regulation, says regulators have been straddling the desire to promote competition among exchanges while trying to preserve an integrated market "to achieve efficient price improvement and best execution" of trades. That has left the internal trading issue up in the air.
"The SEC hasn't blessed it," Becker says. "And hasn't banned it."