market moved from trading in fractions to dollar decimals this past April, investors got something of a price break, because it meant they could get trades closer to the prices they were seeking. But it looks like they're going to wind up paying for that break through higher online brokerage fees.
This reduction in spreads is reducing profits for market makers on the Nasdaq. While this isn't a direct concern for investors, it's reducing the revenues and profits of online brokers through the payment for order flow that market makers use to reward online brokers for their business. In turn, analysts say, online brokers are likely to raise their fees.
Several online brokers already have instituted or raised fees for inactive or low-balance accounts.
are among the big online brokers that have recently instituted or raised such fees, although
hasn't added such fees or raised commissions. Some online brokers, such as
Terra Nova Trading
, have also
begun charging small fees for sending out paper confirmations of trades.
All of these brokers, though, say that the new fees are unrelated to decreases in payment for order flow. Michael Dunn, a Datek spokesperson, says the company's new inactivity fee is not related to the decline in payment for order flow because Datek has never kept those revenues but has always rebated them to customers.
Likewise, Melissa Fox, a spokesperson for T.D. Waterhouse, says that the company's decision to institute inactivity and paper confirmation fees on July 1 was a result of the company's decision earlier in the year to cut costs in "light of the overall weakness in the financial markets."
But analysts say the timing of these changes is not a coincidence. While the payment for order flow that market makers pay to online brokers is typically a penny or less per share, it adds up to substantial amounts of money, says Gerard Cronin, senior vice president, financial services, at
, an investment banking and financial advisory firm. Ameritrade receives 11% of its revenue from payment for order flow, E*Trade receives 6% and T.D. Waterhouse 4%, according to Cronin.
Russell Keene, an electronic brokerage analyst at investment banking firm
Keefe Bruyette & Woods
, says that higher commissions may even be in the offing. "There's a chain of events here that you can't stop," Keene says.
A Penny for Your Trade
In a fractional environment in which a majority of stocks traded in 1/16th increments, or 6.5 cents, the trader's fee came to half that amount, or about 3 cents. But with decimalization, spreads have dropped to as little as 3 cents, and sometimes even 1 cent to 2 cents, according to Nasdaq. That means traders' commissions have been cut by half or more.
estimates that pretax earnings at market makers have fallen by an average of 35% since the Nasdaq moved to decimalization on April 9. Profits for specialists on the
New York Stock Exchange
, which moved to decimalization on Jan. 29, have fallen as well, but not as much. According to Greg Smith, senior research analyst at
, this is because there is only one specialist for each stock on the NYSE, giving them more control over the market. Also, specialists do not pay online brokers for orders, says Michael LaBranche, chief executive officer of
LaBranche & Co.
, which is a specialist for 500 stocks on the NYSE.
"The fact that spreads moved from 6 cents to a penny, you would expect market makers' profits to compress, but it's been more severe than anyone expected," Smith says. "For many stocks, spreads really have gone to a penny or 2 cents."
Sharp Earnings Shortfalls
The first sign of a reduction in profits at market makers is turning up in their second-quarter preannouncements. The earnings shortfalls at
are a direct result of decimalization and narrowed spreads, analysts say.
Specifically citing how decimalization has reduced its profits,
, the biggest market maker on the Nasdaq, preannounced July 5 that it expected to post second-quarter earnings of 7 cents to 10 cents a share, half its earlier guidance of 15 cents to 20 cents a share.
Likewise, on July 2, Merrill Lynch preannounced that it expects to report net income of 52 cents to 57 cents a share, significantly less than analysts' consensus of 82 cents, as reported to
Thomson Financial/First Call
Unfortunately, those warnings are likely to have a direct effect on online investors.