In a bid to distinguish itself from trading competitors, online brokerage service Datek is passing back to customers an obscure third-party fee generated by trades - a move focusing attention on "payments for order flow," a controversial but common practice.
The payments, well-established in the brokerage industry, work like this: When customers place a trade, their broker passes the order along to third-party market makers who actually execute it. In aggregate, the trades offer the market makers valuable market information, for which they pay the brokerage firms.
Regulators have questioned the practice because brokers are required to provide the best execution possible for orders, and they question whether this can occur if money is exchanging hands between brokers and market makers who execute trades.
For online brokerages, the practice has produced millions of dollars in revenue. Last year, 11 percent of E-Trade's revenues came from payments for order flow; for Ameritrade, it was 8 percent, and at Waterhouse it was 5 percent, according to SEC filings.
At Datek, however, only three-quarters of one percent of revenues come from payments for order flow. The number is low primarily because Datek does much of its business through Island, an electronic communications network, or ECN, in which it holds a majority stake, rather than through market makers. So while the announcement seems like a bold move, Datek has the least to lose.
"It's a clever announcement," says Jim Marks, director of equity research for Credit Suisse First Boston. "It creates a marketing wedge between Datek and its competitors and raises the question for investors of why companies are getting paid this money to begin with."
Datek chairman and CEO Ed Nicoll didn't deny the reason behind the company's move. "We're showing that we're prepared to make an issue of the practice and also let investors know that we provide the best execution for our customers without conflict of interest," he said.
Traders pay brokers a small amount of money per share in exchange for receiving orders because they want as much exclusive information about the market as possible. If they get a large flow of orders that only they see, they can get a good idea of how a stock will trade and can profit from that knowledge. "The fact that market makers are willing to pay for the information demonstrates that they know it's worth paying for," says Bill Burnham, a general partner at Softbank Capital Partners.
But regulators are concerned that this system, which Balkanizes the market, prevents investors from getting the best possible execution for their trades because it discourages competition and therefore keeps spreads between bidding and asking prices high.
Presumably, investors also would be unhappy to learn that information about their trades - information they assume is between them and their broker - is in effect being sold, raising both ethical and regulatory questions.
Most investors aren't aware of the practice. Securities and Exchange Commission Chairman Arthur Levitt has indicated that regulators are looking at the issue, noting in a November speech to the Securities Industry Association that "best execution may be compromised by payment for order flow" and that the practice "can present conflicts between the interests of brokers and their customers."
It is unclear whether the SEC will impose new regulations soon.
Datek, meanwhile, is hoping its announcement will bring the issue closer to investors' consciousness. That could put firms like E-Trade and Ameritrade, which rely more on payment for order flow, in a bind. Asked about the Datek move, an Ameritrade spokeswoman said the company had no comment. E-Trade did not return phone calls.
Unless regulatory changes require it, other online trading firms aren't likely to join Datek in providing customers with rebates from order flow payments in the near future. "For some, these payments are eight to 10 percent of their revenues," Burnham says. "That's a big chuck of revenue to be giving up."