Research into broker execution quality in the US cash equities market by Celent, a technology research consultancy, has produced some damning results.
Celent found that for orders of 10,000 shares and below, all 16 leading brokerage firms in the US deliver, on average, execution prices worse than the quote. UBS, which averaged a net share-weighted price worsening of 0.08 cents per share, topped the rankings for best execution in terms of prices, while Deutsche Bank, which averaged 0.97 cents per share ranked bottom.
Bear Stearns and UBS were found to achieve price improvement far more often than the rest, with Bear Stearns achieving price improvement on an impressive 92% of orders, while Banc of America Securities and Deutsche Bank were found to be well below average.
In terms of speed of execution, however, UBS was found to be far slower than the rest, taking an average of 6.4 seconds to execute small market orders of between 100 and 499 shares. Lehman, the next slowest, took an average of 4.7 seconds. Fidelity's NFS brokerage and Morgan Stanley were the two fastest, taking 0.1 seconds and 0.2 seconds respectively. For larger orders of between 5,000 and 9,999 shares Morgan Stanley and Deutsche Bank were the fastest, taking 2.7 and 2.9 seconds respectively, while UBS and Bear Stearns were the two slowest. UBS took an average of 41.7 seconds, while Bear Stearns took 32.7 seconds.
Interestingly, the data showed no correlation between speed and price improvement, indicating that there seems to be no trade-off between the time an order takes to be executed and the level of price improvement achieved.
One of the most intriguing findings of the research, which examined 5.3 million trades involving 4.3 billion shares and had access to brokers' own data over the second quarter of 2004, was that despite failing to do a good job for their clients, all 16 brokerages succeeded in trading well for themselves.
In every case brokers were successful in achieving average realized spreads lower than the average effective spreads given to clients. The effective spread is a measure of implicit execution costs, so from an investor's perspective the smaller the effective spread, the better. The realized spread is a measure of the profits realized by a brokerage firm from taking the other side of a customer's order. If a brokerage firm is achieving a realized spread lower than the effective spread it is earning trading profits.
An examination of the distribution of realized and effective spreads also produced some curious findings. Realized spreads were roughly symmetrically distributed, with executions typically having realized spreads of about 0.8 cents a share. Effective spreads, however, were more skewed. Brokerage firms almost never got execution prices better than the midpoint of the national best bid or offer for their clients, even though the distribution of realized spreads suggests that it should happen more often.
Good news on internalization
On the bright side, the report found that levels of internalization, a controversial practice in which a brokerage firm acts as the exclusive counterparty to its own customers' orders, had no correlation with execution quality. This is good news for investors because levels of internalization have been steadily rising over the past few years. At present, nearly 50% of Nasdaq orders are internalized and levels are expected to continue to rise steadily and level off over the next two years. Internalization of NYSE stocks is, however, set to double from 10% to 20% by 2006.
?The results are surprising because internalization seems to be such a conflict of interest,? says Octavio Marenzi, CEO of Celent Communications and one of the report's authors. ?There is a widespread view that internalization leads to worse prices for customers but our results show that it is not a significant factor.?