Date: February 7, 2005
Publication: Barron's

Shrinking Returns

To the Editor:

Michael Santoli gets the broad business and regulatory trends right in his cover story ("The Big Squeeze," Jan. 24). Trading costs are shrinking and will continue to do so because of efficiencies brought by technology and vigorous competition among brokers. This is undoubtedly a positive development for both retail and institutional investors and our capital markets in general.

That said, Santoli's prediction that institutional stock commissions will "approach zero before long" and his reference to increased proprietary trading to make up the shortfall from the commission squeeze raise some interesting issues.

As an agency-only broker-dealer who eschews principal trading because of its inherent conflicts of interest with the customer business, we have been watching several disturbing trends over the past several years.

The trend of decreasing explicit commission costs seems to be accompanied by its own costs that we're not sure are being adequately accounted for yet -- hidden costs arising from certain forms of principal trading activity.

Increased internalization of trading by the large investment banks and online brokerages may not be delivering the best prices to retail investors. It may also be decreasing market quality, as fewer and fewer orders interact.

In the case of institutional investors, we continually hear about (i) sub-penny commission rates without clients measuring whether the price they are receiving is being manipulated to their disadvantage, (ii) routine "pre-hedging" of portfolios during the principal bidding process (a euphemism for front-running that can have sizeable market impact but has somehow fallen under the radar thus far), and (iii) internal algorithms employed by certain broker-dealers that reportedly analyze the trading patterns of some of the very customers to whom they are providing cut-rate algorithmic trading services, in order to trade against their flow. If trading costs are headed to zero -- and in some cases they are virtually there already -- investors better ask why some of the most sophisticated for-profit banks in the world are giving away products for "free."

Joseph C. Gawronski
Chief Operating Officer
Rosenblatt Securities
New York City

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