Disclosure of information on order execution practices of market centers: How can investors utilize it?

Financial Services Review, Summer 2004 by Saraoglu, Hakan, Ascioglu, N Asli

Abstract

The U.S. Securities and Exchange Commission has recently adopted Rule 11Ac1-5 that requires market centers to disclose statistical information regarding their order execution practices. The rule enables investors to assess the quality of execution for different types and sizes of orders in market centers. This paper develops a framework for comparing order execution quality across competing market centers by utilizing the data set made available as a result of the new rule. Different investors may have different preferences related to the execution quality of their orders. Our framework allows investors to incorporate their preferences as well as order types and sixes into the measurement of execution quality. � 2004 Academy of Financial Services. All rights reserved.

Jel classification; G10; G18; 020

Keywords: Order execution quality; SEC Rule 11Ac1-5; Market microstructure; Market centers; Analytic hierarchy process

1. Introduction

The comparison of order execution quality across different securities market centers has been a central issue in market microstructure studies and in a recent rule of the U.S. Securities and Exchange Commission (SEC). In today's markets, investors demand the best execution of their orders from competing market centers, and a key service of market centers is to provide the highest quality for trade executions. Therefore, execution quality directly reflects market quality.

Execution quality for investors is commonly measured by execution costs. The difference between the ask and bid prices (dollar spread), and the difference between the execution price and the midpoint of the ask and bid prices are common measures of execution costs. Realized spread, measured by the transaction price relative to the midpoint of the bid and ask prices at some time subsequent to the trade, is also commonly used as a proxy for execution costs. Realized spread impounds the price movements after the trade and measures the potential loss to a dealer or a trader taking the other side of the order. Execution quality also has other dimensions such as speed of transaction, which is the difference between the time a broker receives an order from a customer and the time the order is executed, and the extent to which an order is executed for the full size at the best available price. A proper comparison of trading across market centers is dependent on the availability of standardized data on various measures of execution quality. Acknowledging this fact, the SEC introduced Rule 11Ac1-5 to increase the transparency of order execution practices of market centers (see the SEC Final Rule: Disclosure of Order Routing and Execution Practices, SEC, 2001). Rule 11Ac1-5 became effective on January 30, 2001, and market centers began publishing monthly data on execution quality in June 2001.

In this study, we provide a framework for the comparison of execution quality among different market centers using the data made available as a result of Rule 11Ac1-5. Our framework highlights the Analytic Hierarchy Process (AHP), which is a widely used tool for solving multi-attribute decision problems. Given that the assessment of execution quality involves measurements based on multiple criteria, it can apparently be difficult for an individual investor to decide which market provides the most desirable execution of an order. By using the AHP framework, investors can rank market centers based on the relative importance they assign to each execution quality criterion. More importantly, the AHP ensures consistency in the determination of the relative importance of the criteria. This is the first study that provides an analytical decision process for the comparison of market centers.

In the following section, we include a literature review for the execution quality of markets and discuss Rule 11Ac1-5. We provide an overview of the AHP in Section 3. In Section 4, we present an example in which we recommend a suitable order type and a market center to a hypothetical investor using the AHP. We provide a summary in Section 5.

2. Comparison of execution quality in market centers and Rule 11Ac1-5

Studies that analyze the quality of market centers primarily focus on measures of execution price quality such as percentage spread and effective spread, and report significant differences in these measures across market centers. Christie and Schultz (1994) find that National Association of Securities Dealers Automated Quotation System (Nasdaq) dealers avoided odd-eight quotes in 70 of the 100 largest Nasdaq stocks in 1991, leading to higher percentage spreads for those stocks. Using the Trades, Orders, Reports, and Quotes (TORQ) Database that covers 144 randomly selected NYSE stocks from November 1990 through January 1991, Chung et al., (2001) also show that the average Nasdaq spread was significantly larger than the average New York Stock Exchange (NYSE) specialist's spread because of a higher use of even-eighth quotes of Nasdaq market makers. Moreover, Christie and Huang (1994) and Barclay (1997) report that spreads decrease when stocks move from Nasdaq to the NYSE. Bessembinder (1999) finds that spreads on Nasdaq are greater than those of the NYSE after the 1997 Nasdaq market reforms. Heidle and Huang (2002) suggest that informed traders who want to be anonymous prefer to trade in dealer markets rather than in an auction environment, and this leads to wider spreads in dealer markets such as Nasdaq. The SEC's Report on the Practice of Preferencing (SEC, 1997) finds significant differences in execution quality among the NYSE and the regional exchanges.