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

We use QQQ in our example because it has been the most actively traded issue among all the stocks and exchange traded funds listed on the American Stock Exchange (AMEX) since its inception on March 10, 1999. Both small individual investors as well as institutional investors heavily trade QQQ because it provides significant portfolio diversification benefits. The other characteristic of QQQ that makes it a good example for our study is that it is traded on all five market centers that we focus on: the AMEX, the NYSE, Nasdaq, Electronic Communication Networks (ECNs), and regional exchanges.

We suggest potential loss to a dealer or a trader taking the other side of an order (from now on referred to as potential loss), likelihood of execution, and speed of execution as the evaluation criteria of order execution quality. Importance weight of each criterion may be different for each investor based on his or her preferences and constraints. Therefore, the investor must first determine the relative importance of the execution quality criteria through pairwise comparisons. Table 1 presents a pairwise comparison scale typically used in the AHP. A financial advisor can guide the investor in the process of pairwise comparisons through a questionnaire, which can be prepared for a specific order size. With three criteria, the investor has to make three pairwise comparisons. A sample questionnaire and responses from a hypothetical investor are presented in the Appendix. Table 2 Panel A presents the preferences of the hypothetical investor in a matrix format. For example, comparing potential loss to speed of execution (row 1, column 3 of the matrix), the investor assigns a preference score of seven, indicating that he or she puts more emphasis on potential loss as an execution quality criterion. The investor also sees potential loss as more important compared to likelihood of execution, and assigns it a preference score of three.

weights, we refer the reader to Saaty (1977, 1980). Table 2 Panel B presents the relative importance weights of the execution quality criteria as determined by the hypothetical investor. In this example, the investor sees potential loss as the most important criterion for measuring execution quality with a weight of 0.6693. This investor also considers likelihood of execution more important than speed of execution.

Rule 11 Ac1-5 requires market centers to report their execution quality statistics for four size categories and five order types. Order size categories are 100-499 shares, 500-1999 shares, 2000-4999 shares, and 5000 shares or higher. Order types are market orders, marketable limit orders, inside-the-quote limit orders, at-the-quote limit orders, and nearthe-quote limit orders.1 We use these order types and the NYSE, the AMEX, Nasdaq, ECNs, and regional exchanges to form the market center-order type pairs. Regional exchanges in our sample are Chicago Stock Exchange, Boston Stock Exchange, Philadelphia Stock Exchange, and Cincinnati Stock Exchange. We include Bernad L. Madoff Investment Securities, Knight Securities, Salomon Smith Barney, and Trimark Securities in our sample of Nasdaq market makers. ECNs are Archipelago Exchange, Brut LLC, Island, and Instinet.2 A list containing the codes and the titles of market centers as well as the codes and the titles of member firms is provided in Table 3.