Online brokers who use middlemen to execute trades may not get you the best possible share price. This can cost you on big trades, while lining the pockets of the guys in between. The cheap commissions that make online trading so attractive may be costing some investors more than they realize.

        A new report issued by the General Accounting Office, the investigative arm of Congress, finds that retail investors may not be getting the best available price on trades. The fault is a system in which online brokers are paid to send orders to middlemen who actually execute the trade.

        These middlemen, which include market makers, electronic communications networks and stock exchanges, generally fill orders from their own inventory at what's known as the "national best bid or offer," or NBBO, price. Because the orders are filled internally, the report said, "other market participants, such as market makers or specialists, do not see them and, thus, do not have a chance to better the NBBO price."

The Cost to Investors

        So what's the big deal if the price you get is 1/16th of a point less than what's available? On a 1,000-share order, that small difference will cost you $62.50. Meanwhile, the broker is taking your $14.95 commission plus $10 to $20 from the middleman as a "thank-you" for the order.

        The GAO study is a follow-up to an Securities Exchange Commission (SEC) report issued last year that examined the trade execution practices of 29 online broker-dealers. At that time, the SEC found that 17 firms improperly emphasized "payment for order flow" in deciding where to send orders, rather than considering factors that could benefit trade executions, such as the best price. Deficiency letters are not public documents, and SEC staff would not reveal the identities of the 17 firms.

        The full GAO report, issued June 8, also details continuing problems with system capacity, outages and delays, allowing inexperienced investors to purchase unsuitable investments, misleading advertising and spotty disclosure of important information.

Major Online Brokers Faulted

        GAO investigators examined trading practices at 12 online broker-dealers, which together accounted for about 90% of online trading volume in early 1999. Six of those firms were sent a deficiency letter by the SEC accusing the firms of not ensuring that their customers' trades received the best execution possible.

        Instead, the report said, "most of them routed orders to market centers whose execution quality, or percentage of trading orders that received price improvement, were well below industry averages."

        In its follow-up to the SEC report, the GAO found that five of the six firms had since implemented various cosmetic measures, such as establishing "execution quality committees," to address the issue but reported no changes to the basic practice of accepting payment for orders.

Disclosure Often Lacking

        In fact, only six of the 12 firms disclosed in their customer account agreements that they accept payment for order flow.
 
        In a speech delivered last November, SEC Chairman Arthur Levitt put his concerns this way: "I worry that best execution may be compromised by payment for order flow, internalization and certain other practices that can present conflicts between the interests of brokers and their customers."

        Increased scrutiny by the SEC and increased competition among market centers is leading some brokers to provide new execution alternatives. Some market centers guarantee immediate automated execution of trades. Others promise the possibility of price improvement.

Hope for Improvement

        The trend toward decimal trading, rather than the traditional fractions, will also help to reduce the spread between bid and ask prices for stock. Also, the rapid growth of after-hours trading via electronic communications networks, or ECNs, is leading to greater centralization of securities prices and orders, making it easier to obtain the best possible price.

        A growing number of online traders are moving their accounts to brokerages with direct links to the ECNs and market centers. These "liquidity portals" -- such as Tradescape, EdgeTrade and CyberCorp, now a unit of Charles Schwab -- allow customers themselves to direct orders or use computerized order routing to find the best price instantaneously.

        Schwab's CyberCorp.com unit, for example, has just unveiled a new version of the Cybercorp trading system called CyBerX2, aimed at active retail investors who want what Schwab calls "smart order-routing" that gets the best price among market makers, exchanges or ECNs.

        "It's a logical next step for them after acquiring CyberCorp," said Rob Hegarty, an investment-technology analyst at TowerGroup, a technology research firm in Needham, Mass.

        Of course, you can't get something for nothing in the financial markets. If you make less than 50 trades per month, you'll pay a $99 fee on top of your $14.95 commissions to use the CyBerX2 system.