Electronic Commerce in the Retail Brokerage Industry: Trading Costs of Internet Versus Full Service Firms

Abstract

Electronic brokerages on the Internet represent one of the most successful examples of electronic commerce, having captured over 20% of retail stock trades. According to economic theory, prices of commodities like securities should converge to one price in a market with the transparency of the Internet. A review of published commissions for online brokers shows that this "law of one price" does not appear to hold for the commissions charged by retail brokers. In this paper we explore one possible explanation for these differences in commissions. Specifically, we test whether the total cost of trading, including commissions and savings based on the quality of execution, obeys the law of one price. In a carefully designed experiment, we simultaneously purchased or sold 100 share lots of stock using a voice-broker, an expensive online broker and an inexpensive online broker in each trial. We found relatively few price improvements, which are a measure of execution quality. The difference among brokers in obtaining price improvements was not statistically significant. The brokers do exhibit statistically significant differences in total trading costs; at a volume of 100 shares commission costs dominate execution quality. We explore the implications of the findings for larger lot sizes, choosing a broker, and electronic commerce in the brokerage industry.