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July 31, 1999

Hands Off Price Improvement

By Gene L. Finn

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  • Hands Off Price Improvement
  • Page 2

Price improvement, the term used to signify the execution of a stock trade for a better price than the publicly available best bid and offer is a regulatory delusion. Price improvement doesn't, in fact, improve the prices received by retail investors for stock. It only takes account of the gross trade price without an adjustment for commissions, processing costs, immediacy, size, liquidity, certainty of liquidity services and other factors.

As a measure of the quality of order execution, the price improvement ratios of individual firms and markets can often be misleading. Unfortunately, the push for price improvement causes competition to be guided by these same price-improvement ratios, rather than by more objective customer quality execution factors. These factors link the so-called NBBO - the National Best Bid or Offer - with immediacy, limit order display and automatic order processing.

Price improvement, therefore, should instead focus on the net price received by customers, after adjustment is made for all of the non-price factors.

Lately, the Securities and Exchange Commission has focused its attention again on price improvement - or best execution, as it is sometimes called - for retail orders. Price improvement typically means mid-point pricing between the NBBO, although prices can even be "improved" by penny increments.

Whatever the supposed investor gains, price improvement regulation is controversial. Competition among markets for order flow is so intense, that regulation turns it into an effort to eliminate rational choice among competitors. The bottom line: Competitive forces strike a better balance and price level when all price and non-price factors are allowed to compete for small investor order flow, without regulatory intervention. Let me explain.

Price improvement regulation is, in effect, used as a competitive "hammer" to cause the routing of small investor orders to markets that produce higher price improvement ratios.

Critics of regulation argue that, because of its negative impact on order-execution costs, the anticipated benefit for small orders, as a result of price improvement efforts mandated by regulators, actually turns out to be negative. The regulation causes market order handling and liquidity costs to be shifted from unexposed buy and sell order flow to the small investor order flow subjected to mandatory price improvement. That small investor order flow is forced to be re-routed from competitive channels to accommodate unexposed buy and sell orders.

Unexposed orders are those listed and Nasdaq institutional block trades that are not publicly disseminated, unlike other trades that must be exposed widely, as required under the order handling rules.

Several years ago, two New York Stock Exchange-sponsored academic studies reported that the Big Board had higher price improvement ratios than competing markets. The studies implied that best execution was not being obtained unless orders were routed to the NYSE. However, a later academic study of NYSE limit orders, not sponsored by the NYSE, showed that about 50 percent of the limit orders sent to the NYSE - which would have improved the NBBO prices - were not being reflected in the NYSE quotation. This had the effect of artificially widening the NBBO spread while increasing the price improvement ratios. In other words, despite the reportedly high price improvement ratios, this last study revealed that claims of price improvement at the Big Board were not accurate.