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July 31, 2001

Meddling in Markets

By Gene L. Finn

Government meddling in retail order flow has hurt individual investors and shaken the very foundations of the marketplace. Congress did not intend the securities laws of our nation to cause this serious damage.

At issue is the byproducts of aggregated retail order flow. Congress did not intend the government to use these byproducts to be taken from one and given to another.

The byproducts include a liquidity value, an information value as well as a market data and spread value.

Cash payments for order flow to independent retail brokers from competing market centers is another side of the value. The decline in order flow payments, a sign of increased regulation, is the result of SEC reengineering.

The SEC has taken several steps that have harmed competition and hurt investors. From the fixing of commission rates prior to 1975 to the fixing of market maker quotation sizes from 1988 to 1997, the exact opposite of what the SEC intended - helping individual investors - has occurred.

Now take the SEC's efforts to minimize market spreads with price improvement regulation. It is transferring the byproduct values of small investor order flow captured in the dealer execution process, to market centers and other market participants.

Most offensive, the price improvement requirements of best execution obligations illustrate, once again, the damage caused by regulation. (So is the regulation of market data and order display.)

Under the threat of best execution enforcement, the SEC requires retail brokers to search markets for unexposed bids and offers that are better than the published NBBO, or National Best Bid and Offer quotations.

Effectively, price improvement and unexposed bids and offers are two sides of the same coin. If a market center's price improvement record is high, its quotation price quality - the public display of bids and offers waiting for offsetting orders for execution - is probably low. The small investors and the quality of the NBBO suffers.

On the other hand, the search requirements of price improvement ultimately result in a "free option" that regulation is shifting, arbitrarily, from small to large customers.

That's the ability for traders to "lay in the weeds" on the NYSE or in an ECN (and either execute or not execute against incoming market orders in front of published bids and offers).

Moreover, unexposed orders can achieve price improvement on every trade while the re-routed small order flow achieves price improvement only in the stocks that coincidentally happen to match the stocks with large investors' unexposed bids and offers.

Regulation removes the competitive pressure on unexposed traders placing bids and offers to publish quotations. The market center with the most bids and offers not reflected in published quotations (that is, with the least relative transparency) is rewarded with greater order flow.

To make matters worse, the NBBO, while a good minimum best execution standard for small orders, it is not a perfect measure of market prices. Quotation prices vary in the size of orders, electronic accessibility for execution, the likelihood of split trades, in the handling of odd lot portions, added execution fees, and the gross or net character of the price.

Gross prices in agency trades include all market center transactions costs as part of the reported trade price. Net prices in dealer trades exclude the dealer center costs from the reported price.

With decimal pricing, conceptual differences in what quotation prices measure can no longer be ignored by SEC best execution regulation.

Moreover, the potential value of price improvement and the unexposed trader's cost of exercising that free option has been reduced to a penny per share or less.

What's the solution to this mess? Through unrestrained competition for small orders, a share of order flow byproduct values is returned to small investors in the form of better services and lower transactions charges.

The SEC needs to return to a best execution policy that is competitively neutral. That means broker efforts to price-improve over the NBBO must be left to competition. The commission also needs to eliminate the anti-competitive requirements for market data and order display that also expropriate small investor order flow value.

Gene L. Finn, a former chief economist at the SEC, also served as a chief economist with the NASD.