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January 1, 2002

ECNs, Dealers Differ on Subpennies

By Gregory Bresiger

Once again officials of electronic com munication networks are mavericks, taking a position out of step with much of the trading industry, especially the market making community.

This time the topic is subpenny trading. With the New York Stock Exchange and the Security Traders Association on record opposing subpenny trading, saying it causes "chaos," five of the biggest ECNs are telling the regulators that the market, not the regulators, or the exchanges, should decide the fate of subpenny trading.

Among the ECNs sending this opinion to the Securities and Exchange Commission are Instinet, BRUT and Archipelago.

Competitive Forces

In a letter to the SEC sent by the STA's ECN Subcommittee on Trading Issues, regulators are told, "that the forces of competition, rather than regulation, are best equipped to resolve the issues associated with the placement, display and execution of orders and quotations in sub-penny increments.

"Within this context the Commission should work to ensure equalized application of its rules across all market centers as related to sub-penny quoting and trading, in order to ensure fair and consistent practices for both investors and their intermediaries in the competition for order flow and best execution."

Lawmakers on Capitol Hill and the regulatory agencies are now hearing differing sentiments within the trading industry. The Securities Industry Association, as the ECNs were sending their letter to Washington, dispatched a letter to the SEC opposing subpenny trading.

"Most SIA member firms believe that the trading and quoting of equity securities in subpenny increments would undermine the benefits of decimalization by causing confusion for investors and securities professionals in the purchase and sale of equity securities and would not contribute to the maintenance of stable and orderly markets as called for by our national market system," wrote Donald Kittell, executive vice president of the SIA.

Kittell also wrote that subpenny trading would destroy decimal pricing's goals of providing greater simplicity, contribute to the incidence of flickering quotes, which stand in the way of best execution standards. He also charged that subpenny trading would lead "to the production of less meaningful quotes, and decreased market depth and liquidity." The STA also sent a letter against subpennies a few months a go.

The impact of subpennies on market participants is not spread evenly, some trading pros note. ECNs, which operate agency brokers, make money matching buy and sell orders and charging commissions. The advent of narrower spreads is of minor consequence to ECNs compared with market makers. Indeed, before the latest hue and cry, some ECNs traded stocks at increments narrower than the previously minimum increment of one sixteenth. Market makers, on the other hand, have seen their profit margins decline since the introduction of decimal pricing and subpenny trading. That's because market makers have traditionally relied on spread-based trading.

Mark Borelli, a Chicago-based securities attorney who formerly worked for the SEC, said the disagreement within the STA as well as between Nasdaq dealers and ECNs on subpennies is inevitable.

"ECN officials are facing some difficult choices," he said. Among them, is whether they either remain with Nasdaq or start their own exchanges. But for some ECNs, he noted, starting up an exchange would be "very, very difficult and incredibly expensive."