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June 30, 2004

The Case for Real Reform

By Larry Leibowitz

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  • The Case for Real Reform

Competition is being held back in the NYSE and Amex-listed securities markets. It can be unleashed by reforming the trade-through rule and the current market data system. The SEC's Reg NMS contains reform proposals. And what has to be reformed? For starters, the trade-through rule, which purportedly protects investors from inferior prices. It has actually insulated the specialist system from competition. The trade-through rule reduces efficiency, because it forces orders to be routed to manual markets for execution. In some cases, it undermines a broker's duty of best execution. Moreover, investors attempting to cancel orders often find themselves in limbo, waiting for an exchange response, and then discovering that their orders have been executed against their wishes.

There is a better alternative: When securities are traded in an automated environment without a trade-through rule - as they are in Nasdaq today - investors obtain greater order protection, faster executions and better prices. But let's backup. Taking a stand against a hard trade-through rule is very different from being in favor of trade throughs. It is a distinction often lost in this discussion. Investors would continue to be protected by the broker dealer's overriding legal obligation to provide best execution. In fact, the 11Ac1-5 quality of execution statistics show that automatic markets, that are free of trade-through restrictions, provide investors with better results: That's right, better prices and faster executions.

The appropriate reform therefore seems obvious. Eliminate the trade-through rule and, like the Nasdaq market, allow competition to flourish. In the absence of outright repeal, the Securities and Exchange Commission should improve the interaction among markets trading listed securities. Then, after appropriate analysis of listed trading data, it should determine whether to fully eliminate the trade-through rule.

Investors should have the choice to ignore slow and inefficient market centers. The SEC should support a fast market/slow market exception to the trade-through rule. An exception would induce markets to implement automatic execution and automatic quote updating. That would benefit investors through the ensuing efficiency. The SEC also should require specific disclosure of trade throughs as part of 11Ac1-5 reporting. That would allow investors to determine the execution quality of their orders. It would also allow regulators to determine if the broker is fulfilling best execution obligations.

Finally, customers should be allowed to decide for themselves what constitutes best execution. The SEC should include an opt-out provision so that investors, rather than one-size-fits-all rules, can determine how best to execute their orders.