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May 10, 2006

Trade Shredding Reform Rule Passed

By Gregory Bresiger

The Securities and Exchange Commission wants to take another step to end trade shredding, the practice of slicing up orders for tape revenue, so it recently approved an NASD rule.

But some trading executives say that any regulatory reform must be carefully applied or proprietary-trading operations could be hurt.

The NASD rule change comes in the wake of the same action at four major exchanges, actions taken at the behest of the SEC, which already have recently filed rules banning trade shedding. The latter is described as the "unbundling" of customer orders for the monetary gain of a brokerage at the expense of best execution standards. An example of the abuse would be cutting up a customer's 1,000-share order into ten 100-share orders in order to generate more revenue.

The SEC, in its new rules, wrote that, "No member or associated person may engage in conduct that has the intent or effect of splitting any order into multiple smaller orders for execution...for the primary purpose of maximizing a monetary or an in-kind amount to be received...."

The NASD, which has been behind the major exchanges on this issue, recently filed its own order entry and execution practices rule change. In it, any money generated by trade shredding would include "credits, commissions, gratuities, payments for or rebates of fees, or any other payments of value to the member of associated person."

Still, Jefferson Wigley, a managing member of Sun Trading, which makes markets in some 600 stocks, said he supported efforts to end most trade shredding. But Wigley contends that regulators should differentiate between customer and proprietary orders.

"We share the concern where members are splitting customer orders into multiple smaller orders solely for the purposing or maximizing payments for the benefit of a member," Wigley wrote in a recent comment letter to the SEC. However, he noted that when a firm is trading for its own account, trade shedding can lead to tighter and more efficient markets. That, he adds, "benefits the public."

A trading executive, who didn't want to be quoted by name, said "any trade shedding reform rule must distinguish how we trade for ourselves and what we do for customers."

Others caution that the SEC, in pushing for the new trade shedding rules, is going over old ground. Trade shredding, they say, was already addressed last year with the passage of Reg NMS. The massive regulation revises the market data trading formulas through reducing the prior emphasis on trading volume.

Still, the SEC, in publishing the final trade shedding order in the March 3 Federal Register, took note of these objections.

Despite Reg NMS, the SEC wrote that "it is appropriate for self-regulatory organizations to take additional steps to address trade shedding and its potentially distortive effects."