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May 10, 2006

Debating Hybrid's Automated Price Improvement

By Peter Chapman

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  • Debating Hybrid's Automated Price Improvement

Is clean-up pricing workable under hybrid? The New York Stock Exchange believes it has incorporated a design feature into its hybrid market proposal that will encourage limit order traders to come out of the woodwork. Those hardy souls who risk their necks and post orders on the book may get filled at prices even better than expected, according to the Big Board.

That could happen if an incoming sweep order trades against a series of limit orders posted at a range of prices. Those limit orders posted at the top of the book will fill at the market's best price. But those orders posted away from the inside may fill at the so-called "clean-up price," or the last price in the range necessary to completely fill the incoming sweep order. A limit order to buy at $25.40, for example, when the best bid is $25.50 might, in theory, fill at $25.30 if an incoming sell order sweeps down to $25.30.

At this year's TradeTech confab, two traders tackled the pros and cons of the clean-up price. John Wheeler, American Century, and Dan Mathisson, Credit Suisse, offer their views.

John Wheeler, American Century

We've always taken the exchange's price improvement mechanism with a grain of salt because it was always price improvement for the intermediaries, for the specialist, for the orders that come into the exchange. It was not necessarily price improvement for the people who are taking the risk of displaying those limit orders on the floor. We've been making that argument for 15 years. Hybrid finally acknowledges that. It gives us a structure whereby we're rewarded for posting limit orders in the book. (We would of course like to have electronic reserve access, but that they are denying us.) But if you are [on the book as a seller] with 7-cent, 8-cent, 9-cent orders [when the best offer is higher] and someone comes in and is willing to pay a dime, you will roll up to that higher price versus walking the book now. There is a big debate as to how much of this activity there will be, but there will be some willingness on the buyside to display or even hide in reserve limit orders on the NYSE book. Because, for the first time ever, as the aggressors come into the marketplace, we will be rewarded versus being compromised.

Dan Mathisson, Credit Suisse