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Elaine Wah

Modern Markets, Modern Metrics - A Blog By IEX

In this blog by IEX's Elaine Wah, the newest public exchange looks to refute public claims that the metrics it uses are designed to inflate its own volume numbers and mislead people.

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August 9, 2006

New Rules Cause Dealers to Drop Stocks Under a Dollar

By Gregory Bresiger

Dealers in National Market System stocks, owing to rule changes brought about by Reg NMS, are dropping names trading for less than one dollar.

Behind the moves, traders say, are locked and crossed markets brought on by ECN pricing practices.

"I am clearly seeing problems with some of these ECNs locking and over locking," Steven Winkler, co-head of trading at Hudson Securities, said. "Sometimes they're even locking themselves."

Dealers mentioned a few small-cap stocks in which the locked or crossed markets are most commonly occurring. These include Atari (ATAR) and PRG-Shultz (PRGX), dealers said.

Winkler says Hudson is not dropping any stocks, but other dealers concede they are. "We've dropped a lot of these stocks because of the locked markets," Larry Leibowitz, UBS' equities' chief operating officer, said at a recent industry gathering. "It is another one of those law of unintended consequences. Sub-pennies go in without the prohibition against locked and crossed markets and people lock the market."

At issue is the sub-penny rule component of Reg NMS. Under the rule, traders are prohibited from quoting NMS stocks in increments less than a penny if the stock is trading for more than one dollar.

For those NMS issues trading for less than one dollar however, the ruling allows traders to quote in increments as fine as $0.0001 per share.

Problems arise, market makers say, as a result of ECN rebate policies. Traders using ECNs are typically paid about $0.0025. Critics say they are posting orders that intentionally lock or cross other quotes in the broader marketplace knowing they will not be required to trade. They simply pocket the rebate.

The sub-penny rule was aimed at stopping the practice of stepping ahead of displayed limit orders by small amounts. It encourages "the depth and liquidity of trading in NMS stocks," the SEC wrote in the final Reg NMS. But dealers contend that the rule is leading to some gaming as fees exceed spreads.

"It may not seem like point three cents or so is a very small amount, but on a 50 million share trade it can be huge," the head of one desk, who requested anonymity, told Traders Magazine about the rebates, He conceded that his firm had jettisoned some penny stock trading because of "gaming concerns."

Hudson's Winkler argues the ECNs have found "a weakness in the Reg NMS rule that they can take advantage of." Nick Ponzio, an executive with market maker Hill Thompson Magid, added his firm would drop these stocks "only as a last resort.."

Reg NMS's order protection rule does contain a prohibition on locked or crossed markets, but the new rule won't be effective until May 2007.

Nasdaq, some dealers noted, corrected some of the problem by changing the pricing model in these stocks to basis points. Still, points out Tom Richardson, a managing director in equities at Citigroup, "The number of market makers in stocks under $1 has certainly declined."

About 120 NMS stocks trade for less than one dollar. About half are Nasdaq and half are American Stock Exchange listed issues. None are New York Stock Exchange issues.