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September 12, 2006

Trading Execs Worry About Quote Shredding

By Gregory Bresiger

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  • Trading Execs Worry About Quote Shredding
  • Page 2

The Reg NMS market data revenue reforms, scheduled to go into effect in April, could provide an unintended boon for big rebate arbitrage players, according to trading executives.

They say some players are preparing to exploit the new market data calculation section of Reg NMS by designing advanced quote technology that will use flickering quotes to earn extra revenues.

This quote shredding-jumping in and out of a quote before there is a hit-could become a problem next year, said trading executives.

Traders will pretend to trade, post quotes, then shred the quote after a second just to generate market data fees, according to the trading executives. "It's a complicated rule with all sorts of unintended consequences," said one trading official, who declined to be quoted by name. "It's a competitive market and people are going to find any opportunities that they can," he added.

"It's using market data to incentivize market behavior. That's not really what Reg NMS intended to do, but that is what we have now," said another trading executive.

Exchanges earn market data revenues by selling their quote and trade data to distributors such as Bloomberg and Reuters or large trading organizations. The fees they receive are designed to fund their regulatory operations.

But they also may be used to rebate big traders. That is the source of the problem.

The Reg NMS changes to the market data revenue picture, due to go into effect over the next year in various phases, were partly an attempt to prevent market data manipulation. They change the market data revenue distribution formula. Previously, that formula had been based exclusively on trade counts. The new formula will call for 50 percent trade counts and 50 percent quotes. The reform was adopted because previously there was an excessive emphasis on the number of trades in making fee allocations, according to Reg NMS.

This, according to the SEC, led to "distortive trading practices" such as wash sales, trade shredding and print facilities. They resulted in inequities such as an excessive allocation of revenues for a small trading volume.

A quote, according to the new rule, is defined as establishing a new inside market and holding it for one second in order to earn a credit.

"One full second," the SEC wrote in Reg NMS, "is designed to assure that only quotations that are readily accessible can earn Quote Credits."

But trading executives questioned if this change will work out as planned. One second allows someone to have a claim on the quote portion of the pool, even though the participant never completes the trade, they warn. Regulators have held that requiring someone to hold a quote for a second will prevent gaming because the quote can be hit. But some trading executives warn that it will not work out that way.

"In stocks with a wide spread, you can establish the quote for a second, going in and out, and I don't think you'd have a high probability of being hit," according to a trading executive.