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October 14, 2009

OTC Dealers Brace for ECN Fee Fight

By Peter Chapman

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Over-the-counter market makers are girding for another fight over ECN access fees.

The Financial Industry Regulatory Authority has reintroduced a proposal to allow alternative trading systems and ECNs to charge access fees without incorporating them in their quotes. And this has OTC dealers hopping mad because they believe it puts them at a competitive disadvantage with ECNs.

Under the proposed changes, FINRA would eliminate the requirement that ECNs and ATSs display their fees in their quotes, but such a rule would place limits on the size of those fees. The change to FINRA Rule 6540, if approved by the Securities and Exchange Commission, would benefit ArcaEdge, operated by a unit of NYSE Euronext, and the only ECN-like facility in the OTC market. The rule change is specifically aimed at the OTC Bulletin Board marketplace and not the Pink Sheets. Both make up what is known as the OTC market.

"We are in favor of anything that improves market transparency; however, removing access fees from displayed ECN quotes is a step backwards," Knight Capital Group chief compliance officer Mike Corrao told Traders Magazine. Knight is the largest market maker of OTC securities.

Dealers are opposed to allowing ECNs to forgo access fees in their quotes for a variety of reasons. First, they contend the move would put them at a competitive disadvantage vis-à-vis ECNs because the full price of a given security would not be reflected in the ECN's quote.

Under the proposal, the ECN could quote at the same price as the market maker, even though the final price would be inferior by the amount of the access fee. Today, by contrast, traders quoting on ArcaEdge must take into account the ECN's fee when pricing their orders in competition with dealer quotes.

"You shouldn't discover a hidden fee after you take or hit a market," Corrao said. "People should see the true cost of the shares in the public quotation."

Dealers also oppose the change to Rule 6540 because it would mean dealers, as the primary takers of liquidity from ArcaEdge, would receive a bill every month. They would have to pay that bill; whether they would seek reimbursement from their customers is an open question. Today, they simply pass the ECN fee on to their customers as part of the net cost of the security.

If market makers did pass the fees on to their customers, those customers would never again be sure of the price they were likely to get when placing an order, said Nick DeMaria, managing director of equities trading at discount brokerage StockCross Financial Services. "How will they be able to differentiate? The inside market is not necessarily going to tell them."

Another possible outcome, market makers say, is that if dealers start getting billed for their ECN trades, they might start billing others for trades done against their quotes. "If Arca can quote a stock and then bill, then every dealer is going to do the same thing," DeMaria said. "In the dealer community, it will be a zero-sum game."