Richard Repetto
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Why Do Exchanges Own Multiple Licenses? It's Not Hard To See, Look at the SEC

In this recent research note, Sandler O'Neill + Partners, L.P. Principal Richard Repetto examines why the public exchange operators hold multiple licenses and that rationale behind this phenomenon.

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March 18, 2010

How Low Can You Go?

Ticks may tick downward for low-priced stocks

By James Ramage

A Securities and Exchange Commission idea to bring more trading to the displayed markets goes too far for some trading officials and not far enough for others. To draw more quotes and better price discovery to the displayed markets, the regulator broached the idea of trading in increments of less than a penny for lower-priced National Market System stocks. The topic came to light in the SEC's recent concept release on the structure of the equities markets, a document meant to open up discussion about the state of the market.

This sub-penny quoting idea would mean using increments of half-a-cent, a tenth-of-a-cent or less on stocks that trade between $0 and $5 or $0 and $10. Dark pools, which have been capturing a growing percentage of business in high-volume, low-priced stocks, already trade in lower increments, industry pros said.

Exchanges and some kinds of high-frequency traders like the idea, as it would likely improve business. Long-onlys on the buyside are opposed. They say quoting lower than a penny would make their jobs harder.

This isn't the first time the sub-penny quoting idea made headlines across the industry. In 2003, Nasdaq filed with the SEC for permission to conduct sub-penny trading. At the time, ECNs such as Island, Instinet and Brut, among others, could trade sub-penny. The SEC rejected the request.

Supporters of sub-penny quoting say it would encourage market makers to quote these stocks on displayed markets. This would bring more flow to public markets, thereby improving the quality of the market.

For certain very active securities, trading in sub-pennies make sense, said Cameron Smith, general counsel at Quantlab, a Houston-based quantitative trading shop that uses high-frequency-trading strategies. With these names, traders see tremendous liquidity in the displayed markets on both the bid and the ask. There's too much size and too many orders crowding at one increment, he said, which forces everyone there to wait for an execution. Dark pools have provided an answer.

"For a market maker who's internalizing, or somebody in a dark pool, it's very easy for them to match the price in, say, Citi when it's too wide," Smith said. "But if it was trading efficiently down to a sub-penny, and that was the price they needed to match, it would be much more difficult, and therefore a lot more of the volume would be done at the exchanges, and customers would get a lot better prices."

The problem, as the SEC sees it, is that too much trading done off-board leaves too little quote competition in the displayed markets to produce the "true" price. The SEC champions price discovery and limit order display above everything. If everyone is hiding in the dark, the thinking goes, then there isn't enough competition to generate the highest bid or lowest offer.

According to a mid-January research note from Macquarie, the minimum increment rule creates spreads on displayed markets that are "artificially wide." Consequently, market makers and other liquidity providers are able to make money by capturing the spread by matching--or only slightly improving upon-those quotes.