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February 1, 2011

NYSE Vents Over Offboard Trading

By Peter Chapman

The percentage of orders reaching the public markets is in decline, and that's vexing NYSE Euronext. In December, the exchange operator fired off a letter to the Securities and Exchange Commission, asking the regulator to take a hard look at the trend.


See Chart: Offboard Shoots Upward


NYSE sent the letter to the SEC primarily to criticize plans by competitor Direct Edge to rework its controversial flash order, but ended it with a plea to review internalization. The company noted that only about two-thirds of all orders were making it to the public markets.

In October 2010, NYSE noted, trades reported to the trade-reporting facility operated by Nasdaq and the Financial Industry Regulatory Authority totaled 32 percent of all shares traded that month. Brokers that internalize, or fill their orders within their four walls, typically report their fills to the Nasdaq TRF.

That figure was up from 25 percent in October 2009 and 14 percent in October 2008. The problem, NYSE stated, was that those orders don't "participate in the price-discovery process."

Critics of internalization argue the practice ensures that stock prices aren't as realistic as they should be. Some say a number of internalized trades approaching 40 percent implies an unhealthy marketplace.

NYSE also noted that much of the flow being "skimmed from the public markets" was "attractive," leaving the exchanges with the dregs. And because these orders tended to be from professionals, they made market making unprofitable, NYSE averred.

NYSE pointed out that according to Rule 605 data, realized spreads are considerably slimmer on the public markets than they are inside the brokerages. (Realized spreads measure the difference between the trade price and the midpoint of the bid-ask spread, and effectively determine dealer profits.)

The NYSE's plea to the SEC isn't falling on deaf ears, sources say, as the SEC is equally concerned. Still, any action by the Commission to address the situation would likely prove difficult. "Chairman Schapiro and SEC staff are very focused on this issue," one D.C. insider told Traders Magazine. The source noted, however, that the SEC faced two hurdles in addressing internalization.

First, the regulator is bogged down with rule-making associated with the Dodd-Frank bill, and must wrap up that work by July. This obligation cuts into the time the SEC has to address the long list of market structure issues on its plate.

Second, it is likely to prove extremely difficult to craft any solution to the "problem." The SEC's concept release, published last year, broached the possibility of a "trade-at" rule, which would considerably circumscribe off-board trading.

The trade-at issue, however, "is very explosive," the source said. "Any rule would dramatically change the nature of the business, even more so than Reg NMS. It would take a huge amount of political will to put something like that on."

Regardless of the hurdles, one industry lawyer believes the Commission will investigate the issue. "There are a number of market structure initiatives that are outstanding," said Howard Kramer, a partner at Schiff Hardin. "It would surprise me if we didn't see some resolution one way or another on some or most of these during the year."


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