NYSE's Sub-Penny Quandary
Traders Magazine, January 2012
An NYSE Euronext proposal to permit its members to quote in sub-pennies is proving highly controversial.
The exchange operator's "Retail Liquidity Program" would create dark pools at the New York Stock Exchange and NYSE Amex, where members could vie for retail order flow with quotes only a tenth of a cent better than the market's best displayed prices.
If approved, the scheme could upend one of the four planks of Regulation NMS-the prohibition against sub-penny pricing-and possibly change trading behavior dramatically.
NYSE submitted the proposal to the Securities and Exchange Commission in October. The regulator put it out for public comment in November. The comment period ended in December, but many of the respondents requested the industry be given more time to digest the plan.
"This is a pretty flashy proposal," Joe Wald, an executive with Knight Capital Group, said at a recent industry conference. "There are several elements that need considerable time to comment on."
Knight is no bystander here. If the NYSE wins SEC approval for its proposal, the big trading house could find itself in competition with the exchange as well as a highly sought-after customer. Knight's general counsel Len Amoruso has already had one meeting with the SEC's Division of Trading and Markets over the proposal; the sit-down included division head Robert Cook and eight staffers.
Others in the industry are also asking for more time to absorb the plan. The Securities Industry and Financial Markets Association, an industry group representing the largest brokerages, told the SEC the NYSE proposal raised "significant market structure implications that require additional time to be considered."
Hudson River Trading, a large market-making firm and NYSE member that would be eligible to quote in the new pools, contends the proposal "raises significant issues regarding competition among exchanges, ATSs and over-the-counter internalizers." The issues are too broad to be addressed in a proposal by a single exchange operator, HRT managing director Suhas Daftuar told the SEC in a letter, and ought to be addressed with "comprehensive rule-making."
Most of the debate revolves around sub-pennies. Currently, traders are not allowed to quote in sub-pennies, but they may trade in sub-pennies if it leads to better prices for customers. This exception has benefitted brokers over exchanges, permitting wholesalers such as Knight to win order flow from retail brokers. Wholesalers will "price-improve" retail orders by fractions of a cent over the market's best bids and offers.
With its proposal, NYSE hopes to level the playing field, acquiring the same price-improvement powers as the wholesalers. "It's our way of fitting into the ecosystem," senior NYSE Euronext executive Joe Mecane said in December at the Investment Company Institute's Equity Markets Conference.
Partly driving the proposal, he said, are complaints by NYSE market makers that the quality of flow reaching the exchanges is increasingly toxic. Thus they are moving their operations "upstream" into ATSs to interact with higher-quality retail and institutional flow. On the exchanges themselves, more often than not, they find themselves trading against other professionals. And that can be a money-losing proposition. "It is simply not profitable for people to trade in the public markets," Mecane said.
On the surface, the NYSE proposal appears to be a swipe at the wholesalers such as Knight. In reality, sources tell Traders Magazine, any retail flow captured by the program would likely come from the wholesalers themselves. Not every order that arrives at the wholesaler's front door is internalized, or traded against. A sizable amount is routed out to other broker-dealers. It is this "exhaust" that the NYSE is eager to capture.
"We want to make the program friendly to retail firms, but more importantly, to firms like [Knight] that handle orders on behalf of retail brokers," Mecane said at ICI.
Whatever its intentions, NYSE must overcome the sub-penny hurdle. In 2004, during the debate over Reg NMS, the idea of quoting in sub-pennies was shot down by much of the industry. It was considered detrimental to the marketplace, primarily because it would put limit-order traders at a disadvantage. If a trader knew he could be beaten to an order by a tenth of a cent, he would be reluctant to post a quote.
During the debate, all of the major brokerages lined up against sub-penny pricing, making the SEC's task easy. It approved Reg NMS Rule 612, which requires all quotes or indications of interest to be in 1-cent increments.
In tandem with its proposal, NYSE asked the SEC for an exemption to Rule 612, arguing the proposal did not subvert the goals of Rule 612 as quotes would not be displayed, just ranked. In a letter to the SEC, competitor BATS Global Markets disagreed, stating Rule 612 is most concerned with the size of the quote.
This time around, the industry has not bashed the proposal, but has labeled it "problematic." If the NYSE gets its way and is permitted to compete for retail orders with sub-penny quotes, the practice will spread and become standard for all orders, trading officials contend.
A few high-profile trading executives even support the proposal. Nasdaq chief executive Bob Greifeld publicly declared his approval of the program, as did Mike Stewart, UBS's head of global equities. In general, brokerage and exchange executives say they sympathize with the plight of the NYSE and profess support for competition for retail orders.
Others, however, don't like it. "This seems like an incredibly bad idea," Kevin Cronin, global head of equity trading at Invesco, a large money manager, said at the ICI conference. "It will merely benefit the high-frequency guys, because the minimum increment for them to jump in front of our orders will change from a penny-where there is some risk-down to well below a penny-where there is virtually no risk."
Others echo Cronin. Robert Bright, chief executive of a proprietary trading firm bearing his name, told the SEC that "Bright Trading has serious concerns that this proposal will discourage displayed liquidity providers, further compromising the liquidity in our markets."
Given that the ban on sub-penny quoting is a central tenet of Reg NMS, some believe it will be impossible for the SEC to approve the NYSE proposal.
"Frankly, I don't see how the SEC can possibly OK it," Knight chief executive Tom Joyce said in November at Keefe, Bruyette & Woods' annual brokerage and market structure conference. "Fair competition amongst market participants would compel the agency to eventually allow sub-penny trading marketwide. That would represent a wholesale shift in the current regulatory offering."
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