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March 2, 2012

Short Stopped

FINRA Dealt Setback in OTC Quoting Plan

By Peter Chapman

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The Securities and Exchange Commission has halted plans by the Financial Industry Regulatory Authority to impose a new quoting regime on the over-the-counter market, citing concerns over market quality. In an order made public last month, the SEC instituted proceedings to determine whether to disapprove a FINRA proposal to change the minimum quote-size requirements of the over-the-counter marketplace. Critics of FINRA's proposal, namely two large OTC players, say the lower quote size would negatively impact liquidity and ultimately hurt investors.

The SEC stated the "proposed rule change can benefit from additional consideration and evaluation," and gave FINRA and other "interested persons" another three weeks to submit "data, views and arguments" to support their positions.

In November, FINRA proposed reducing the number of shares needed to quote OTC stocks at most price levels in a bid to make it easier for limit order traders to comply.

The idea was shot down by the largest OTC market maker and the operator of the marketplace's primary quoting system. In letters, officials from Knight Capital Group and OTC Markets Group (formerly known as Pink Sheets) told the SEC the proposal would dramatically reduce liquidity in the over-the-counter market.

"FINRA's data analysis was flawed and simplistic," Cromwell Coulson, president and chief executive of OTC Markets, told Traders Magazine. "That led to questionable conclusions."

FINRA's plan would replace the existing quotation thresholds applicable to market makers with new ones that would apply to both market makers and limit-order traders. The new thresholds would be easier to reach, and likely lead to more limit orders from public customers.

Tiering

OTC market makers must adhere to size minimums when quoting a stock, depending on the price of the stock. For stocks trading for less than $1 per share, dealers must quote in amounts of 2,500 shares or 5,000 shares, depending on the price. For stocks trading from $1 to $100, dealers must quote in lots of 200 or 500 shares, depending on the price. The minimum quantities are intended to ensure there is liquidity in stocks that don't trade very often.

The existing structure has nine tiers. FINRA's proposal would cut the number to six. Most of the proposed tiers would require traders-both market makers and agency brokers-to post significantly fewer shares when quoting. The single exception is for stocks trading under 2 cents per share. Under the FINRA proposal, the threshold would rise from 5,000 to 10,000 shares for those securities.

Approximately 4,700 securities trade for less than 2 cents in the OTC market, according to data on OTC Markets' Web site. Another 5,450 securities trade at prices above 2 cents. About 2,800 of those trade for more than $1.

For FINRA, the proposed rule change is an attempt to strengthen a new rule that went into effect in the OTC market last year that requires market makers to post customer limit orders. This limit-order display rule has applied to exchange-listed securities for many years, but was only extended to the over-the-counter market last year.

Under the limit-order display rule, dealers don't have to post customer limit orders that fall below the tier sizes. So many don't get displayed. FINRA estimated that only half of all limit orders received by dealers are displayed. The regulator contends that figure would jump to 90 percent if the SEC approved its proposal.