Changes to OTC Market Coming
Traders Magazine, October 2012
Tighter spreads, but less liquidity. That may be the outcome of a rule change by the Financial Industry Regulatory Authority affecting the over-the-counter market. The changes to FINRA's Rule 6433 promote competition between limit-order traders and market makers by loosening the requirements for quoting. As a result, spreads could tighten and quoted size could decline.
The rule was approved by the Securities and Exchange Commission in June and will go into effect on a one-year pilot basis starting Nov. 5.
"We predict a reduction in displayed liquidity," said Cromwell Coulson, president and chief executive of OTC Markets Group, which operates the quotation infrastructure for the over-the-counter marketplace. "But we'll see."
The changes to Rule 6433 reduce the number of shares traders must put up when they quote OTC names. Under current rules, for example, market makers must post at least 2,500 shares when quoting stocks that trade between 51 cents and $1. Under the changes, they need only post 1,000 shares.
While the minimum quote size in the market for listed securities is 100 shares, it varies for OTC names. That's because the majority trade for less than $1. As the price of the security declines, the minimum quote size increases. The object is to keep the dollar value of the quote relatively constant. Currently, the market operates with nine quote tiers. The rule changes reduce that to six tiers.
The changes to Rule 6433 make it cheaper to quote, an advantage for individual investors and market makers. Currently, the rule applies only to market makers, but is being expanded to include limit-order traders. In the OTC market, these are typically retail investors.
That makes one brokerage executive happy. "We applaud FINRA and the SEC's recent rule changes and reforms," said Barry Scadden, a vice president with Arca Edge, a unit of NYSE Euronext and an ECN that operates in the over-the-counter market.
"By simplifying the existing tier structure and lowering the minimum quotation tier size requirement for thousands of OTC Equity Securities, we believe this rule will enhance transparency while affording individual investors the ability to have more of their limit orders displayed," Scadden said.
In an environment overwhelmingly dominated by market makers, Arca Edge has made strong gains in market share in recent years. On a recent day, the ECN was the single largest trader as ranked by dollar value, and the third largest as ranked by number of trades. Otherwise, trading is controlled by such registered market makers as Knight Capital Group, E*Trade and Citi/ATD.
Arca Edge has made its mark in the over-the-counter market's higher-priced stocks, according to data from OTC Markets' Web site, precisely the group of securities most impacted by FINRA's new rule.
A study conducted by FINRA, and later corroborated by the SEC, showed that a large chunk of limit orders left with brokers for stocks trading between 51 cents and $1 were not being posted. If the rule changes had been in effect during the period of FINRA's analysis, the regulator predicted the share of posted limit orders for these securities would've surged from 47.5 to 73.8 percent.
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