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October 1, 2012

Changes to OTC Market Coming

By Peter Chapman

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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.

For all price tiers, the increase is expected to be less dramatic. If the rule changes had been in effect during the period of analysis, the share of total posted limit orders would have grown from 85 to 96 percent.

Limit orders have only become a mandatory part of the over-the-counter market since last year. Then, FINRA Rule 6460, modeled on similar rules covering listed securities, forced dealers to display their customers' limit orders. The intent was to put customers on a par with dealers and to reduce spreads. The changes to Rule 6433, in turn, are intended to make it easier for limit order traders to display their quotes.

While many-including the SEC-applaud the leg up the rule changes give to limit order traders, others fret that displayed liquidity will shrink. Coulson, for instance, predicts more than half of the 10,000 securities quoted on his platform will see a reduction in posted size.

Indeed, the SEC rejected FINRA's first proposal, after complaints by OTC Markets and Knight. FINRA was forced to revise its proposal, effectively targeting a smaller swath of securities. The regulator worked with Knight in revising its proposal, and Knight eventually told the SEC it was satisfied with the changes.

The original proposal would've cut minimum quote sizes for stocks trading for 2 cents and above. That's about 6,000 of the total 10,000 securities traded on OTC Markets' systems. The revised proposal affects stocks trading for 20 cents and above. That's about 4,200 securities, according to data from OTC Markets.

Despite FINRA's eagerness to promote the interests of limit-order traders, it acknowledged the dangers of reduced liquidity. That's why it chose to make the changes on a one-year pilot basis. If the regulator deems the changes have harmed the OTC market, it would "consider rescinding the pilot," it stated in its proposal.

For Coulson, the pilot is a tonic. "Instead of being a permanent rule change, it's a pilot," he said.


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