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February 1, 2013

Trading Through

By Tom Steinert-Threlkeld

The mispriced transactions totaled 442,600, from October 2008 through the start of this year. The amount owed customers for the mistakes was $420,360. Less than a buck a trade. On a 200-share trade, that equals less than 3 cents each.


Those are the core numbers of BATS Global Markets' second technical debacle of the last 12 months. This time, chief executive Joe Ratterman said market structure was partly to blame. Markets had become too complex. The cause? Market rules.

Particularly, the trade-through rule, which just so happened to account for all but 3,600 of the price processing mistakes BATS disclosed.

The trade-through rule enacted in 2007 as part of the Securities and Exchange Commission's efforts to upgrade the National Market System requires all markets to execute trades at the best available price at the moment or send the trade through to the market that has the best price.

Apparently, that's easier said than done, when you have 13 national exchanges, from four different operators.

Indeed, Georgetown University's long-time student (and teacher) of capital markets, James J. Angel, gets an 'I Told You So' Award for his June 4, 2004 comment letter to the SEC that warned "the proposed trade through rule will create enormous implementation headaches while providing little real benefit."

The commission, he felt, had not "fully justified the need" the need for the rule. Particularly when a system that met the need for achieving the best price - the best execution mandate - already existed, eight years ago. And now.

"Here's the thing," he said. "The trade through rule sounds great, in theory. Oh, yes, everybody has to get the best price. But, you know what? Brokers already have a duty of best execution to their clients."

Number one, brokers then and now are in the business of working their hardest to get each client the best price. "You don't really need to dump it on the exchanges," he said.

Number two, the trade-through principle is carried out in trading platforms, any way. To get business, the electronic exchanges promise brokers "give us all your order flow and if we don't have the best price, we'll route it out," Angel said.

Which means, practically speaking, the trade-through rule was unnecessary.

But, with all that's on the SEC's plate, and it leadership in transition, you can be sure that rule is here to stay.

Unless customers more closely watch the prices they get.

After all, for more than three years, none of BATS' members noticed. And in that time, 8.9 trillion shares changed hands in consolidated volume of all national exchanges, according to Nasdaq OMX Group statistics. That's roughly 44.3 billion 200-share trades. The BATS errors means 1 out of every 100,000 trades got mispriced.

The other 99,999 need inspection.