Proposals by two of the exchanges operated by NYSE Euronext mark the second time in the past two years the exchange operator has looked to sub-penny pricing to gain an advantage over brokers in the trading of retail orders.
The New York Stock Exchange and NYSE Amex have asked the Securities and Exchange Commission for approval to allow a special group of "Retail Liquidity Providers" to quote between a stock’s best bid and offer in increments of one-tenths of a cent. The quotes would be hidden from view and only accessible by providers of retail order flow.
The intent is to provide the retail customer with better pricing than is visible on exchange books, a service now provided by wholesalers and other brokers that internalize their orders.
Under the plan, the exchanges would pay order senders and charge the liquidity providers. Only bona fide retail order senders would qualify for the service. The RLPs will come from the ranks of the exchanges’ Designated Market Makers and Supplemental Liquidity Providers.
Still, under the SEC’s Regulation NMS, exchanges are barred from quoting in sub-pennies. NYSE and NYSE Amex are seeking exemptions to the rule, which does not apply to broker-dealers.
Much retail flow is internalized by broker-dealers. The proposal by NYSE marks its second attempt to win approval from the SEC to quote in sub-pennies as a way to compete with internalizers. Last year, NYSE and two other exchanges wrote a joint letter to the SEC requesting the ability to trade in sub-pennies in certain low-priced stocks. The SEC did not approve the request.
There has been some debate over the use of sub-pennies in recent years as spreads in many stocks have narrowed to a penny. Some trading officials contend that a penny increment may be too high for some securities.
"What is the natural tick increment at which stocks should trade?" Joe Mecane, an NYSE Euronext executive vice president, asked rhetorically at October’s Security Traders Association’s annual conference. "This has been subject to debate since the SEC released its Concept Release."
The NYSE proposal calls for using hidden, not displayed, quotes. That contrasts with the proposal in the letter sent by NYSE, Nasdaq OMX, and BATS Global Markets last year to the SEC that called for using displayed quotes.
"Why not do this in displayed fashion and put them on the SIP feeds?" Chris Isaacson, BATS’ chief operating officer, asked at the conference.
Besides the issue of transparency, the proposal is likely to impact the ongoing debate over a trade-at rule. The SEC is mulling a rule that would push wholesalers and other internalizers to offer more price improvement to their customers. The brokers have complained such a rule would kill their business.
The SEC is worried that not enough flow is making it out of brokerages’ trading departments and to the public markets. Giving exchanges the right to trade in between the spread could take the pressure off of the wholesalers.
That would "certainly move the trade-at discussion in a different direction," Mecane said.
Chris Nagy, a managing director at TD Ameritrade, contends the proposal, if approved, could diffuse the trade-at issue.
"It won’t be the demise of internalization," Nagy told Traders Magazine. "But it’s a very elegant solution for trade-at."
Nagy contends the likely customers for the proposed service will come from the ranks of the wholesalers or internalizers, not firms like his. The exec is wary of the program as his mandate is to win price improvement for 80 percent of TD Ameritrade’s orders. "If I send in 100 orders, how many will get price improvement?"
Still, one wholesaler found the proposal objectionable. Jeff Martin, president of ATD/Citi, found fault with the idea of letting a market maker’s hidden order take precedence over a displayed quote.
"That means I no longer have to enforce Manning either," Martin said at STA. "[NYSE] has a resting order and allows someone to step inside for less than a penny."
Under the so-called Manning Rule, market makers like ATD can only trade ahead of their customers if the price they trade at is inferior to that a customer might receive by at least a penny.
The NYSE proposal would let the exchange dealers trade at sub-pennies. That’s why the proposal needs an exemption to Reg NMS Rule 612, Mecane said.
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