Price improvement, the term used to signify the execution of a stock trade for a better price than the publicly available best bid and offer is a regulatory delusion. Price improvement doesn't, in fact, improve the prices received by retail investors for stock. It only takes account of the gross trade price without an adjustment for commissions, processing costs, immediacy, size, liquidity, certainty of liquidity services and other factors.
As a measure of the quality of order execution, the price improvement ratios of individual firms and markets can often be misleading. Unfortunately, the push for price improvement causes competition to be guided by these same price-improvement ratios, rather than by more objective customer quality execution factors. These factors link the so-called NBBO – the National Best Bid or Offer – with immediacy, limit order display and automatic order processing.
Price improvement, therefore, should instead focus on the net price received by customers, after adjustment is made for all of the non-price factors.
Lately, the Securities and Exchange Commission has focused its attention again on price improvement – or best execution, as it is sometimes called – for retail orders. Price improvement typically means mid-point pricing between the NBBO, although prices can even be "improved" by penny increments.
Whatever the supposed investor gains, price improvement regulation is controversial. Competition among markets for order flow is so intense, that regulation turns it into an effort to eliminate rational choice among competitors. The bottom line: Competitive forces strike a better balance and price level when all price and non-price factors are allowed to compete for small investor order flow, without regulatory intervention. Let me explain.
Price improvement regulation is, in effect, used as a competitive "hammer" to cause the routing of small investor orders to markets that produce higher price improvement ratios.
Critics of regulation argue that, because of its negative impact on order-execution costs, the anticipated benefit for small orders, as a result of price improvement efforts mandated by regulators, actually turns out to be negative. The regulation causes market order handling and liquidity costs to be shifted from unexposed buy and sell order flow to the small investor order flow subjected to mandatory price improvement. That small investor order flow is forced to be re-routed from competitive channels to accommodate unexposed buy and sell orders.
Unexposed orders are those listed and Nasdaq institutional block trades that are not publicly disseminated, unlike other trades that must be exposed widely, as required under the order handling rules.
Several years ago, two New York Stock Exchange-sponsored academic studies reported that the Big Board had higher price improvement ratios than competing markets. The studies implied that best execution was not being obtained unless orders were routed to the NYSE. However, a later academic study of NYSE limit orders, not sponsored by the NYSE, showed that about 50 percent of the limit orders sent to the NYSE – which would have improved the NBBO prices – were not being reflected in the NYSE quotation. This had the effect of artificially widening the NBBO spread while increasing the price improvement ratios. In other words, despite the reportedly high price improvement ratios, this last study revealed that claims of price improvement at the Big Board were not accurate.
Similarly, in the decade 1989-1998, fixed-minimum quotation sizes prevented market makers from reflecting customer limit orders in their quotations. This caused wider than normal bid and ask spreads and it encouraged market makers to use private networks, such as Instinet, to improve prices over the wide NBBO bid and offer spreads. Of course, price improvement rates rose to 25 to 30 percent of trade volume, as the transparency of the NBBO deteriorated. Fortunately, that SEC experiment in "size improvement" was finally abandoned in mid-1998.
Price improvement regulation has the unintended effect of unfairly favoring unexposed buying and selling interests.
For one thing, it enables this order flow to avoid the NBBO, thus minimizing search and order display costs. The order handling rules give unexposed orders a chance to execute against displayed prices. For another thing, price improvement regulation maximizes the opportunity for unexposed orders to capture the liquidity represented by the many dispersed flows of small investor market orders. The result, ironically, is price improvement for the unexposed orders. Illiquidity costs associated with large order executions are minimized. Therefore, unexposed orders benefit at the expense of retail orders.
Given the valuable chance to execute against market order flow, unexposed buyers and sellers will take it. They will achieve price improvement on all orders for themselves and for the portion of the incoming orders that are matched against theirs. In the process, avoiding the NBBO is achieved, thus reducing market transparency. This hurts the pricing efficiency for all users of the NBBO, including the market orders that were price improved. Taking away the chance to interact and execute against market order flow, an unexposed buyer or seller might have to publish a quote or execute against published quotes and pay a spread.
Consider what healthy competition currently does for retail-size order flow. Market makers, seeking to capture efficiencies on retail-size order flow with automated execution systems, commonly provide NBBO price and size liquidity guarantees of up to 3,000 shares for client order flow. In addition to processing efficiencies, aggregations of small orders have a liquidity value, an information value, a market data value and possibly other values that make such aggregations desirable. Those who compete for small investor order flow capture these values. Thus, competition ultimately benefits small investors with lower commissions and better services.
Regrettably, the SEC appears to be making the same mistake with price improvement regulation as it did with quotation-size regulation. Small investors should not be forced to pay higher commissions, tolerate delays in executions, nor have the economics of their order routing manipulated by naive interpretations of best execution obligations. Only competitive forces can reduce order execution costs to the best net price for customers.
It is one thing when retail investors use brokerages that advertise price improvement and executions on 3,000-share size trades on all stocks, in up to three seconds. It is quite another thing for regulators to eradicate competitive forces and unwittingly require that all order flow be directed to systems that contain the most unexposed customer orders. Regulators should let competition work out which participants incur the costs of spanning the gap in the NBBO.
