The Securities and Exchange Commission on Tuesday approved controversial proposals by exchanges operated by NYSE Euronext that will enable them to compete with wholesalers for retail order flow. The exchanges plan to launch the so-called “Retail Liquidity Programs” on August 1.
The programs aim to confer better pricing on retail orders than is available at the national best bid or offer. In a statement, Joe Mecane, an NYSE Euronext executive vice president, said: “Providing price improvement for retail orders within an exchange environment affords individual investors new economic incentives and ensures greater transparency, liquidity and competition throughout the U.S. cash equities marketplace.”
In granting its approval, the SEC exempted the exchanges from Regulation NMS’ sub-penny rule and agreed not to pursue the exchanges for violations of its bedrock Quote Rule.
The regulator defended its decision by noting that the programs operate no differently than programs run by the major wholesalers. In recent years, the SEC has expressed concern that too much retail flow was not reaching the public markets; rather it was being intercepted by wholesalers.
The SEC noted the programs would be run as one-year pilots.
The New York Stock Exchange and NYSE MKT (formerly NYSE Amex) first proposed their programs last October. The proposals drew opposition from both the buyside and sellside for a variety of reasons, but mainly because they would violate Rule 612 of Regulation NMS, or the sub-penny quoting rule.
Under the exchange’s programs, market makers will be allowed to post hidden quotes in sub-penny increments that may only be traded against by qualified retail brokers. The plans’ detractors noted this was a violation of the SEC’s ban on sub-penny quotes, which the regulator has noted could discourage traders from posting limit orders.
The NYSE Euronext exchanges requested exemptions from the rule and the SEC granted them. In doing so, the SEC noted that limit order traders were unlikely to be harmed by the hidden sub-penny quotes because they were specifically earmarked for retail orders. The SEC argued that limit order traders were unlikely to interact with retail flow anyway as very little reaches the public markets.
Also problematic with the proposal was the New York’s method of alerting holders of retail orders to the availability of those sub-penny trades. The exchange plans to send out semi-blind messages called “retail liquidity identifiers,” or liquidity flags, to participants. The messages divulge symbol and side, but not size or price.
The flags are similar to so-called “actionable indications of interest,” which brokers have sent to their dark pool participants over the years. Actionable IOIs came under SEC scrutiny a few years ago because they seemed too much like quotes to the regulator.
Because they function like quotes, the SEC argued, the flags are subject to the regulator’s Quote Rule. That means they must be published in the consolidated quote stream for all to see. They cannot be shared with a select group of traders.
NYSE argued the RLIs were not quotes. But if the SEC insisted they were, the NYSE said, then the NYSE should receive “no-action relief” from the Quote Rule, as its program is beneficial to retail investors. In approving the RLPs, the SEC agreed to provide the no-action relief, saying the flags “would increase the amount of pricing information available to the marketplace.”
Industry and regulatory pressure earlier forced the NYSE exchanges to make one significant change to their proposals. In February, they narrowed the definition of the retail orders they would accept under the program. Despite a plan to market the program to wholesalers, the NYSE now will no longer accept their layoff, or principal, trades. Now, under the program, it will only take retail orders handled on an agency basis.
In May, Nasdaq OMX announced it would propose a similar program, called a “Retail Investor Auction.” Under the scheme, Nasdaq’s flagship exchange would offer price improvement on retail orders by pitting market makers against each other in special auctions.
Both of the major exchange operators have complained for the past few years that prime retail order flow was being intercepted by wholesalers before reaching the public markets. The regulators did nothing to curtail the practice, so now the exchanges are hoping their actions speak louder than their words.
Their plans pit them squarely against the big wholesalers, which dominate the retail business. The exchange operators’ plans also arrive during lean times for wholesalers. Volume is down as the American public avoids the stock market.
In letters to the SEC, brokers and their representatives criticized the NYSE proposal and recommended the regulator not rush into a decision. In public, they have said they are ready for any competition from the exchanges, as their services are superior.
For Goldman Sachs, a relatively new entrant to the wholesaling game, it’s all about service. “The service model behind it is incredibly important,” Greg Tusar, head of electronic trading at Goldman Sachs, said at an industry conference earlier this year. “What is missing from the [exchange] model is the desk that is there to help answer questions about order flow. Or the desk that is there to commit capital when necessary. Their service model will cause it to struggle.”
