History
Many factors and opinions come into play when discussing the need for a Trade-at Rule, but most agree it warrants evaluating. Practices such as Payment for Order Flow (POF) are causing Traders, Exchanges and Regulators to review the current market structure and consider implementing a Trade-at Rule, while traders are still fighting for market share.
Payment for Order Flow, the arrangement where a third-party firm will pay brokers to send orders to them instead of to the open market, is a cunning strategy we’re all aware of, although there seems to be complacent acceptance. This payment structure developed over time with the advent of Alternative Trading Systems (ATS) and rapid advancements in computerized trading.
Advancements in Technology Have Changed the Markets
The combination of computerized algorithms and an ATS, or other off-exchange venues, have had great impact on the market and how we trade securities today. Most traders today dream of efficiency in the market and a level playing field. The Stock Exchanges today are not occupied by boisterous traders on the floor shouting orders. It is now an age of computer algorithms scanning the exchanges for available shares, buying and selling securities in milliseconds.
Not only are computerized algorithms constantly conducting trades, many of those trades are now conducted in an ATS that is facilitating orders like an exchange, but employing their own rule set. Often, these off-exchange venues offer price improvement, decreased trading costs for investors, and fast execution. This is where there develops a conflict of interest to the firms processing these orders, which by the way, contain nearly all retail trades. Conflict arises when brokers can either route their order to an off-exchange venue that offers the best price improvement with less costs, or they can send their orders to the venue that gives the best rebates.
With so many choices, there has developed a fragmented market, which now consists of thirteen stock exchanges, several ECNs and over forty dark pools. It’s no wonder people are talking about liquidity, paying for it, and wondering how to keep it flowing in an ethical manner within regulations, or is it time for new regulations? (or are they long overdue?)
The Impact of Technology on the Market
Liquidity
With the introduction of computer algorithms that are getting smarter all the time, combined with the liquidity in dark pools, ATSs and ECNs, the markets experienced a dramatic increase in off exchange trading. This automation combined with the option of using an ATS with high speed, low cost and fast execution was the catalyst to High Frequency Trading (HFT). HFT firms had the speed and ability to see orders in process, and snatch them up for themselves, thus making money on stock they know they’ll turn around and sell at a slightly higher price.
Sub-Pennying
This combination along with the decimalization of the markets in 2001, has spurred the predatory practice of sub-pennying which goes hand in hand with HFT, and is a regular occurrence today. Sub-pennying occurs when a broker gets in front of a displayed order by 1/100th of a penny, or .0001. This is all done inconspicuously with a computer algorithm program. They can tell that an order is pending, so they’ll snatch up shares within a sub penny difference.
Sub-Penny trades happen because POF firms have to justify taking the trade for themselves, so they better the price by .0001. The market is showing $10.00 x $10.01, so when an order comes to the POF firm to sell at $10.00, they fill it themselves at $10.0001, letting them claim they improved the price for the customer. In reality, there is probably a bid in a dark pool at $10.005, which the POF firm will then sell, making themselves .0049/share in the process. Even if there isn’t anything in the middle for them to immediately get out of the trade, they are long from the bid, which is what all the bidders in the market at $10.00 wish they could be, but never get the chance as the POF firm steps in front of them without ever having to risk putting a bid into the open market.
This leaves the majority of traders experiencing whiplash in a scenario of “now you see it, now you don’t” when attempting to execute their orders.
RegATS, RegNMS and the effect on Markets
Reg ATS in 1999 increased the popularity of ATS venues, as they became allowed to register as a broker dealer, rather than with more stringent regulations of an exchange. This increased volume on ATS venues, thus removing liquidity from the exchanges. The SEC responded to the huge increase of trading in off-exchange venues with Reg NMS in 2005, aimed to streamline and unify the ATS market share by requiring all orders from an ATS to be routed through a national market system, one combined trading network.
Reg NMS also mandated that exchanges route orders to the trading venue with the best displayed price, regardless of where the order originated. The best displayed price did not necessarily have to be on an exchange. These regulations drastically decreased the stronghold that exchanges had over the market, as they lost even more liquidity. For example, prior to Reg NMS the NYSE traded approx. 85% of market share, and after RegNMS the NYSE decreased to about 30%, and was as low as 20% in 2014.
These regulations made ATS and Dark Pools even more attractive, as a loophole in RegATS allows them to trade with hidden prices as long as the volume of stock trades is less than 5% of the national trading volume of stock. This allowed investors to go to dark pools and trade anonymously, in order to avoid alerting the HFT firms of their intentions. Exchanges lost market share again to ATS as more investors chose dark pools to execute orders.
SEC Considers Proposals for a Trade-At Rule
Exchanges & Regulators have suggested various systems to address the increase in volume of off-exchange trading and market liquidity. The proposal is a Tick Size Pilot Program is currently in process and will study and review the effect of widening the tick size by increasing it from one penny ($.01) to five cents ($.05) on certain piloted securities. The program involves three different sub-groups, with different rules in place to study the effect, and one control group. One group of stocks is using a Trade-At rule, in one group the quoting must occur in $.05, while in another group both the quoting and trading must occur in the $.05 increments.
The Tick Size Pilot Program began in October of 2016, and is scheduled to last for two years. Visit FINRA.org for more information on the Tick Size Pilot and to receive email updates of the program.
Two other suggestions have been proposed. The “Grand Bargain” was suggested by ICE, the Intercontinental Exchange, which suggests a trade-at rule combined with reduced access fees. Nasdaq proposed a plan as well, simply with a decrease in fees and no trade-at rule.
Our View on Trade-At
If a trader is willing to display a quote in the public markets, that trader should get executions when orders come in at or through his price. Currently the trader’s public quote acts as a reference price for POF firms and dark pools to trade in front of him. The trader only gets executed once POF firms do not feel there is an edge at that price any longer, meaning the trader that risks the most in displaying a bid or offer is the last to be filled at that price.
That is not a fair system, and de minimis price improvements should not be used to justify the practice.
Most traders competing with this pricing model agree – a Trade-At Rule is necessary.
Headquartered in Chicago, Great Point Capital, LLC, is a member of FINRA and has been serving the trading community since 2001. Our mission is to be the leader in the equity day trading community by giving the best traders the tools and support to make the most of their trading careers. Contact Great Point Capital, LLC today, in either our Chicago Office, or our Austin Office, to learn more about how we can successfully trade together with high performance results.