REG NMS Cheat Sheet
Sub-Penny Pricing
Essence of the Rule:
Sub-penny pricing likely is the least controversial segment of the reproposed Reg NMS because it is similar to the original proposal, around which there was a lot of industry consensus. The Sub-Penny Rule would prohibit participants - namely ECNs, exchanges, market makers and alternative trading systems - from displaying, ranking or accepting quotes in NMS stocks that are priced in increments of less than a penny, unless the stock price is less than $1.00.
The rule would address the practice of "stepping ahead" of displayed limit orders - buy or sell orders displayed at a price that is better than the price the market is offering - by trivial amounts. The Sub-Penny Pricing Rule aims to prevent hedge funds and other active traders from gaining execution priority by improving the price of another limit order by an economically insignificant amount. This occurs when hedge funds, active traders and buy- and sell-side participants that use algorithmic trading have sub-penny pricing built into their models. The models can generate orders that step ahead of limit orders priced at a full penny.
Impact
Sell Side:
For sell-side firms, the Sub-Penny Pricing Rule would be a non-event. Brokerages may see some reduction in quote traffic by having one price point per penny instead of 10.
Currently, in U.S. markets, only four equity securities that trade above $1 are traded in sub-pennies: INET allows trading in sub-pennies of shares of Sirius Satellite Radio; JDS Uniphase; the QQQs (the Nasdaq 100 tracking stock) and SMH (the semiconductor holder). Some brokers raised the idea that there are specific securities for which the natural pricing increment is less than a penny. For example, the QQQs (ticker symbol:QQQQ) and SMH are derivative securities, whose prices are based on an underlying basket of stocks and are accurately calculated by an algorithm. The other two securities currently traded with sub-penny pricing (JDSU and Sirius) are very actively traded, low-price securities, and many argue that high-volume stocks may justify being trading at smaller price increments.
Buy Side:
Traditional mutual funds and buy-side firms likely are going to be in favor of this proposal because many believe that quoting in sub-pennies is used to jump ahead of their limit orders, rather than for reasons of legitimate price improvement.
ECNs:
Most of the ECNs have drastically modified their sub-penny pricing proposals in reaction to the original Reg NMS proposal. In the summer of 2003, Brut and INET made a number of modifications to their sub-penny pricing to restrict it to lower-priced securities, somewhere between $5 and $10. On Jan. 3, Brut changed its policy to match the guidelines proposed in Reg NMS. Brut and INET will continue to allow sub-penny pricing for any security priced below $1.
If the Sub-Penny Pricing Rule passes, INET simply would need to make a minor code change to eliminate sub-penny pricing for those four securities priced above $1.
Exchanges:
This is a win-win for exchanges: It relieves them of the development effort to accommodate sub-penny pricing.
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