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Reg NMS Hearing: Buy Side is Divided over Opt-Out

Buy-side institutions disagreed over the SEC's plans to revamp the trade-through rule. Vanguard rejects the opt-out clause, while Fidelity favors it.

Large buy-side institutions testifying at yesterday's Securities and Exchange Commission hearing on Reg NMS, agree on the necessity for maintaining the trade-through rule but are divided over the opt-out clause.

A major concern for buy-side traders testifying at the hearing held in a New York City hotel was that offering an opt-out clause to the trade-through rule could create an environment where customers' limit orders could be ignored.

Gus Sauter, chief investment officer of the Vanguard Group says the trade-through rule does encourage investors to place limit orders. "A trade-through rule is necessary. We think it would be a tremendous disincentive to place limit orders if orders are executed around you," says Sauter.

Currently the trade-through rule protects limit orders in listed stocks because once the limit order becomes the best price, a competing market venue must ship the order to the market displaying the best price.

Under the proposed opt-out clause of Reg NMS, institutions would be allowed to skip the national best bid and offer (NBBO), and tell their broker to access liquidity on an alternative venue at an inferior price.

Once that limit order becomes marketable and becomes the new best price, if someone goes off and trades at an inferior price, then that limit order is left hanging.

John Thain, chief executive officer at the New York Stock Exchange (NYSE), warned commissioners that allowing certain investors to opt-out would undermine investor confidence and reduce liquidity in the marketplace.

Coming to the defense of the small individual investor, Thain says "the trade-through rule ensures that all investors whether minnows or sharks get the best price. Investors who enter limit orders are protected from their orders being ignored," he adds.

But some buy side traders say the current trade-through rule does not protect limit orders on the NYSE, because if another market does route an order to the NYSE, by the time it arrives and there is a delay because of manual intervention, the limit order may not be the best price. These traders argue that while there is price-priority under the current trade-through rule, there is no time priority.

"There is no inter-market time priority," says Ed Nicoll, CEO of Instinet Group. "We are concerned about a few exceptions where one market center may want to trade through another by a few pennies," says Nicoll. "If the real issue here is that the trade-through rule protects the person who places the limit order, then let the competing market venues argue about time priority as well as price priority," he says.

Sauter says "limit orders should be honored and the best way is for market centers to implement price and time priority." But Scott DeSano, head of the equity-trading desk at Fidelity Management and Research Company, says he favors the opt-out provision. "If I have the opportunity to see and capture liquidity at a price which are two cents or four cents away from (the best price), that's a more effective way for completing the transaction," he says. A fiduciary should have the ability to go where we want, how we want and when we went," says DeSano.

Fidelity's head trader says he doesn't see a need for the trade-through rule. "We think it works just fine on Nasdaq," which does not have a trade-through rule, says DeSano.

Pointing out that Nasdaq has operated without a trade-through rule for its entire history, and has a one-cent spread in its top 200 most active stocks, Robert Greifeld, chief executive officer of the Nasdaq Stock Market, urged the Commission to adopt opt-out. (However, under Reg NMS, the trade-through rule would apply to Nasdaq as the SEC attempts to apply uniform rules to all securities markets in the NMS).

Greifeld argues that the best protection for investors is best execution, and then cited the SEC's own definition of best execution as including liquidity, cost, price input and accessibility as important factors in determining best execution.

"Without opt-out provision, best execution is reduced to a single dimension of price," says Greifeld. "I urge the commission not to put the concept of best execution in a straight jacket."

While the buy-side appeared to be split over the opt-out clause, there seemed to be consensus on the SEC proposal to allow automated markets to trade through non-automated markets' quotes.

Thomas Peterffy, CEO of Interactive Brokers Group, says automatically executable quotes should be protected by the trade-through rule and manual quotes should not.

"Really this debate comes down to fast markets vs. slow markets," says Bernard Madoff, chairman of Madoff Investment Securities. While there was debate over how to define a fast market, and whether it should be in milliseconds or micro-seconds or even pico seconds (one billionth of a second), Madoff simplified the issue. "The definition of a fast market is an automatically accessible market. It doesn't have to be under a second. I just want to know that when I see that quote that it will be accessible to me." Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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