SEC May Risk Harming Investors With ‘Trade-At Rule’ for Stocks

SEC-CFTC Report Advises Limit-Up/Limit-Down System
Traders work on the floor of the New York Stock Exchange in New York. Photographer: Jin Lee/Bloomberg

Individual investors could be hurt should regulators alter an equities-trading rule limiting the prices at which brokers can execute orders away from public markets, an executive at TD Ameritrade Holding Corp. said.

An eight-member committee urged the Securities and Exchange Commission in a report yesterday to adopt a restriction called a trade-at rule. It would prevent venues and brokerages from executing orders within their walls unless they improve pricing by a specified amount versus the market’s best level.

The change is designed to limit the amount of trading on private venues, including dark pools, that represent about 30 percent of the market. NYSE Euronext and Nasdaq OMX Group Inc., the biggest operators of U.S. exchanges, argue the transactions impair price discovery, or investors’ ability to determine the best prices based on buying and selling interest. While the rule may shift more orders to public markets, it may also mean retail investors won’t get prices that are as good as what they now receive, TD Ameritrade’s Christopher Nagy said.

“I was disappointed,” Nagy, a managing director for order routing, sales and strategy at the third-largest retail brokerage by client assets, said in an interview. “The report appears to be a politically motivated stalking horse to implement the trade-at rule. A trade-at would serve to increase costs for retail investors by creating an inconsistent trading experience.”

Joseph Stiglitz

The committee, created by the SEC and Commodity Futures Trading Commission after the 20-minute plunge on May 6 erased $862 billion from U.S. shares before prices recovered, gave 14 recommendations for improving regulation. Members include Joseph Stiglitz, an economist who won the Nobel Prize; David Ruder, a former SEC chairman; Brooksley E. Born, who was chairman of the CFTC; and John J. Brennan, chairman emeritus and senior adviser at mutual-fund operator Vanguard Group Inc.

The trade-at rule "might affect the business models of a number of firms," Maureen O’Hara, a committee member and finance professor at Cornell University in Ithaca, New York, said at a meeting in Washington yesterday. "This is not a trivial change."

TD Ameritrade’s retail customers usually get better prices from wholesale brokers, such as Chicago-based Citadel LLC, who trade against the orders within their own walls instead of sending them to the public marketplace, Nagy said. The trade-at rule may provide a disincentive to wholesalers, who may not be able to offer the requisite level of price improvement or pay as much to retail brokers for the orders, he added. The result may lead to investors paying more for executions as brokers seek to cover the lost payments.

Half a Cent

The advisory group suggested that brokers provide price improvement of half a cent per share if they want to internalize, or trade against, a customer’s order.

Citadel, Knight Capital Group Inc. of Jersey City, New Jersey, and other brokers that execute retail orders for securities firms usually improve the prices they provide beyond what’s publicly available, as well as pay retail brokers, such as Omaha, Nebraska-based TD Ameritrade, for sending trade requests to them.

The SEC introduced rules in 2007 that prohibit exchanges and brokers from executing orders at prices worse than the best available quote on a public venue. The rule aimed to tie together a marketplace composed of several dozen trading venues by requiring them to respect the best published price.

“While such a routing regime provides order execution at the current best displayed price, it does so at the expense of the limit order posting a best price which need not receive execution,” the committee’s report said. “An alternative framework is a ‘trade at’ regime in which orders must be routed to one or more markets with the best displayed price.”

Right Problem

By seeking to limit trading off public markets, the advisers focused on the right problem, said Joe Ratterman, Kansas City, Missouri-based chief executive officer of Bats Global Markets, the fourth-largest operator of U.S. exchanges last month. A broad trade-at rule could affect exchanges, which allow investors to use hidden orders, and would be the “regulatory equivalent of a sledgehammer," he said.

‘‘Exchanges would be hampered from providing price improvement’’ unless they were displaying quotes at the best price, he said. ‘‘There are subtler ways to swing the pendulum of dark liquidity to a healthier level.’’

Data Vendors

Ratterman said the SEC could alter the formula used to allocate the hundreds of millions of dollars in annual fees exchanges collectively get from data vendors such as New York-based Thomson Reuters Corp. and Bloomberg LP, the parent of Bloomberg News. The current formula, which the SEC changed in 2005, allocates half the money to exchanges based on their quotations and half based on their trades. He said regulators could also adjust the so-called fair-access level at which dark pools must make their orders publicly available.

Half of the committee’s recommendations didn’t call for specific actions, instead saying regulators should explore or examine potential rule changes. The committee could have been ‘‘a little bit more specific,” said John Bates, chief technology officer at Progress Software Corp. and a member of the CFTC’s group of technology advisers.

The committee also recommended that U.S. equity markets limit price moves before resorting to the current technique of halting a stock when it fluctuates a certain amount. The system, known as limit-up/limit-down, would prevent prices from moving outside bands based on trading in the previous five minutes and would trigger pauses only if liquidity, or trading interest, remains insufficient during the period, the committee said.

S&P 500, ETFs

Exchanges implemented single-stock circuit breakers after the May 6 rout. The pause lasts five minutes for Standard & Poor’s 500 Index and Russell 1000 Index companies as well as more than 300 exchange-traded funds when they rise or fall at least 10 percent within five minutes. The committee recommended expanding the program to “all but the most inactively traded” stocks, ETFs and related derivatives.

Limit-up/limit-down “really is a more efficient system,” said Mike Shea, a managing partner and trader at Direct Access Partners LLC in New York. “I can only think of a couple instances since the circuit breakers were put in place where a stock was halted for something other than a single clearly erroneous print.”

The circuit breakers, which started in June, have been triggered by at least 21 companies, according to data compiled by Bloomberg News. The five-minute halt “has been particularly problematic in a number of situations in which a single erroneous trade triggered the pause,” according to the report. The recommended system is “highly desirable if it operates as a supplement to the present process.”

High-Frequency Traders

Regulators should consider implementing fees for market participants when they exceed a specified level of order cancellations relative to executions, according to the report. Those fees would be aimed at high-frequency traders, who have a “disproportionate impact” on market data traffic and exchanges’ costs for conducting surveillance, the advisers said. Fees would help ensure that the costs of that activity are borne by those responsible for the increase in market data.

“Algorithmic trading, high-frequency trading poses some special problems in terms of orderly trading on the markets,” Born, the former CFTC chairman, said at the event in Washington. “The high percentage of order cancellations I think could well be considered a disruptive trading practice that should be looked at very carefully by the commissions.”

Create Incentives

The committee urged regulators to consider incentives for market participants to supply liquidity in various conditions including times of high volatility. The report recommended exchanges consider a “peak load” pricing strategy in which they charge higher fees to execute orders against bids and offers and provide bigger rebates to traders adding liquidity when prices are fluctuating more. That could ensure there’s more liquidity during “bad times,” the report said.

“I don’t think any of this will make a difference when markets decline,” Nagy said. “The solution is to pause trading and let the fear subside. Limit up/limit down is the most important change we can put into the marketplace.”

The committee said regulators should consider switching the benchmark that triggers market-wide circuit breakers that stop trading across securities and futures exchanges to the S&P 500 instead of the Dow Jones Industrial Average. Regulators should also reassess the amount the index must decline before the market-wide circuit breaker is triggered. The initial trading halt should be reduced to as little as 10 minutes, the group said. It also said the circuit breaker should be allowed to be triggered until 3:30 p.m. New York time.

Better Measure

“It just seemed to us to be a better representation of the markets, if you will, and not coincidentally has some cross-market characteristics that seemed to us to make it a better benchmark,” Vanguard’s Brennan said at the event in Washington.

The eight-person group recommended the CFTC and Chicago-based CME Group Inc., the largest U.S. futures exchange operator, consider whether safeguards beyond a five-second trading curb on the Chicago Mercantile Exchange is warranted. The price-based limit let S&P 500 futures rebound after a trigger was hit on May 6. Most equity exchanges didn’t have a similar mechanism for stocks.

The advisers said the CFTC should impose "strict supervisory requirements" on futures brokers sponsoring trading by firms using algorithms, which slice a larger order into smaller pieces and execute them over a period of time. The SEC adopted risk controls and stronger supervisory requirements for brokers in November.

A trader’s use of an algorithm to execute an S&P 500 futures order on May 6 helped set off the chain of events that sent the Dow down as much as 998.50 points, the SEC and CFTC said in a report on Oct. 1. Two people with knowledge of the findings identified the company as Waddell & Reed Financial Inc., an Overland Park, Kansas-based mutual-fund company.

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