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This is from the July 2004 issue of Active Trader magazine.

The NYSE against the world?

The trade-through battle

By JEFF PONCZAK

 The trade-through rule changes being considered by the Securities and Exchange Commission are predictably evoking many different responses from a wide variety of market participants.

 However, every conflict needs a villain, and it appears the New York Stock Exchange is filling that bill nicely.

 If the changes are implemented, the effect would be potentially detrimental to the NYSE. As a result, the Big Board is firmly against any changes to the current rules. The exchange has its supporters — mostly from specialist firms and companies listed on the NYSE — but even most groups that oppose the rule changes as they are written still take some issue with the NYSE.

 Trade through

 The trade-through rule as it currently sits on the books states trades sent through the Intermarket Trading System (ITS) must be executed by the market showing the best price.

 Because the NYSE generally displays the best price in its listed stocks, most orders are sent to the NYSE, which helps the exchange do about 80 percent of the transactions on NYSE stocks (by comparison, the Nasdaq does less than one-third of all Nasdaq transactions).

 However, the NYSE is a floor-based, non-automatic-execution market, unlike most of the other participants in ITS. Critics argue, if the NYSE shows a price of 50 and another, electronic venue shows a price of 50.02, it is often beneficial for a buyer to “trade through” to get the higher price, because the trade will be executed in less than a second. If the trade goes to the NYSE, the floor-based specialist has up to 30 seconds to execute the trade, in which time price could change dramatically and go higher than the 50.02 the other marketplace was showing. 

There are currently two proposals under consideration by the SEC. The first would give customers the ability to opt out of the trade-through rule and choose a market venue with a lesser price. The second would allow trade throughs to occur only in the case of a “fast” market vs. a “slow” market.

 The NYSE response

 The NYSE does not believe the trade-through rule is harmful to the investing public.

“One of the NYSE’s fundamental tenets is that orders are executed at the best price,” says NYSE chairman John Thain. “The trade-through rule ensures all investors get that best price. Individual investors overwhelmingly view price as the most important factor when executing trades in the marketplace.

 “Allowing trade throughs will increase internalization of order flow and fragmentation of the market place.”

 However, proponents of the rule change say the NYSE is missing the big picture, and price is only one component of effective execution.

 “The heart of the matter is what [offers] the best protection for investors, and best protection is best execution,” says Robert Griefeld, president of the Nasdaq Stock Exchange.

 Griefeld points to a 1993 SEC study regarding best execution. The report states best execution is more than just price — liquidity, cost, speed and access were other important factors.

 “Investors should determine the finer points of best execution, and the opt-out clause allows them to choose,” Griefeld says. “Without the opt-out, best execution becomes a single element of price.”

 Thain also believes the trade-through rule provides protection for limit orders, as the entire point of a limit order is to get the best price possible instead of entering a market order and hoping for the best.

 However, Ed Nicoll, CEO of Instinet Group, says the NYSE’s price priority means nothing without price-time priority.

 “The trade-through rule does not give people priority for their limit orders,” Nicoll says. “It allows internalization by all parties. If an order goes down to the floor and is displayed, the rule is people can’t trade through, not people have to hit that limit order, because there is no time priority.

“So we are allowing parasitic behavior at the price, but somehow we are concerned about the very few exceptions where one market center might want to trade through by a few pennies,” he says. “The notion that supporting the trade-through rule is protecting limit orders is disingenuous.”

 Nonetheless, while very few market participants agree with the NYSE model, there are quite a few who believe changing the trade-through rule will not accomplish anything.

 Surprisingly, one of those participants is Archipelago, which began as an ECN and later became an exchange because it felt that was the only way to compete with the NYSE.

 Archipelago CEO Gerald Putnam believes the new rules are too complicated. He says the existing rule is simple and straightforward — trade throughs are prohibited — yet the rule is still frequently violated. The new rules, Putnam believes, are too complex to properly enforce.

 The NYSE has another somewhat unlikely ally in the Chicago Stock Exchange. The CSX has championed proposals that would modify the trade through rule and has criticized the lack of openness on the NYSE, but CEO David Herron doesn’t think the opt-out proposal is beneficial to anyone.

 “The trade-through rule has unified the markets,” Herron says. “I was trading before the rule was in place, and there was not liquidity, depth or tightness of spreads. Even proponents of doing away with the rule have benefited from price discovery caused by it.”

 Herron, along with many others, believes the need for the trade-through rule will be eliminated if the SEC mandates automatic execution for all marketplaces. By doing so, the issue of speed would become irrelevant, and the best price would truly be the best price.

 The NYSE says it is way ahead of the game by modifying its Direct+ execution system to increase the number of trades the Big Board executes electronically.

 Currently, Direct+ only works for limit orders up to 1,099 shares. It was fully implemented in April 2001 and on average does 7 percent of daily NYSE volume with an average execution time of one second.

 Direct+ orders, trades and share volume have all doubled since 2002, and the system sends practically every NYSE order to the floor electronically. In February, the NYSE proposed changes to the Direct+ system that would eliminate the 1,099-share limit, eliminate the 30-second waiting time between consecutive orders and make market orders eligible for execution.

 The changes have to be approved by the SEC, but as of late April, the SEC still did not have a legitimate proposal from New York. The NYSE’s first document for the SEC, sent right after the exchange approved its plan, was just three pages long and contained no real detail as to how the changes would be implemented.

 The NYSE thinks there is enough opposition to the opt-out rule to prevent it from being passed. However, that would probably increase the chances the “fast vs. slow market” proposal would be passed (in general, the comment period the SEC provides for a rule change does little to change the Commission’s mind).

 That rule specifies a trade through can only occur when a fast market is trying to bypass a slow market — i.e. the trade through would be allowed if a slow market showed the best price and the trader wanted to access a price on a fast market.

The Big Board believes the changes it is making to its system will allow it to be designated a “fast” market, although it seems the SEC doesn’t agree quite yet.

 And, that opens up an entirely different can of worms. The SEC has no concrete definition of a “fast” or “slow” market, and what is fast to some market participants might not be to others.

 “That’s one of the problems,” Nicoll says. “We have total turnaround times of less than a millisecond. We’re leery of a rigid definition of what is and isn’t a fast marketplace. If it’s one that responds within a second, you would have all markets responding in a second, yet a second is quite slow to some.”

The SEC also must consider the numerous groups that make up the entire market arena. For an active trader with a scalping strategy, sub-second execution is imperative. For an investor who holds stocks for months or years, he’s generally happy when his order comes back filled within a few seconds.

Not everybody trading stocks is concerned with executing orders in milliseconds — in fact, the majority of the trading public likely is not. However, if the fast market scenario is adopted, it is likely the marketplace will eventually decide.

 “I made a lot of money offering people 60-second response time,” says Nicoll, who founded online brokerage firm Datek and was its CEO for many years. Datek was acquired by Ameritrade in 2002. “Now a big firm is guaranteeing a two-second response time. They are responding to the needs and demands of investors.”

 Griefeld experienced a similar situation when the SEC passed Regulation ATS, which allowed for the creation of ECNs. Griefeld says the ECNs brought sub-second execution to the market and took a considerable amount of business away from the Nasdaq

 The Nasdaq and other market participants, though, caught up within a year, and everybody was trading at essentially the same speed.

 “If the opt-out rule is approved, it will be used less and less as marketplaces learn how to compete,” he says.

 Bernard Madoff, CEO of the market making and investment firm that bears his name, says ECNs can’t compete with slow markets, which causes the problem.

 “If you made all markets fast, the issue goes away,” he says. “My definition of a fast market is one that is automatically accessible.”

 Putnam, though, thinks the fast vs. slow debate is misguided. Instead, he wants markets to be classified as to the nature of their quotes — firm vs. soft.

 “That’s where distinctions should lie,” Putnam says. “A slow market has soft quotes, and at times investors would like to avoid that in exchange for having a firm quote.” 

According to Putnam, a quote is firm if that price is available instantaneously.

 “If another order comes in, it will execute without human intervention,” he says. “Nobody has to look at it. A floor-based model — those quotes are not necessarily firm.”

 The NYSE’s Thain, though, is steadfast in his belief the changes at the NYSE will put the exchange on par with its competitors. And, he thinks the NYSE will continue to show the best price the majority of the time on NYSE-listed stocks. 

“If there is dramatically different execution times, speed does make a difference,” Thain says. “But price should be first among equals. The simplest way to distinguish between the fast/slow differentiation is automatic execution, computer to computer, and I don’t think it matters if it’s milliseconds or microseconds. 

“But once you have fast markets, there is no reason why you shouldn’t go to where the best price is. If you allow people to opt out where you have comparable execution, there is no good reason for it.” 

However, even if the SEC decides to pass the fast market proposal and designate the NYSE as a fast market, that doesn’t really help the overall trading community. The changes to Direct+ will be beneficial to the NYSE members with access to the platform, but they still will not help other market centers looking to get trades done on the NYSE. 

The SEC has put a big emphasis on access and connectivity, and that may work against the NYSE when it comes time for the SEC to make a decision, both on the trade-through rule and on the NYSE’s proposed changes.

 “This is a bold step forward by the SEC,” Greifeld says. “The failure of this commission to adopt opt-out rules is a denial of the full benefits of best execution as the governing force in our markets.”

  June 2004

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