Tuesday, December 14, 2004

SEC Discusses NMS Tomorrow - Here's How Arca Feels about Some of the Proposals

Judith Burns of Dow Jones Newswire published a story today at around noon (EST) which includes some choice quotes from various stakeholders. This article and some of the quotes contained in it serve as a good mixer for AX's CEO, Jerry Putnam remarks to the Committee on Banking, Housing, and Urban Affairs titled, "Regulation NMS and Developments in Market Structure." These were published on July 21, 2004, You can read them here:

The following is a quick review of NMS and Arca's stance on some of the rules contained within the proposed regulations.

Subject: ENFORCING the trade-through rule for the NYSE
Arca's View: Jerry Putnam says that (see the aforementioned remarks), " . . .the SEC must
monitor and enforce whatever trade-through rules are in place. Industry insiders have
known for years that the trade-through rule is the least enforced rule this side of the double
nickel speed limit on America’s highways. For example, despite the fact that there is a
trade-through rule for NYSE- listed securities, ArcaEx quotes are traded through on
average of over 2,000 times per day (ArcaEx runs software (aptly named 'whiner') that messages alerts when exchanges trade through an ArcaEx quote in violation of the ITS Plan. For the week of June 21st 2004, ArcaEx complained to otherexchanges 11,816 times about being traded-through for an average of 2,363 complaints per day

In fact, trade-through violations have actually risen most recently despite the glare of the regulator spotlight on the NYSE. On any given day, ArcaEx has a billion shares on or near the national best bid or offer. Yet, the NYSE sends only two million shares to ArcaEx over ITS when we have the best price. The existing trade-through rule protects the NYSE’s market share by requiring orders to be funneled to the specialists at the NYSE when they display the best price. This provides the specialist with a virtual put option on the order and ensures that they, the specialist, obtains the best price (Earlier this year, the NYSE’s five largest specialist firms agreed to pay a total of about $240 settle SEC allegations that they short changed customers by trading for their own accounts. See Traders Will Pay Fines Of $240 Million ”, Wall St. J., February 18, 2004. Some five months large specialist firms paid nearly a quarter of a billion dollars to settle SEC trading ahead allegations, NYSE’s other two much smaller specialist firms paid roughly $5 million to resolve similar SEC NYSE Small Specialists to Pay $5 Million in Cases on Trading”, Wall St. J., July 9, 2004). The customer, on the other hand, may or may not get the best price and may have even lost the opportunity, through this process, to receive any execution at all, not only at the NYSE but across all market centers.

Putnam continues, "Clearly, today’s trade-through rule is not effectively enforced, other than to ensure that the NYSE specialists receive the best price (It is difficult for a market participant to pursue enforcement of the current trade-through rule because it is an ITS rule and not an SEC rule. One has to go to the ITS Committee to complain before approaching the SEC. In addition, enforcement is after the fact so it is time -consuming and otherwise troublesome. Moreover, the existing rule is riddled with exceptions which has built up interpretive complexity over time). Implementing a clear-cut rule with no exceptions will be essential to ensure that the rule is adhered to and enforced. Reform
would enable investors to choose how they want their limit orders handled. They could
then send them to electronic markets that provide instantaneous display and automatic
executions against incoming orders. Or, investors could choose to send them to a manual
market if they want to expose the orders to specialist and floor broker handling".

Subject: Extending the trade-through rule to the OTC marketplace
Arca's View: (From Mr. Putnam's aforementioned comments) "Execution speeds in OTC stocks are generally sub-second and currently surpass quote update speeds. Accordingly, introducing a trade-through rule in OTC would result in holding up executions while awaiting dissemination of quote updates, or worse yet, in instigating increased cancellation of orders. From a practical perspective, in OTC stocks where speed and certainty of execution are critical, the customer sending the order in an environment with a trade-through rule is disadvantaged because not only will it take longer to execute the order, but he or she may receive a partial fill - or no fill at all. In other words, the OTC market is not broken so why fix it."

Nasdaq's View (from today's Dow Jones article): "Nasdaq officials disagree [that the trade-through rule should be expanded to the OTC marketplace]. 'Nasdaq really, really doesn't need that rule," said Adena Friedman, executive vice president for corporate strategy and market data at the Nasdaq Stock Market. She said trading through doesn't occur that often on Nasdaq and is more of a problem at the NYSE, where 'they trade through all day.'

There remains an issue regarding government intervention for setting market access fees. Arca is opposed to this.

Putnam says in the aforementioned remarks, "We are very concerned, however, about the role of government in regulating the amount of any fees. History has not been favorable to command economies, in which the government places its judgment above that of the free market. In essence, by setting maximum access fees, the SEC would engage in ratemaking, substituting its views for that of the markets."

Putnam continues, "Most ECNs were able to charge significant access fees only when participants were not technically able to avoid trading with them. Nasdaq—through SuperSOES and SuperMontage—did not provide members with the ability to avoid trading with auto-ex
ECNs, even when they charged exorbitant access fees. However, with Nasdaq’s selfimposed
cap on ECN access fees, such excessive fees are no longer a significant issue. Moreover, the problem will not recur so long as OTC market participants are provided with the ability to choose not to trade with a market center that charges unreasonable fees. By virtue of market competition, fees have dropped well in excess of 80% since 1997. Competitors that did not reduce fees as a result of market forces found their market share and profits eroded."

To be sure, tomorrow's SEC meeting stands to be historical. Lets just hope that the reforms are fair, simple, and foster innovation. For more on the ethical questions related to govenment intervention in a free market system check out this section of
Man, Economy, and State, with Power and Market, by Murray N. Rothbard.


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