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Changing the Rules of the Game

A change in the trade-through rule now on the SEC's agenda could lead to more direct-access and smart order-routing tools.

With upheaval dominating the nation's largest stock exchange in recent months, equity market structure is top of mind for 2004. Chief information officers need to focus on a rule change that could shake up trading in listed stocks and force them to alter their technology along Nasdaq lines.

In an effort to bring the listed-equity markets dominated by the NYSE into open competition with rival electronic-communications networks, the Securities and Exchange Commission is expected to either repeal or amend the trade-through rule by June, according to industry sources.

"This is going to be the premier change to happen in 2004," says Jamie Selway, managing director of White Cap Trading, an institutional brokerage firm.

The arcane rule dates back to 1974, when Congress mandated a national market system to create competition in listed stocks by linking the markets. In 1978, the trade-through rule was implemented with the creation of the Inter-Market Trading System (ITS), an order-routing network that links nine exchanges. They include the New York, American, Boston, Chicago, Cincinnati, Archipelago and Philadelphia stock exchanges, as well as the Chicago Board Options Exchange and the Nasdaq.

Under the so-called ITS plan, which governs the trade-through rule, brokers and traders are forced to route orders to the marketplace showing the best price, as defined by the national best bid and offer. The rule's objective is to prevent firms from "trading through" to a marketplace with an inferior price.

Though the SEC and ITS plan participants have discussed a repeal of the trade-through rule for five years, the exchanges on the ITS Operating Committee failed to reach a consensus. It's now in the regulator's court, says Selway, who sits on the ITS Operating Committee's user group.

Why is the SEC acting now?

Electronic Communications Networks have complained that the ITS system slows orders because other market centers must interact with the NYSE, which is given 30 seconds to respond. They argue that traders should be permitted to choose speed over price, when speed equals certainty of execution.

Defenders of the rule say it protects investors, particularly those who post limit orders, from being traded through by a marketplace with an inferior price or having their orders not be executed at all.

"There are other ways to correct the situation than to disadvantage investors that are providing liquidity," says Peter Driscoll, senior equity trader, The Northern Trust Company. "The mandating of automatic execution of smaller orders probably takes care of all that. Because if you're automatically executing, there wouldn't be any time delay of 30 seconds."

On the other hand, disaffected buy-side traders have let their frustration over the auction model be known - even if that means that limit orders will get traded through.

"We firmly believe that anybody who's willing to post a limit order deserves protection, and no one within the system should be able to trade through that displayed order," says John Wheeler, manager of equity trading at American Century, the Kansas City-based mutual-fund company. "We are willing to make the concession that unless the New York Stock Exchange changes to a fully electronic book, it may be that-in the name of speed and automatic execution-people get traded through," Wheeler adds.

Repeal of the rule is unlikely, but two compromise proposals are under consideration.

One proposal would allow firms to trade through manual quotes created by specialists but not to trade-through quotes generated by trading systems. This proposal addresses the struggle that ECNs and Nasdaq market makers who fill orders instantaneously are having with the NYSE. While Nasdaq market makers and ECNs have computer algorithms that automatically match buy and sell orders at the best price within one second, an order sent to the NYSE via the DOT system is reviewed by a specialist before it is executed. It could be matched against a customer limit order, or it may enter the auction system for a better price.

"When I send an order down to the floor through ITS, the specialist walks around the floor, picks the order off the machine and decides whether to fill it," says a Nasdaq market maker in listed securities.

When a client sends an order to the market maker and the NYSE has a superior price to the market maker's quote, it routes the order via DOT to the NYSE, where the average response time is 18 seconds. "I now get delayed by 18 seconds," says the market maker, which means the NYSE price may change and the client order may not get executed.

Rather than route orders to the NYSE, some market participants want the flexibility to trade through the NYSE's prices to choose a destination that offers speed over best price. The view is that if the NYSE sees its markets being traded through, it will be compelled to offer its own automatic execution system.

An NYSE spokesman says, "The NYSE already offers its own auto-execution system for limit orders up to 1,099 shares, called NYSE Direct+." While 75 percent of the NYSE orders qualify to use the system, only seven percent do, he says, "indicating that most customers choose to wait an averate 11 seconds to get an opportunity for a better price, versus a one-second auto-execution at the prevailing bid or offer."

A second idea, which addresses the speed-over-price issue, and one that has the most likelihood of passing muster, is for the SEC to implement a de minimis trade-through rule, similar to the three-cent exemption it has been granting three exchange-traded funds (ETFs). The commission pioneered a pilot in the three most liquid ETFs-QQQ, SPY and DIA-from Sept. 4, 2002, through June 4, 2003. The pilot allowed market participants to trade up to three cents away from the best price and is considered a smashing success for ECNs such as Archipelago and Instinet. The rule has been extended to March 4, 2004.

Best Execution Up for Grabs

Any potential amendment to the trade-through rule would allow brokers and buy-side institutions to route orders to market centers and ECNs that are not displaying the best price.

"I think the biggest impact will be on direct-access vendors and smart-order-routing systems, because once you get through the trade-through rule, you're opening up execution measures, such as execution speed and fill rates, [and] not looking at best price," says Jodi Burns, an analyst at Celent Communications.

Right now, if exchanges are to abide by the rule, they have no choice. But a rule change opens the possibility to execute an order on a market that isn't posting the best price. "It becomes incumbent on brokers to decide where to route the order, and they're going to use smart-order-routing systems," Burns says. That puts a larger burden on the person making the routing decision, whether it's a person or a system.

Internal software programs that measure best execution will become popular, predicts Burns. "I think firms would be smart to invest in these types of technologies so when their customers are concerned about the elimination of the trade-through rule, they can point to their own statistics and say, 'We're still doing right for you,'" says the Celent analyst.

Direct Access for Buy Side Will Pick Up

Traders agree there will be an uptick in demand for direct-access-trading and smart-order routing tools, although many buy-side traders already use them. Buy-side adoption of smart-order-routing tools is likely, but "I don't think it's going to be a gold rush," says Robert Hegarty, vice president, securities and investment practice at TowerGroup. "There's still a need for more consolidation of access to alternative electronic marketplaces," he says. "That's where the pain point is."

Watching these trends, many market observers predict that the NYSE will lose some of its 80 percent market share if the Big Board doesn't respond with a new or revamped automated trading solution. The NYSE spokesman declines to speculate on what the NYSE will do if the SEC acts on the rule, but says, "The NYSE will continue to offer the most competitive execution services for our listed stocks."

"What does the CIO do in relation to this change? The CIO who is on top of this should look at the way Nasdaq has changed in the last three years," says Selway. "I better be thinking about ECN aggregators, FIX order routing [and] market data. The problem is getting a lot more complex, but the opportunities are substantial."

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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