After weathering the storm of decimalization, the brave souls of the market-data world thought they were safe. However, in the coming year, they may be faced with another unprecedented increase of quotes.
The Securities and Exchange Commission is considering sub-penny pricing of equities, and the options market faces possible penny pricing on certain exchanges. These impending decisions are sending market-data professionals scrambling to prepare for an immense increase in the information that is their lifeblood.
When the equities market moved from pricing at 1/16ths to pennies, possible price points increased by six times, according to the Financial Information Forum. The FIF foresees a possible 10-fold increase if pennies moved to 1/10 pennies, and a hundred-fold increase if that move is to 1/100 pennies.
While the impact on transparency can be debated, the impact on market data is definite. Possible effects could include increased traffic and therefore a need for greater capacity in market-data networks.
As always, where technological upgrades are needed, costs follow close behind. "The cost of ownership for a market-data system will increase because of additional capacity needs," explains Joe Doria, an industry consultant with New York City-based consulting firm Jordan & Jordan. "Do we really need to make the market-data systems any more expensive and costly than they already are?"
In addition, managing market data on terminals will become increasingly difficult for users, Doria notes, exacerbating the phenomenon of flickering quotes. "Some of these securities are quoting multiple times per second now," he says. "The more data you get, the tougher it is to see it all."
IT'S ALREADY OUT THERE
Sub-penny pricing is not new for the Street. Many electronic-communications networks are already trading certain listed equities at sub-penny prices, under the argument sub-penny trading affords enhanced transparency, and therefore, a greater value for the investor.
However, a recent Nasdaq study concludes that when trading at three decimal places most trades occur at either .001 or .009, and at four decimal places the majority of trades occur at .0001 or .0009. This adds weight to the theory sub-penny pricing encourages penny-jumping.
Ameritrade's director of trading, Chris Nagy, says this action is negative for the investor. "If you've got a resting limit order on your book that is within a penny of where you're going to trade proprietarily, then you need to fill that client order," he explains, adding this is known as the Manning Rule. "So you've got sub-penny trading occurring in the marketplace most predominantly to do penny-jumping, or to jump in front of resting limit orders at sub-penny prices."
However, Nagy also concedes sub-penny pricing makes up a small percentage of his firm's total executions at 4.5 percent, which is consistent with the total percentage of sub-penny trading on the market, he says.
Adena Friedman, executive vice president of Nasdaq Data Products at the Nasdaq Stock Market, says the electronic exchange is at a competitive disadvantage because the SEC does not permit its trading platform, SuperMontage, to trade at the sub-penny level.
"We calculate that about 15 percent of the trading in Nasdaq securities occurs in sub-pennies. That's not tiny," Friedman says. "For us to sit while that trading goes on, it's not a situation we can live with."
Based on this argument, Friedman says Nasdaq submitted a rule filing to the SEC in early August to allow for sub-penny trades.
While the rule filing might suggest Nasdaq is pro sub-pennies, Friedman says Nasdaq is opposed to them as a minimum-price variation. Nasdaq additionally submitted a petition to the SEC to consider pennies as the minimum-price variation across all Nasdaq marketplaces.
"Going to sub-pennies on the best bid and offer would thin out the market even further. You'd see fewer shares available at that best price," Friedman says. "It would require (market-data) vendors to provide more and more information to investors just to get a basic picture of the market."
In addition, Friedman says screen space on market-data terminals would be jeopardized. "You could have 10 price levels and only go down a penny. That's a lot of real estate," she says. "You'd have to scroll down pretty far just to see the full montage of what's available on the market."
A spokesman for the SEC said it is premature to comment on the Nasdaq proposals, only noting the SEC is reviewing them. "The whole issue of sub-penny pricing is part of a larger review of market structure that is ongoing," he added.
THE DOMINO EFFECT
Sub-penny pricing of equities also has an effect on other markets, such as the options market, where prices are often based on underlying securities.
"Coming up with fair values for options is dependent on a reliable sense of what the fair price of the equity is," explains one market-data executive at a market-making firm.
However, the executive, who declines to be named, continues that because of the insubstantial amount of sub-penny-priced equities at this point, that is not the foremost concern in market-data capacity for the options market. Instead, he and others offer cross-exchange listings, multiple-quote contributors and additional exchanges as reasons for the options market to prepare for heightened market-data volume.
While options are priced in nickels and dimes, one newly established market, the Boston Options Exchange (BOX), is proposing to quote in nickels and dimes but trade in pennies, points out Tom Knorring, vice president of market operations at the Chicago Board of Options Exchange.
"It's not clear if that is going to get approved by the SEC, but that brings a question of what will our competitive response be?" Knorring says, adding that other options exchanges would likely move to pennies to stay in the game. "If at any point Philly decided it was a good idea, we would have to go also from a necessary competitive standpoint."
Ameritrade's Nagy says BOX could be live as early as the end of the year. "I think the other exchanges would be forced to meet them to be competitive. That could be up to a 500 percent increase just based on going from a nickel to a penny," he says.
Knorring says the CBOE has designed its systems to be penny-capable, and expects all of the other exchanges are equipped for this as well. However, he adds that one worry on the minds of the marketplace is the ability for the Options Price Reporting Authority (OPRA) to handle the increased market-data volumes.
Nagy agrees and adds, "OPRA has experienced capacity issues. In the past couple of years they have built that out," but there is still a legitimate concern they may not be able to handle it.
OPRA Executive Director Joe Corrigan says it is unknown at this point whether BOX would even send its penny quotes to OPRA. However, he adds, the pricing authority can process up to 50,000 messages per second. "That's our capacity, but the peak traffic we've seen is 12,000 quotes per second," he explains. "So we have a 300 percent expansion ability."
If quotes reach beyond that, Corrigan says development would be necessary in communications and computer upgrades at SIAC, OPRA's processor. Until anything is formally decided by the exchanges and the SEC, though, "It's a wait and see approach."
Who pays for operational updates to OPRA? "Everybody pays for OPRA," says Nagy. "Every time you pull an option quote, firms have to pay."
The market-data executive who requests anonymity laments that whatever the decisions of the SEC are, market-data departments will have to grin and bear it. "Our firm's stance on the issue wouldn't be based on the market-data aspect of the problem, but instead on issues of best practice and best execution," he says. "I'm going to have to handle that data, distribute it, and make sense of it ... or tenths of cents."