The Securities and Exchange Commission has halted plans by the Financial Industry Regulatory Authority to impose a new quoting regime on the over-the-counter market, citing concerns over market quality.
In an order made public last month, the SEC instituted proceedings to determine whether to disapprove a FINRA proposal to change the minimum quote size requirements of the over-the-counter marketplace. Critics of FINRA’s proposal, namely two large OTC players, say the lower quote size would negatively impact liquidity and ultimately hurt investors.
The SEC stated the "proposed rule change can benefit from additional consideration and evaluation," and gave FINRA and other "interested persons" another three weeks to submit "data, views and arguments" to support their positions.
In November, FINRA proposed reducing the number of shares needed to quote OTC stocks at most price levels in a bid to make it easier for limit order traders to comply.
The idea was shot down by the largest OTC market maker and the operator of the marketplace’s primary quoting system. In letters, officials from Knight Capital Group and OTC Markets Group (formerly known as Pink Sheets) told the SEC the proposal would dramatically reduce liquidity in the over-the-counter market.
"FINRA’s data analysis was flawed and simplistic," Cromwell Coulson, president and chief executive of OTC Markets, said. "That led to questionable conclusions."
FINRA’s plan would replace the existing quotation thresholds applicable to market makers with new ones that would apply to both market makers and limit order traders. The new thresholds would be easier to reach, and likely lead to more limit orders from public customers.
OTC market makers must adhere to size minimums when quoting a stock, depending on the price of the stock. For stocks trading for less than $1 per share, dealers must quote in amounts of 2,500 shares or 5,000 shares, depending on the price. For stocks trading from $1 to $100, dealers must quote in lots of 200 shares or 500 shares, depending on the price. The minimum quantities are intended to ensure there is liquidity in stocks that don’t trade very often.
The existing structure has nine tiers. FINRA’s proposal would cut the number to six. Most of the proposed tiers would require traders – both market makers and agency brokers – to post significantly fewer shares when quoting. The single exception is for stocks trading under 2 cents per share. Under the FINRA proposal, the threshold would rise from 5,000 shares to 10,000 shares for those securities.
Approximately 4,700 securities trade for less than 2 cents in the OTC market, according to data on OTC Markets’ website. Another 5,450 securities trade at prices above 2 cents. About 2,800 of those trade for more than one dollar.
For FINRA, the proposed rule change is an attempt to strengthen a new rule that went into effect in the OTC market last year that requires market makers to post customer limit orders. This limit order display rule has applied to exchange-listed securities for many years, but was only extended to the over-the-counter market last year.
Under the limit order display rule, dealers don’t have to post customer limit orders that fall below the tier sizes. So many don’t get displayed. FINRA estimated that only half of all limit orders received by dealers are displayed. The regulator contends that figure would jump to 90 percent if the SEC approved its proposal.
Officials at OTC markets contend that number is inflated and that the reduction FINRA is contemplating would do more harm than good. OTC Markets told the SEC that FINRA failed to take into account the fact that many less-than-tier-size limit orders received by dealers are, in fact, posted as they are aggregated with others. Also, FINRA did not eliminate marketable limit orders from its calculations that would be filled by dealers immediately and not posted anyway.
Finally, OTC Markets contends, in basing its conclusions on the number of orders rather than the dollar value of those orders, FINRA understated the economic implications of its proposal. OTC Markets estimates the total dollar volume of the missing limit orders is less than 10 percent of the value of all over-the-counter quotes. That figure pales in comparison with the amount of liquidity that would be lost from market makers because of the proposal.
If the tier size thresholds were reduced, Knight told the SEC, market makers would reduce their quote sizes as well, seriously damaging liquidity in the over-the-counter market.
FINRA would not comment for this article, but in an email sent to the SEC, the self-regulatory organization indicated that OTC market makers might not be completely necessary. Marc Menchel, general counsel for regulation at FINRA, told the SEC that "In NMS securities, the role of the market maker has been radically reduced yet liquidity in NMS securities appears intact." NMS, or national market system, stocks are those traded on exchanges.
At least one market maker echoes Knight. Nick DeMaria, head of trading at StockCross Financial Services, said that the liquidity supplied by OTC dealers is a hallmark of the marketplace. "I’m not in favor of reducing tier sizes," he said. "Dealer liquidity is what differentiates us from other marketplaces. If you decrease the tier sizes, then the dealer community will shy away from risking any capital for customers."
Coulson seconds DeMaria. He contends the over-the-counter market is a superior venue on which to trade small capitalization companies. "With tier sizes, we have better liquidity and a better trading platform than the NMS markets for smaller companies," he said. "It’s incredible for FINRA to want to change that."
Still, sources said, some market makers are opposed to the proposal for purely selfish reasons. It would require them to represent more customer limit orders in their quotes. These orders compete with their proprietary quotes.
Other dealers, however, will likely embrace the proposal, sources said, because it would allow them to reduce their risk. DeMaria maintains some market makers will take advantage of the looser rules to trade for their own accounts. The changes would also induce gaming from both market makers and customers alike, he said. "It will allow for less risk, but that benefit will accrue to the dealer community-not the investor community," DeMaria said.
Another source adds that lower risk thresholds will lead to "tail" trading by some market makers, a practice akin to scalping. Dealers tail trade when they fill most of their customers’ orders on an agency basis rather than entirely with their own capital.
With tail trading, a dealer will fill an order at progressively worse prices as he continuously picks off an updated top-of-book quote. He only commits capital on the final-or tail-trade.
After the customer’s order is filled, the market maker waits for prices to return to their "natural" levels, as other dealers refresh their quotes. Then he unloads his position at a profit. The upshot: the customer gets an inferior fill, while the dealer reaps a large profit.
Lower tier sizes will make this practice much easier, said the source. That’s because there will be fewer shares available at each price level. So the market maker will have to run through several levels to fill the order.
