The Financial Industry Regulatory Authority, to the surprise of many industry pros, is proposing the elimination of the “three-quote” rule used in the over-the-counter market.
The regulator says the rule is “overly prescriptive and can often result in unnecessary delay in the execution of a customer’s order.”
In its place, FINRA proposes adding “supplementary material” to a newly proposed best execution rule that would require firms to maintain policies and procedures for handling those orders previously subject to the Three Quote Rule.
While the proposal would make it easier and faster for OTC market makers to fill orders in so-called “gray market” stocks, or those that aren’t quoted on any system, dealers aren’t necessarily in favor of the elimination of the rule.
“This is a negative for Hill, Thompson and the dealer community,” Nick DeMaria, managing director for trading at Hill, Thompson, Magid & Co., said. “I am not in favor of the rule’s elimination.”
Rick Petrone, director of sales and trading at Domestic Securities, says the elimination of the rule would not effect the way his firm does business. “We put three quotes on all our gray market stocks,” Petrone said. “We’ve been doing it for years. Even if we didn’t have to, we probably would anyway. It’s second nature by now.”
Under the existing rule, which has been on the books for more than 20 years, dealers must call at least three other dealers to obtain prices when they have an order for a stock for which there aren’t at least two quotes visible on a quotation system.
If there are at least two quotes visible, dealers can use those when pricing a customer order. The primary inter-dealer quotation systems are supplied by FINRA’s Bulletin Board and Pink Sheets.
There are about 9,000 securities quoted on these systems. Another 20,000 names, it is estimated, trade in the gray market. These stocks generally do not trade enough to merit the filing of documents with the Securities and Exchange Commission by dealers willing to support and publicly quote them.
It is uncertain what prompted FINRA’s proposal. Sources say dealers are partly behind it. Others say market makers’ broker-dealer customers also have a vested interest in the rule’s elimination as it would reduce the amount of work involved in filling these orders. Both groups would be able to reduce staffs if the process was made faster.
Despite FINRA’s proposed elimination of the Three Quote Rule, the regulator still suggests dealers maintain procedures that require contacting other dealers for quotes when pricing these orders.
DeMaria, however, believes the current rule is best as it ensures the customer order will get filled at the best price. He asks: “Will dealers be able to obtain quicker executions if they weren’t required to obtain three markets? Yes. But I would question the validity of those executions.”
The executive is also concerned that, if the rule were eliminated, fewer calls would come into Hill, Thompson from other dealers seeking quotes. That would mean Hill Thompson would potentially miss trades.
Legal experts say the proposal is a bad move as well. It would make an already contentious examination even more contentious. Steve Nelson, principal at the Nelson Law Firm, notes examiners from regulators frequently wrangle with market makers over the prices they give their customers. Eliminating the Three Quote Rule, Nelson explains, would only give the examiner more reason to question the fills.
“I would be reluctant to get rid of a rule that allows an examiner to come in and argue the firm is not living up to its best execution obligations,” Nelson says. “And the firm has no hard way to prove that it was. I don’t think dealers want a rule that allows examiners to pick them to pieces.”
The Three Quote Rule came into being in order to prevent dealers from giving their customers whatever price they felt like. It predates the Pink Quote system when there was less transparency.
In 2000, with the advent of Pink Quote, FINRA amended the rule. From that point, dealers did not have to call for quotes as long as there were two, two-sided publicly displayed quotes available.
