Dealers operating in the over-the-counter equity markets may soon feel the brunt of the Manning customer-protection rules being extended into their territory. The Manning rule went into effect for all OTC securities 10 days ago, on Nov. 11.
“Generally speaking, firms may see a decline in margins in these markets,” said Len Amoruso, general counsel at Knight Capital Group. “Additional order-handling rules and requirements such as these could have an impact on margins.” He said it’s too soon to tell what this will mean for Knight, the largest OTC market maker, but he noted that OTCBB and Pink Sheets market-making has been a shrinking part of Knight’s overall business in the last few years.
Louis Piro, a senior sales trader at Domestic Securities, agreed that Manning will have an impact on brokers. “It will affect every firm, with the result varying based on their business,” he said. In his view, those trading exclusively OTC stocks could feel the impact the most. He added that the rule’s implementation will only affect a small portion of Domestic’s business since the firm trades a lot of foreign securities and Nasdaq stocks.
The Manning rule, officially known as IM 2110-2, prohibits brokers from trading for their own account at a price equal to or better than an unexecuted customer limit order in that security, unless the firm immediately executes the customer order at the price the firm traded at or better. The rule also prescribes a minimum level of price improvement a firm must provide to trade ahead of an unexecuted customer limit order. The price-improvement levels are tiered based on the price of the security.
The Securities and Exchange Commission approved the Manning rule extension to OTC markets in spring 2007. However, implementation was delayed until this month to coincide with the effective date of the new price-improvement levels laid out by the Financial Industry Regulatory Authority. Brokers said they needed the additional time to prepare their systems for the new rules.
The Manning rule is new for Pink OTC Markets, formerly called the Pink Sheets, and the gray market. In bulletin board stocks, a version of the Manning rule has been in place since 2003. NASD Rule 6541 for bullies, which was based on Manning, prohibited brokers from trading ahead of a customer limit order without first executing the limit order at that limit price (as opposed to the price the dealer traded at, which the current rule requires). Rule 6541’s price-improvement requirements were also different. That rule has been supplanted by the new requirements.
R. Cromwell Coulson, chairman and CEO of Pink OTC Markets, said that while the extension of Manning will affect dealers’ per-trade profitability, it will grow the markets by giving customers greater confidence in the quality of executions they receive and providing the “same regulatory standard across all markets.” In addition to increased volume, he said he expects to see more limit orders displayed, and more price improvement of limit orders. He said there could also be some spread narrowing as a result of the rule.
For bullies, Coulson said, FINRA’s rule tightens brokers’ responsibility. Brokers previously had to execute a customer’s limit order at that limit price if they traded ahead. Now, they must give the customer their execution price. “In providing price protection, like for National Market System stocks, a broker-dealer has to sell it at the price they bought it at [if the customer has a buy limit order that’s protected],” he said. “This adds price-for-price protection on top of share-for-share protection.”
Frank Grampone, managing director of operations and client services at Knight, said the change for bullies is significant. “Previously, if a client had an order to buy at $10 and a market maker bought at $9.99, it had to give the client an execution for the same number of shares at the customer’s limit price,” he said. “Now the market maker must give the customer order price improvement. The market maker must provide price-for-price protection in addition to share-for-share protection.” In other words, it must now sell the stock to the customer at $9.99, instead of $10, providing price improvement of a penny.
Knight’s Amoruso added that one of the difficulties for regulators in extending Manning to the OTC markets was determining the right methodology for the price-improvement levels, since many OTC names trade to four or five decimal places. “Regulators realized that if a stock was priced less than $0.001, one-tenth of a penny, they needed to tier those markets so market makers would know the minimum level of price improvement they had to provide to trade ahead of an unexecuted limit order,” Amoruso said. So for a $0.001 stock, “it’s half of the inside spread or one-hundredth of a penny, whichever is smaller.”
Manning protection of limit orders for OTC equities is seen as an important shift in the process of standardizing some of the investor-protection rules across markets. “This is a pretty important change,” Grampone said. “It will translate into benefits for customers and provide them with similar protections to those afforded them in the Nasdaq [and listed] markets.” Manning protection “could result in higher fulfillment rates and more price improvement for customers,” he added.
The Manning rule in OTC equity securities applies only to customers’ limit orders. However, Knight and UBS are extending Manning protection to market orders as well. Several other large OTC market makers are expected to do the same, if they haven’t begun doing so already.
