The Securities and Exchange Commission is likely to initiate a debate on a potential new rule that could drastically crimp the activities of broker-dealers that trade against their own orders.
Known as "trade-at," the rule would force brokers who match their orders internally–rather than send them to a public exchange–to make a choice. They could either fill the orders at significantly better prices than are available in the public market or route them away to the public market.
Such a rule could wreak havoc with the businesses of wholesalers and operators of dark pools. It could increase their costs significantly and/or force them out of the business altogether. Just about every major broker internalizes a portion of its orders. For the wholesalers, the practice is a considerable part of their overall business.
"The SEC has a political issue with the original ‘flash crash’ report," Janet Angstadt, a partner with law firm Katten Muchin Rosenmann," said yesterday at the annual conference of the New York chapter of the Security Traders Association. "It showed how the internalizers reacted that day. So we may see something from the Commission."
On May 6, 2010, within a 15-minute timeframe, the major market indexes dropped 6 percent and then rebounded. The ‘flash crash’ frightened American investors and led to cries of action from Congress. The SEC produced a study that, among other things, alleged the wholesalers dumped their sell orders on the public markets, thereby fueling the crash.
"I think the Commission has to do something about the internalizers," Angstadt said. "It may be a concept release. It will be interesting to see if it is a trade-at rule or something else."
The SEC first broached the idea of a trade-at rule in its January 2010 Concept Release covering market structure. At the time, the idea was derided as a non-starter by many in the industry. After the flash crash, however, the sentiment changed.
"The probability of a trade-at rule happening is much higher than it ever was," said Vlad Khandros, who heads market structure and government relations at Liquidnet, a block crossing network.
"There are some very senior Congressional staffers asking us how this would work," Khandros told the STANY crowd. "The fact that they are thinking about it and asking us tells us something."
Others contend that a recent report from an advisory committee convened by the SEC and the Commodity Futures Trading Commission makes it inevitable that a trade-at debate will be forthcoming. The committee presented the regulators with a list of 14 recommendations for preventing another flash crash. Among them was the implementation of a trade-at rule.
Khandros expects action by the SEC after it finishes up its work on Dodd-Frank–perhaps later in the year or next year.
The SEC broached the issue last January because it was concerned too much volume was being traded off-board. It worried internalization might be impairing the public market’s ability to discover price. Currently, about one in three shares is traded away from the public markets. That figure has grown sharply in recent years.
Exchanges would be the beneficiaries of any trade-at rule as they would likely receive more orders. However, publicly at least, they are not clamoring for one. While they are worried about the growth in off-exchange trading, they maintain a trade-at rule might be going too far.
"Trade-at is a sledgehammer," Chris Isaacson, chief operating officer at BATS Global Markets, said yesterday. "It would be the biggest change in U.S. equities market structure since Regulation NMS–maybe even bigger."
In any case, Isaacson says, the industry and the regulators need to first agree that there is a problem. "Do we believe there is too much off-board trading that is hurting price discovery?" he asked. "I think there is a big debate whether or not there is actually a problem."
Still, he noted that at least 40 percent of the share volume of three of the top four traded stocks was done off-board. That was true of five of the top 10 stocks as well. (Those figures include the shares of Citigroup which recently announced a 1-for-10 reverse split, a move which is expected to dramatically reduce trading volume.)
Isaacson and other exchange executives say some action may need to be taken, but any solution could involve something less drastic than a trade-at rule.
Among the alternative ideas floating around are a price improvement requirement; an exemption for block trades or child orders of block trades; or shrinking spread widths.
"I think what will evolve as the debate continues is perhaps not a full trade-at type rule, but other things that are more palatable or incremental," Joe Mecane, chief operating officer at NYSE Euronext, said at the STANY conference.
