To understand why trade-at is a bad idea, one need look no further than its proponents: the for-profit exchanges and their largest customer base – high frequency traders. The exchanges, which before demutualization were once considered a bastion of market structure integrity, today answer to shareholders, just like the broker-dealer community.
In the past decade, exchanges have seen their market share deteriorate due to competition and innovation by broker-dealers, fostered by the SEC’s adoption of Reg NMS in 2005. When broker-dealers internalize their customers’ orders, the for-profit exchanges lose out on exchange fees. Exchanges’ best customers today are not retail or institutional investors; they are the high frequency shops that pay for co-located servers and feed the exchanges’ maker-taker pricing model. And those high frequency traders would like nothing more than to see more & more displayed order flow for them to prey on.
Who is against a trade-at rule? Just about everyone else: both the buy-side and the sell-side, and most retail investors in the know. Within the past few weeks, the largest trade association for mutual funds (ICI) and the largest trade association for the broker-dealer community (SIFMA) both filed comment letters opposing a trade-at rule, as it would peel back several of the benefits investors have come to expect in the past decade.
In large part due to broker-dealer internalization practices, it’s never been a better time to be a retail order. Liquidity is prevalent, spreads are narrow, executions are fast, transaction costs are low and opportunities for price and size improvement abound. Internalization is the primary reason behind the $8 trade and empowerment of the individual investor. And a trade-at rule would do away with all this.
Let’s compare retail execution data from 2006 (pre-Reg NMS implementation) vs. 2010 (post-Reg NMS) for the largest retail market makers (Citi’s affiliate ATD, Knight, UBS and Citadel) for all stocks and all “marketable” orders (market and marketable limit orders up to 10,000 shares).
Market makers executed roughly three times the volume in 2010 vs. 2006 because order sending firms like TD Ameritrade, Scottrade and E*Trade have embraced the reduced cost of execution via a market maker and the price improvement of their client orders.
The speed of execution has declined approximately 50 percent, which indicates both an increase in available liquidity at the inside market (NBBO) and a commitment of more capital by the market makers. Average spread size has also declined substantially, by approximately 23 percent. The retail investor today is receiving a better price in a reduced spread market, as evidenced by SEC Rule 605 best execution statistics. All good things.
The percentage of orders price improved has increased by 74 percent and the actual number of shares price improved has quadrupled. Comparatively, retail investors received nearly $238 million of price improvement in 2010 vs. $126 million in 2006. These are real dollars that go directly into the pockets of retail investors. Additionally, fewer orders are being filled outside the quote, meaning that more retail investors are “getting what they see on the screen” when their orders are executed by market makers.
And they’re getting all this much cheaper than they would if they were forced to execute all on exchanges and pay ever-increasing exchange and regulatory fees. A trade-at rule would eliminate this almost entirely as it would require by regulation a minimum price improvement that would, practically speaking, not make any economic sense to those market makers who currently provide such improvement.
When expanded to include institutional execution data, research further reveals a greater percentage of price improvement occurring in trades that are reported to the ADF (which includes virtually any liquidity that cannot be ascribed to an exchange, such as dark pool liquidity). Across large, mid- and small capitalization stocks, roughly 37 percent of the executions reported to the ADF receive some degree of price improvement (45 percent for small cap names). In the case of mid- and small cap stocks, the percentage of ADF-reported executions occurring at the midpoint of the NBBO exceeds that of all other exchanges and ECNs.
Some have argued that internalization and price improvement practices should be done away with altogether because, despite the impressive aggregate amount of improvement, the per-share amount is not large enough. Isn’t that like biting off one’s nose to spite one’s face?
Would retail investors rather have some price/size improvement or none (which is exactly what a trade-at rule would do in practice)? Why would we encourage a market structure that sacrifices the good for the perfect, recognizing that a “perfect” structure is unobtainable if we force market makers out of the game?
Adopting a trade-at rule would be step one toward imposing a central limit order book (or CLOB), where all orders would have to be publicly displayed and none could be price improved. Any investor of any substantial size will tell you that publicly displaying all of its trading interests would be like jumping into a tank of piranhas (only here they’re called high frequency traders). A trade-at rule would cause too much information leakage into the market and could actually have a deleterious, not additive, effect on liquidity.
A CLOB would be like replacing Restaurant Row with a government breadline. It’s just plain un-American. Innovation and investor choice would disappear. A trade-at rule would set us down that path.
Equity market structure is a mosaic, with different participants each providing valuable contributions to the overall flow. Trade-at seeks to replace this with a “one size fits all” approach, replacing a rainbow with a single swath of color. The only beneficiaries would be the for-profit exchanges and high frequency traders…and it would come at the detriment, once again, of the retail investor.