July 11, 2012

NYSE Goes Retail

The recent SEC approval of plans by the NYSE to attract retail dark liquidity generated a nationwide acronym alert.

Just kidding. Mostly. But acronyms in hordes do assault readers of the NYSE rule. It was not readily apparent that the filing had been composed in English.

If you didn’t hear, the SEC last week approved plans by the NYSE to host undisplayed orders originating from retail investors for matching against high-frequency trades in sub-penny increments.

We don’t fault the NYSE. It’s trying to compete for data revenue under plans that require it to match at least 25% of trades to earn revenue from the data those trades generate. With its share of market slipping below that level in May, the need was urgent.

But there are problems here for IR pros and public companies beyond that fact that it represents an abrupt and contradictory about-face from the SEC. We could go on for pages but because some of you would become alcoholics as a result, we’ll confine ourselves to a single, overriding flaw:

The rule effectively establishes 1,000 price points per dollar. In Regulation National Market System, Rule 612, called the Sub-Penny Rule, states: “No national securities exchange, national securities association, alternative trading system, vendor, or broker or dealer shall display, rank, or accept from any person a bid or offer, an order, or an indication of interest in any NMS stock priced in an increment smaller than $0.01 if that bid or offer, order, or indication of interest is priced equal to or greater than $1.00 per share.”

In approving the NYSE Retail Liquidity Program, the SEC granted an exemption to this rule that will permit retail orders to trade in tenths of pennies. Since any firm including prolific high-frequency proprietary traders and market makers can offer to match these trades for a fee, the market opens up to sub-penny trades.

Who benefits from more and more price points per dollar? Not long-term money. The more opportunity to leave in increments, the less reason to buy and hold.

But three parties do benefit. First are statistical arbitragers, who can contra-trade other securities and orders on markets where there are no sub-penny trades allowed. Second, the exchange, which needs transactions to generate data, which can be monetized as it’s consumed at brokerages and via websites, and through Bloomberg, Thomson, Dow Jones and other distributors.

And third: The SEC. Dodd-Frank changed the SEC’s budget. It now derives entirely from Section 31 per-trade fees. Volumes have been falling in equity markets for three years, even as the SEC’s responsibilities increase.

What’s a regulatory body to do? Change the price points to allow more transactions in order to revitalize volume, even if that means contradicting your own public policy and your own rules on minimum price increments.

All rules seek to benefit someone. But as Alexander Hamilton wrote in Federalist 62, “laws are made for the FEW, not for the MANY.” This rule claims to serve retail interests but utilizes that order flow to foster profits from data and statistical arbitrage in order to fund regulatory budgets. It’s the opposite of what the Securities and Exchange Act requires – that rules foster equality and promote capital formation.

Last word: Never confuse volume with liquidity. Volume is how many times things change hands. Liquidity is how much of it exists. Making the same amount change hands more times is like converting one-half to six-twelfths. It’s confusing busy with productive.

Remember, if you don’t like these rules, say so. Public companies can write to regulators, the exchanges, and your congresspersons, who oversee the SEC. Rules get reversed – or exempted – all the time.

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