July 13, 2010

Sub-Penny Quoting and What it Means to IR

Yesterday, I was forced to set aside comedian Dave Barry’s old book, Dave Barry is Not Taking This Sitting Down, and particularly his thoughtful essay on 1992 federal legislation imposing low-flow toilets on the American people, which produced an alarming increase in toilet-flushing-related carpel tunnel syndrome, to answer a question about sub-penny front-running in stock trading.

The question was: Can smart order-routing algorithms quoting in increments of less than a penny front run the national best bid or offer?

In English this phrase translates to: “My Name is Inigo Montoya. You killed—”

Wait, wrong decoder. It means: If every trade in your stock must be made at the best available national price, according to rules established by Regulation National Market System, could someone or something trade at a different price?

The logical answer is “of course not.” The correct answer is “of course.”

Under Rule 612 of Reg NMS, quotes of less than a penny – that is, instead of $20.10, the price might be $20.1001 – are forbidden. Except for broker-dealers offering clients “price improvement.” If a broker dealer working an order for a client steps in front of the best bid or offer in that fashion, it’s allowed by existing rules. It’s no big deal on the surface because an order for 1,000 shares, for instance, would cost just ten cents more.

But suppose an investor has a limit order to sell 10,000 shares, and the price next drops to $20.09 and never again is at $20.10. What’s the cost then? While in theory only broker-dealers may do these things, the fact is that aside from a finite set of liquidity providers, the great bulk of program-driven volume today derives from broker-dealers and agency traders – who could in theory use the exception.

These things may seem unimportant to an investor-relations officer in the throes of editorial rounds on the script, the release, and the Q&A plan for the quarterly report next week or the week after. And we’ve oversimplified a complex event in the markets today that involves more than sub-pennies.

Our purpose today isn’t to vet the issue, but to put it on your radar. If someone stops you on the street and says, “What’s sub-penny quoting?” we want you to be able to do something more than make a toilet-flushing noise.

To us, it’s a structural issue. If intermediaries have any advantage at all, then why wouldn’t everyone prefer to intermediate trades rather than own things? This blurs prices. In one sense, there’s an advantage to straight auctions. Someone hosts the auction and gets a cut of the action, and then the parties at the auction place value on the goods. But if auctioneers are determining outcomes by getting pricing advantages over the participants…well, that doesn’t seem consistent with either common sense or sound principles of finance.

Now if you’ll excuse me, I’m going to look for some boot-legged high-flow toilets. I hear Canada has got them.

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