August 20, 2014

Tray Dat

We’ll be listening in the car to a song on satellite radio’s The Pulse, trying to keep current, and I’ll say to Karen, “Do you understand what he’s saying?”

You may feel the same way about equity-market rules. Take for instance the Trade-At Rule.  No it’s not Tray Dat, but I think I heard that in a song on The Pulse.  We didn’t hear something sounding like Tray Dat during the Little River Band concert Sunday at Denver’s Hudson Gardens, the band touring 39 years with a revolving cast still delivering goose-bump harmonies on Lady, Take It Easy on Me, Cool Change and Reminiscing.

Anyway, the Trade-At Rule matters to IR because it sharply impacts the buyside and sellide – your two core constituencies. And if the CFO stops you in the hallway and says, “What do you think of this Tray Dat thing the SEC is considering?” you don’t want to stammer.

So here’s what’s happening.  The SEC in June directed exchanges and Finra, the regulatory body for brokerages, to develop a plan for testing wider spreads in stocks. The SEC wants three test groups for a year-long pilot program.  All three will include stocks with market caps under $5 billion, volume below one million daily shares, and prices over $2.

One group, the control, will trade as it does now.  The second will have greater tick sizes, or spreads between prices for buying and selling shares, called the best Bid (to buy) and Offer (to sell). The plan is still conceptual – the SEC in June gave market participants 60 days to craft their proposal – but it’s probable we’d see five-cent spreads.

The third group will incorporate along with bigger ticks another idea: The Trade-At Rule. Best way to describe it? If you’ve read the book Flash Boys, there’s a story Brad Katsuyama tells about seeing 25,000 shares for sale on his screen, and readying his own order to buy those 25,000 shares. His finger is poised over the keyboard, counting down, 5-4-3-2-1…click. He presses the button to buy – and the orders disappear and he gets but a small portion of what he could clearly see was available.

The Trade-At Rule would ostensibly remedy this problem by prohibiting somebody from front-running the displayed price. It would seem to force trades out of dark pools where prices can’t be seen, onto exchanges, where they can. There are exemptions for big block dark pools like Liquidnet and Aqua, and for exchanges with the best price right before the new “marketable” order arrives.

You’d think it would hurt broker dark pools and help the NYSE, NASDAQ and BATS (which alone opposes the rule among exchanges as it’s broker-owned). Kevin Foley, Aqua CEO, wrote at the traders’ community, TABB Forum, in June that it may instead prompt dark pools to become price-displaying electronic communications networks (ECNs) – back to the future! That would foster better transparency (but ECNs before almost annihilated exchanges, until exchanges went public and bought ECNs).

Now, how does it impact the buyside and sellside? Billions of dollars have been spent figuring out the current structure, leading to broker business models predicated on leveraging share-inventory profitably, and buyside schemes for generating alpha, or excess return, through the trading process. That’ll get revisited, shifting focus again from corporate fundamentals.

We’re not complaining! Structure needs changing, and tests are the best way to identify what works.  But market structure dominates buyside and sellside behavior and decision-making. Executives who lack a sense of how the market is structured will have misconceptions about how fundamentals price shares.

Which leads to the central conclusions for you, in the IR chair: Market structure statistics have got to be more than Tray Dat to you. Second, the more complicated market rules are, the less your core constituencies can focus on your story, and buying it.

Finally, public companies should have a say in this pilot program! NIRI could organize those interested in participating. We can only plant the seed – the rest is up to you.  Power to the IR chair!

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