Thoughts On Trade-At Rule

Somewhere along the line “payment for order flow” stopped being a negatively connoted term, and now we allow it in every facet of our securities market. We are against it. We should be for it, as a more murky executing environment makes for much greater reasoning to use Themis Trading, but it is just wrong-headed.  You can gage what we think by seeing our comments highlighted below.

A good synopsis of the Trade-At Rule portion of the SEC’s Concept Release, from the law firm of Wilmer Hale:

The Commission also appears to be considering the potential usefulness of a “trade-at” rule that would

prohibit any trading center from executing a trade at the national best bid or offer (“NBBO”) unless the trading center was displaying that price at the time it received the incoming contra-side order. Such a rule would require a trading center not displaying the NBBO at the time it received an incoming marketable order either to execute the order with significant price improvement (e.g., the minimum allowable quoting increment), or route intermarket sweep orders (“ISOs”) to full displayed size of NBBO quotations and then execute the balance of the order at the NBBO price. The SEC asks a number of questions about such a rule’s ability to promote pre-trade price discovery, whether it should apply to all types of trading centers, and whether “trade-at” protection should be conditioned on a small or no access fee.

From Traders Magazine:

Call it the battle of the seen versus the unseen. The “trade-at” question in the Securities and Exchange Commission concept release pits the public exchanges against brokers who internalize trades and other off board liquidity providers.

Trading executives see no reason for the rule, given that off-board or internalized trading is only 20 percent of total market volume and the remaining 80 percent of trading flows are still done publicly. Prices, they contend, haven’t suffered and liquidity has actually been improved, bringing more retail investors into the trading markets and keeping commissions low.

“In our minds, the most detrimental issue when it comes to trade-at is of information leakage,” said Chris Nagy, managing director, order routing sales and strategy at TD Ameritrade. “If the retail order gets executed at the exchange, the high frequency traders and others will likely cancel their orders and retail clients will wind up paying higher market fees and inferior execution prices due to the information leakage.”  TD Ameritrade routes a huge % of its orders to HF firms, in exchange for $$. No Surprise.

Academics have weighed in on the effects of a trade-at rule. The Shadow Financial Regulatory Committee, an advisory group composed of 12 academics, wrote in a comment letter to the SEC that focusing on long-term investors and trying to protect the direct retail trader reflects a naive view of the interests of investors and traders. Furthermore, when referring to price impact and trading, the authors said it is inappropriate for the SEC to dictate the trading strategy as well as the display requirements of institutional orders, unless it can demonstrate strong externalities associated with the display.

Liquidnet: “The equities market is working. Particularly when you look at how bid/ask spreads are narrowing, it’s been good for investors,” said Howard Meyerson, general counsel at Liquidnet. “There are still challenges for institutional traders, but it’s better to let traders work through those challenges than have the SEC dictate how they can or cannot trade.” Liquidnet’s model depends on HFT players now, as well as institutional investors. No Surprise. Also as a “dark player” their worst nightmare is an environment where displayed orders get better treatment over dark orders.

Buyside traders are not in favor of a trade-at rule, either. According to one source who recently attended a buyside conference in New York, a straw poll was conducted on the question and not one buysider in the room raised his or her hand in favor of the rule. What an irresponsible statement! So heresay that a guy moderating a “buyside conference” (buyside = HFT firm? Mutual fund? Huh?) said no one in the audience raised their hand in favor of a Trade At Rule means that Buysiders are not infavor? How about asking a buysider at the next TraderForum meeting if, as he offers stock at $30/share publically on an exchange or ECN, he minds that others get the option on incoming market buy orders to make sales all day long instead of him?

Len Amoruso, chief compliance officer and general counsel at Knight Capital Group agreed and said more research and data on market performance needs to be conducted to determine if the market is in need of trade-at. “Trade-at is a solution in search of a problem,” Amoruso said. “However, we don’t know exactly what the problem is yet.”  Uhhh I think Knight has a stake in this as well. No surprise.

The following is a point of view you will not hear on Tabb Group’s Forum. Dennis Dick of Bright Trading is against sub pennying.  I won’t highlight it because it is concise, well written, and I would just bastardize it in my attempt.

“Trade-At Rule” a Good Solution to Sub-Penny Issues

The SEC’s concept release on equity market structure, offers a good solution to a serious problem that is occurring in our two-tiered market structure.


An abusive strategy that has been occurring with increased frequency is a practice called “sub-pennying”.  It is the practice of a market participant stepping in front of a displayed limit order by 1/100ths of a penny (this practice is outlined in detail on my website,

SEC rule 612 prohibits market participants from displaying orders in a sub-penny increment.  Most broker-dealers will not even accept these sub-penny orders from their customers. So brokers can’t accept order in sub pennies, but they can trade them. Huh? While I get mid point pricing, that does not explain all the 1/100th of a penny reports etc.

Broker-Dealer Internalization

However, broker-dealers themselves are exempt from SEC Rule 612, to provide “price improvement” to their customers.  When an investor places a market order from their retail brokerage account, their broker-dealer routes this order to their OTC market maker.  The market maker then decides if they want to trade against their customer, by taking the opposite side of the order.  If the market maker believes they can make money by trading against their customer, they will fill the order from their own inventory.  In this case, the market order never makes it to the public exchange.  This practice is known as broker-dealer internalization.

Statistics from the SEC concept release, state that 17.5% of all trades are internalized by broker-dealers.  A more alarming statistic from page 21 of the release states that, “a review of the order routing disclosures required by Rule 606 of Regulation NMS of eight broker-dealers with significant retail customer accounts reveals that nearly 100% of their customer market orders are routed to OTC market makers.”  This means that almost every single market order placed in these retail brokerage accounts, is checked by the broker-dealer’s OTC market maker to decide if they can make money by trading against their customer.  They can legally trade against their customers as long as they match or beat the NBBO.  The NBBO stands for the National Best Bid and Offer.  It consists of the highest posted bid, and the lowest posted offer on the publicly available exchange. It is the best publicly displayed market for the stock.

Nominal Price Improvement

Broker-dealers will often beat the NBBO, by a nominal amount, often as little as 1/100th of a penny.  This gives them justification for internalizing the trade, because they saved their customer a fraction of a cent.  But this savings does not justify the cost to the true liquidity provider that was left unfilled.  To put this into perspective, consider a stock offered at $25.00 on the public exchange, the best posted ask price.  An investor buying 100 shares of this stock would pay $2,500.00. When the broker-dealer internalizes the fill, and beats the NBBO by 1/100ths of a penny, the investor only pays $2,499.99, a savings of 1 cent.  This nominal price improvement of 1 cent, does not justify the unquantifiable loss of the lost trading opportunity, to the person who was publicly offering the stock at $25.00.  This person, the true liquidity provider, is left holding the stock. Read this last sentence again. Like a hundred times please.

Dark Pools Being Used To Hide in Front of the NBBO

If the broker-dealer decides to pass on the opportunity to trade against it’s customer, the order is routed to the exchange.  Many broker dealers use smart routers that check “dark pools” of liquidity for a better price.  A dark pool is an execution venue that provides liquidity, but does not provide public quotations.  In other words, it is a place where a trader can place hidden orders.  Algorithmic programs can place hidden orders that automatically sub-penny the NBBO.  This can be easily done by pegging the order to the NBBO, with a sub-penny offset.

For example, the NBBO offer from the above example was $25.00.  An algorithmic program can be created to peg a sell short order to the NBBO offer with a -.0001 offset, and sent into a dark pool.  Even though the public NBBO offer is $25.00, the algorithm has a hidden sell short order at $24.9999.  If the public offer were to move down to $24.99, the algorithmic program automatically adjusts it’s offer to $24.9899.  In essence, the algorithmic program is always hiding in front of the NBBO.  This sub-penny order does not violate SEC rule 612, because the $24.9899 order is not displayed.

The market order that was sent via the smart router searches out the better price and is executed at the hidden $24.9999 price.  Again, the displayed liquidity provider is not filled. Read this last sentence again. Like a hundred times please.

Discouraging Liquidity Providers

The only time the displayed order on the NBBO is filled from an incoming retail market order, is when the OTC market maker of the broker-dealer passes on the chance to trade against their customer’s order, and there is no undisplayed orders hiding in dark pools in front of the NBBO order.  This means the only retail orders getting through to the publicly displayed NBBO, are the orders that the first two market participants have passed on.  If the first two participants have passed on the opportunity to trade against the order, there is a good chance that the incoming market order is on the right side of the market (in the short-term).  Hence, the only NBBO orders that are filled are those that are more likely wrong (in the short-term).  The displayed liquidity provider is “sub-pennied” when they’re right, filled when they’re wrong.  Therefore, there is no point to displaying liquidity. As liquidity providers become discouraged, they will place less passive limit orders.  This will lead to less depth in the market and larger spreads, both increasing the cost to investors. Read the last two last sentences again. Like a hundred times please.

The “Trade-At” Rule

In the SEC’s concept release on equity market structure, the Commission outlines the concept of a “trade-at” rule.  Quoted from the concept release on page 70, the “trade-at” rule “would prohibit any trading center from executing a trade at the price of the NBBO unless the trading center was displaying that price at the time it received the incoming contra-side order.  Under this type of rule, for example, a trading center that was not displaying the NBBO at the time it received an incoming marketable order could either: (1) execute the order with significant price improvement (such as the minimum allowable quoting increment (generally one cent)); or (2) route ISOs to full displayed size of NBBO quotations and then execute the balance of the order at the NBBO price.”

This rule would solve the problem of market participants stepping in front of the NBBO for fractions of a cent. There would be a minimum amount of acceptable price improvement, for broker-dealers to internalize the trade.  If a one cent increment was imposed, this would mean the customer from the above example would save $1.00 on their market order, a more acceptable amount than the one cent they previously saved.

Secondly, and more importantly, it puts the NBBO back to a “first-come, first-served basis”.  If a market order was placed to buy 2000 shares, and the NBBO was displaying 1000 shares on the offer, the 1000 shares offered on the NBBO would get filled, and then the broker-dealer could fill the remaining 1000 shares from their own inventory.  This would be a much more satisfactory result to the liquidity provider displaying the offer.

In regards to the practice of hiding orders in front of the NBBO via dark pools, the sub-penny order hidden in front of the NBBO is not displayed.  If the “trade-at” rule is carefully designed to include dark pool trading venues in the trading center definition, then market participants hiding in dark pools should fall under the same restrictions.

The “trade-at” rule would increase market order flow to the NBBO.  By increasing the amount of orders going to the publicly displayed market, all those issues discouraging liquidity providers are relieved.

This also forces the broker-dealers, and dark pool liquidity providers to come out of their undisplayed markets, and into the publicly displayed market.  This would increase the number of participants in the displayed market, and thereby will increase competition in the displayed market.  This would lead market participants to display quotations in greater size, and more aggressive pricing, which should lower spreads and increase the depth of the publicly displayed market.

This “trade-at” rule concept from the SEC is an excellent solution to a serious problem.

Dennis Dick,

Bright Trading LLC

Well Done, Dennis