They Threw Me In The Shark Tank Paulie! (Internalization and Sub-Penny Pricing)

Price-improvement. Ah yes – many of us have been conditioned to believe that the small executions with the many decimal places save us money. Many of you even receive emails from your execution vendors/brokers that break out the “savings” for you each day on trades executed through them. In our Friday note to you we detailed how Fred and Ethel, if they saved a tenth of a penny on a trade, would save a whole whopping pair of dimes on  a $5,000 purchase. To put their savings in perspective, imagine if they went to buy a new Honda Civic from a car dealer, and the salesman told them he would take 80 cents off of the MSRP of the vehicle.

This morning we delve deeper into the world of sub-penny price improvement, with the help of Eric Hunsader, who did a nice piece you should all read: Sub Penny Trade Price Anomaly.

He examined on a daily basis the scattering of sub-penny prints on the tape, and he noticed the specific clustering of sub-penny prints at certain sub-penny price points. Please look at the red wedge in the below pie chart (36%). Eric found that 36% of all sub-penny trades occurred just 1/100th  of a penny away from the displayed quote. Said another way, 36% of all sub-penny prints are providing you with a price improvement of just 1/100th of a penny.


Eric continues with his sub-penny analysis. He reasons that there are three parties with a stake in each sub-penny trade. They are:


1)      Investor A who received the sub-penny price improvement.

2)      The HFT market maker who provided the improvement.

3)      Investor B with a limit order in the public quote who lost out on the trade, because the first investor’s order that otherwise would have interacted with him was intercepted through the use of some variant of Flash Order Like Communication and Payment For Order Flow arrangements (this category is almost NEVER mentioned when you hear HFT market makers, exchanges, and “liquidity providers” talk about how they all help you).


Eric breaks out the economic dollar value of all these sub-penny trades, and how it is shared.

And just how is it shared? On just that one day, those sub-penny prints totaled to a total pie of $4,148,321. HFT market makers took $3,578,305 of that total, Investor A garnished $570,016 of the total, and Investor B lost the whole piece to the other two. As Nanex notes, it is “A lot like robbing Peter of $100, paying Paul $1 and pocketing $99.”

We will add that Eric’s analysis does not assign an economic value to the effect that the above practice has in terms of deterring real investors from placing limit orders in the public markets. That would be a tall order, as it is a nebulous but conceivably very large number. After all, why would anyone bid 50 cents for a stock out loud, when they are guaranteed to be last man in the queue of bids, and HFT market makers can step in between their bid and other investors sell orders that should have interacted with it, and only when it suits them?


Eric closes his piece with highlighted text taken directly from Reg NMS. The SEC knows this is going on; highlighted these exact issues (internalization) in the market place that Eric (and all of us) speak of, and yet continue to approve mechanisms that perpetuate the practice (NYSE RLP program Approval).


Rule 612 addresses the practice of “stepping ahead” of displayed limit orders by trivial amounts. It therefore should further encourage the display of limit orders and improve the depth and liquidity of trading in NMS stocks. The proposed rule was designed to limit the ability of a market participant to gain execution priority over a competing limit order by stepping ahead by an economically insignificant amount.


When market participants can gain execution priority for an infinitesimally small amount, important customer protection rules such as exchange priority rules and NASD’s Manning rule could be rendered meaningless. Without these protections, professional traders would have more opportunity to take advantage of non-professionals, which could result in the latter either losing executions or receiving executions at inferior prices.


Widespread sub-penny quoting could decrease market depth (i.e., the number of shares available at the NBBO) and lead to higher transaction costs, particularly for institutional investors (such as pension funds and mutual funds) that are more likely to place large orders. These higher transaction costs would likely be passed on to retail investors whose assets are managed by the institutions.


As one commenter, the Investment Company Institute, stated, “this potential for the increased stepping-ahead of limit orders would create a significant disincentive for market participants to enter any sizeable volume into the markets and would reduce further the value of displaying limit orders.”



So what exactly is the SEC thinking in still allowing, and even encouraging the practice?


Kudos and thanks to Eric at Nanex for quantifying what we all intuitively feel, and helping place the issue in perspective.