Latest Nasdaq Order Routing Scheme: “Retail Trader, F*** You”

The folks at Nasdaq never cease to amaze us.  Rather than focusing on adding value to their listed public companies, they seem to be constantly looking for ways to disadvantage some of the least sophisticated market participants – the retail investor.  The latest proposal from Nasdaq is yet another order routing scheme designed to hand over valuable order flow information to their electronic market maker clients under the pretense of “price improvement”.

We wrote about this proposal back on June 10th when Nasdaq first issued a Trader Alert announcing that they would be proposing a new retail order routing process.  Last week, they filed a more detailed SEC proposal hoping that the SEC would approve their new routing scheme which is known as RTFY (Nasdaq doesn’t define the acronym in the proposal but we think it stands for “Retail Trader, F*** You”).  Here is how Nasdaq is proposing to route retail orders:

1)  NASDAQ will allow retail brokers to enter non-marketable limit orders into the new RTFY order routing option for evaluation.

2)  NASDAQ will determine if the non-marketable limit order may in fact be marketable.

3)  NASDAQ will take these retail limit orders that were non-marketable and meant to be limit orders on the NASDAQ book, and instead send them to electronic market makers directly.

4)  NASDAQ assumes that most of these retail orders will be filled by the electronic market makers.  If the  market makers still do not want to be counterparty to the retail order, then it will finally make its way back to the NASDAQ limit order book.

Listen to how Nasdaq explains the RTFY order routing process:

Rather than allowing the marketable DROs (“Designated Retail Orders”) to immediately remove liquidity from the Exchange order book (unless explicitly instructed to do so), the order will be routed to destinations in the System routing table to increase price improvement opportunities for the DROs.  RTFY may remove liquidity from the Exchange book after routing to other destinations.”

It seems like Nasdaq is assuming that retail investors would gladly give up their right for their marketable orders to interact with the NBBO for some meaningless price improvement.  They state in their filing that electronic market makers will only “likely provide” price improvement for the retail orders.  But what if one of these market makers decides that rather than fill the order, they will simply take that stock for their own proprietary account? What happens to the RTFY order then?  In one of the most egregious paragraphs we have ever read in a SEC filing, Nasdaq spells out in black and white one example of how they will disadvantage the retail investor:

To illustrate how the RTFY routing option would work, consider the following: NASDAQ Quote: $50.00 x $50.02 (100 x 100) 

o Order 2 is received to buy 100 shares at $50.02 RTFY
Order 2 does not check the NASDAQ book
o Order 2 is routed but receives no execution
o The NASDAQ quote updates to $50.00 x $50.03 (100 x 100) while Order 2 is routing 

o Order 2 is posted on the NASDAQ book at $50.02

o The NASDAQ quote now reflects Order 2 $50.02 x $50.03 (100 x 100) 

Nasdaq just described their own failure to obtain best execution and they actually expect the SEC to approve this proposal! To make matters worse, they have not and will not disclose where they are routing their RTFY orders.  They claim their routing table is a “proprietary process” which is monitored by a “best execution committee” made up of internal Nasdaq participants.

Nasdaq is trying to convince the SEC to approve this routing strategy by claiming that the SEC already approved a similar Nasdaq routing strategy (“TFTY”)  as well the fact that BATS has a similar strategy (“TRIM”).  They are claiming that this order routing approach is innovative and drives competition.  We urge the SEC to look past these superficial and selfserving arguments and to disapprove this rule change based on the grounds of failure to obtain best execution and lack of routing transparency.

We find it very disappointing that a stock exchange has to stoop to such a low level to keep their biggest clients happy.  We believe that it is highly likely that they cooked up this routing scheme with the help of their retail broker and electronic market maker clients.  They even admitted that the routing scheme was the “result of a dialogue initiated by NASDAQ more than a year ago with members and non-members regarding various ways the Exchange can help improve execution quality for retail investors”.  

Even if the SEC were to somehow approved this routing scheme, retail investors should realize that they have a choice when routing their orders.  They do not simply need to use the broker provided router.  They can elect to send their orders directly to a particular destination.  All they have to do is demand that their broker provide this function or switch to a broker that will.