Investors see opportunity to choose speed over price

Institutional investors are closer than ever to getting what they've wanted for a long time — the ability to choose where they trade stocks.

On Feb. 24, commissioners at the Securities and Exchange Commission proposed a series of changes to the trade-through rule that would let investors choose speed over price — a choice many institutional investors have been seeking, some vocally, since the New York Stock Exchange was besieged with scandals over alleged trading abuses by its specialist firms and the outsized pay package granted to former Chairman Richard Grasso.

The new opt-out rules would allow investors to trade through the market with the best price to a market with an inferior price – within 5 cents – but quicker execution. Investors would not be allowed to trade through to other markets with comparable execution speeds. The rules are out for a 75-day public comment period, to be followed by the commissioners' vote on a final set of changes.

SEC Chairman William Donaldson called trade-through reform an effort to forge a nationwide system of price discovery, to find "through all the bids and offers, exactly what price buyers and sellers can meet at," he said at the Feb. 24 meeting.

"We do like the SEC's proposal allowing trade-through and the opt-out for investors to avoid the trade-through rule altogether," said Michele Kowalik, senior market research analyst at the $59 billion Ohio Public Employees Retirement System, Columbus. "The proposal addresses the flexibility that we were requesting."

Jonathan Miller, Kentucky state treasurer and board member of the $12 billion Kentucky Teachers' Retirement System, Frankfort, said the proposal was a step in the right direction.

"What does encourage me is that Chairman Donaldson is definitely taking matters into his own hands and is trying to push for change," Mr. Miller said. "What so many of us pushing for reform are calling for is anything that helps promote transparency and the notion that the average investor is getting a fair shake on Wall Street and that insiders and specialists are not getting any unfair advantage."

Ted Oberhaus, director of equity trading at Lord, Abbett & Co. LLC, Jersey City, N.J., said that while full repeal of the rule "would be the best thing," the opt-out feature "seems like pretty good middle ground." He said institutional investors would value the choice of opting in or out of the trade-through rule.

Critics of the NYSE and its specialist system have charged that the trade-through rule today directs most trading to the NYSE, where specialists can post the "best" prices, but by the time the orders reach the floor, that price is gone.

"The trade-through rule has protected the NYSE from competition for a long time," said Gary Findlay, executive director of the $5.4 billion Missouri State Employees Retirement System, Jefferson City. He said the proposed changes to the rule are "too little and too burdensome to abolish its bad effects."

John Thain, the NYSE's chief executive officer has countered such critics by saying the trade-through rule ensures price discovery and liquidity and that the proposed opt-out provision undermines both. He also has argued that if market centers — exchanges and electronic communication networks — have comparable trade execution speed, "I think it's the best public policy that you have to give the customer the best price."

Mr. Thain has argued that the trade-through rule serves investors well and doesn't need major overhaul.

Pointing to the NYSE's roughly 80% market share of listed trading, Mr. Thain has denied that the quoted "best price" by specialists is illusory. "If it wasn't true that we had the best prices, we also wouldn't have 80% of the volume," he told a group of reporters recently. "The idea that prices are ‘maybe' prices that you can't actually execute on is not true."

Mr. Thain has proposed changes to the NYSE's Direct+ automatic execution system that he said would allow greater access to the system by institutional investors and put the Big Board on par, in terms of speed, with other automatic execution platforms.

But some market participants, including Lord Abbett's Mr. Oberhaus, disagreed.

"It's a great idea," Mr. Oberhaus said of the proposed changes to Direct+. "I appreciate what he's attempting, but in reality, the specialist will still be able to hold an order for 30 seconds under the guise of price betterment."

Junius W. Peake, the Monfort Distinguished Professor of Finance at the University of Northern Colorado's Kenneth W. Monfort College of Business in Greeley, said he also doubted the NYSE's changes to Direct+ would put its speed on par with other trading venues. He added, however, that if all venues can trade at the same speed, the trade-through rule is not necessary.

Andrew Goldman, an executive vice president at New York-based Instinet Group, which provides electronic trading platforms for institutional and retail investors and is one of the NYSE's competitors, said the Big Board's proposals to increase automatic execution has loopholes that will limit its effectiveness in providing the speed of execution that institutional investors want.

"To the extent the NYSE truly becomes a fast market and fully electronic in the many respects it pretends to or wants to be, it shouldn't want to hold on to the trade-through rule," he said. He called the trade-through a "crutch" to allow the NYSE to jump back and forth between being a fast automatic execution market and a slower, floor-based auction model.

Mr. Goldman said the SEC's trade-through reform proposal indicated that the commission "recognizes there's a need to address this issue and there's a need to promote greater competition and greater investor choice."

Still, he said: "The devil is in the details," noting the proposal runs 300 pages.

Institutional investors agreed that regardless of how the trade-through rule is reformed, the issue is greater than simply price. They point out that speed of execution, certainty of execution and anonymity also are critical elements to a successful trade.

"The current (trade-through) rule forces investors to execute their trades on a stock exchange whose selection is based on only one variable — price," said Brad Pacheco, a spokesman for the $167 billion California Public Employees' Retirement System, Sacramento. "While we agree that the best price is a significant and needed variable, a modification to the current rule that enhances an investor's choice would improve investor freedom while preserving the integrity of the capital markets."

The trade-through rule, created in the 1970s when trading was done manually, was established to protect investors by ensuring that stock orders went to the marketplace that had the best price. The rule worked well until the advent of electronic trading platforms and automatic execution, which provided investors with the ability to trade quicker than ever.

Any reform of the trade-through rule is expected to dent the NYSE's 80% market share, which already has been slipping in the past few years as more investors seek ways to trade off the floor.

"Relaxation of the trade-through rule will allow ECNs to compete on what they do best, which is anonymity and speed," said Jodi Burns, an analyst at Celent Communications LLC in New York and author of a recent report on execution quality by ECNs. "It's a unique opportunity for them to penetrate the listed market the way they have on the OTC side."

She said execution time is likely to plummet as order flow moves to ECNs from the NYSE, although more trading will likely occur away from the "best price."

"The NYSE is a large provider of price improvement and as order flow migrates away from there, the propensity for price improvement will go down," Ms. Burns said. "But ECNs do provide price improvement so it's not quite so black and white that price improvement exists on the NYSE and not on ECNs."