Institutions at odds with retail over SEC's Order Protection Rule

For many institutional traders and analysts, getting rid of the Securities and Exchange Commission's Order Protection Rule is a no-brainer, making it easier to trade in large blocks.

But that's not the case for retail investors, who value the rule that requires equity trades to be executed on the exchange that offers the best price.

And that institutional vs. retail tug-of-war is being played out in the SEC's Equity Market Structure Advisory Committee.

“I give (the rule) mixed reviews generally,” said Steven Glass, president and CEO of Zeno Consulting Group, a Bethesda, Md.-based consultant to pension funds on trading issues. “But look at the market structure committee; even they are split. I think there's a message in that. A lot of people aren't sure of doing away with OPR.”

Members of the advisory committee, which is tasked with recommending what overall changes should be made on market structure regulation, failed to agree on whether to keep or remove OPR, also known as Rule 611, at their last meeting, April 5.

Committee members representing predominantly retail money managers said the rule protects the smaller investor's interest in the face of larger investors like pension funds and institutional managers that crowd them out with block trades.

Meanwhile, members from managers with institutional clients said the rule negatively affects larger investors who trade bigger blocks of securities. They say it forces managers to find the exchange with the best price, sometimes in opposition to best execution because trading at a venue based solely on best price doesn't take into account variables like venue liquidity and cost.

The rule has been in effect since 2005 as part of Regulation National Market Structure, or Reg NMS, created at a time when equity markets were dominated by two exchanges — the New York Stock Exchange and Nasdaq. “It was a good thing initially,” said Mehmet Kinak, vice president and head of global equity market structure and electronic trading at T. Rowe Price Group Inc., Baltimore, and a member of the SEC advisory committee. “One positive was it got NYSE out of the manual process and into electronic trading. Now, 12 years later, 13 exchanges can talk to each other quickly. We're supportive of that. But we're not going to go back to manual exchanges if you get rid of OPR.”

Added Peter Maragos, CEO of Dash Financial Technologies, a New York-based trading technology and analytics provider: “Institutions look for liquidity at the right price with minimal impact on the market. They like to put up large blocks and get fair prices on them. They shouldn't be impacted because of their large footprint. They also want to trade easier. OPR did the opposite; it caused the proliferation of more exchanges. It's the biggest cause of the fragmentation of the equity market.”

Among the issues with OPR that negatively impact institutional investors and asset owners are its effect on block liquidity and the conflict between selecting venues based on best price vs. on broker analytics that suggest routing orders to other venues would be optimal, said David Weisberger, head of equities at ViableMarkets, a trading technology and market structure advisory firm in New York.

“The rule makes provision of block liquidity harder, as the requirement to sweep the market and immediately print the trade allows proprietary, high-frequency traders to out the liquidity providers' position and take advantage of it,” Mr. Weisberger said.

Also, Mr. Weisberger said, if brokers ignore their own analytics because of the best-price requirement, “The result could be inferior prices for their client, which is a violation of best execution principles, but the broker is forced to do so by the requirement of the OPR,” Mr. Weisberger said.

Not all high-frequency trading is bad, said Zeno's Mr. Glass. “For the most part, high-frequency traders add liquidity. They just happen to trade really, really fast, but the liquidity they add is a net plus for the market. But then there are predatory traders — those who do latency arbitrage. They try to detect the largest institutional order, and then put out a price order that might be attractive in terms of luring the large trader. That's their tripwire. Now the high-frequency trader knows there's all these shares out there, and they can snap them up and then sell them at a penny more a share.”

Active money managers also feel the sting of the rule, Mr. Weisberger said. “While there are many reasons that active is losing out to passive management, one reason is that market structure is currently biased toward passive investors, who trade mostly into the closing auction each day, and retail investors who trade in small sizes throughout the day,” Mr. Weisberger said.

“Active managers also trade during the day, but tend to trade much larger size,” he said. “Those managers — particularly with regard to small-cap and midcap stocks — have difficulty finding liquidity.” He also said OPR's indirect effects, hampering innovation and making equity trading more complex, make finding liquidity even tougher for active managers.

Mr. Kinak said some committee members believe “the mom-and-pop investor will be hurt” if the rule is removed, but the majority of retail orders “are market orders that go to wholesalers with a best-execution obligation. They make sure best execution is measured. We need to have that kind of transparency on the institutional level ... That allows us to lead to better conversations around best execution.”

There are others on the institutional side who think the rule should stay.

“You can make this a better market without removing Rule 611,” said Joseph Saluzzi, partner, co-founder and co-head of equity trading at brokerage Themis Trading LLC, Chatham Township, N.J. “The story is adding liquidity and getting rid of the conflicts and noise, not removing the rule entirely ... There are ways to protect yourself now that weren't there 10 years ago.

“People who want to are missing the issue here,” Mr. Saluzzi said. “They're looking for a solution to a problem, but Rule 611 isn't the problem. High-frequency traders started this argument, and the buy side is buying into it. They don't want to connect to all these venues. That means more trading costs. They think that by getting rid of (Rule) 611 that they'll save money. Someone sold them on this. The buy side is right about this, though - HFT guys put all sorts of traps out there for institutions to display their blocks and then they bang the stock in front of them. But there's already technology to get around (the impact of high-frequency traders).”

Headline risk surrounding the removal of the rule also is a concern, said Messrs. Glass and Kinak. “Would investors get nervous if you eliminated OPR?” Mr. Glass asked. “You could make that argument.”

Asset owners reached for comment on the story said they did not have an opinion on the rule, which Mr. Kinak said wasn't a surprise.

“The SEC motto is, "Do no harm,'” Mr. Kinak said. “They don't want to do anything that appears to hurt the retail investor. When you look at the details of removing OPR, you'd think it wouldn't be too bad to do, but you don't want it to appear that the retail investor is being taken advantage of by the big institutional investors, but also by the sell side. They don't want the retired teacher thinking that his pension fund is taking advantage of the retail investor. So pension plans may have an opinion on the rule but they stay on the sidelines.”