Todays Trade-Through Rule Must Die

Opinion: First instituted in 1975, the rule aimed to make sure investors got the best available price for their stock trade-but it was enacted before electronic markets existed.

The Senate Banking Committee is seldom a hotbed of technological innovation, but the topic of a recent series of hearings was a proposed reform that would change the way stock trades are executed.

This reform, contained in the proposed Regulation National Market System, or Reg NMS for short, would potentially extend the trade-through rule, which bars brokers from executing a trade at a price inferior to the best quote on another market, from the NYSE (New York Stock Exchange) to Nasdaq.

The trade-through rule, which was first instituted in 1975, was designed to make sure investors got the best available price for their stock trade. A market system would not allow one customer to "trade through" an existing order without first matching that order. A customers order has to be routed to the destination with the best price at the moment the order is entered.

That sounds like a good idea on the surface, but the rule was enacted before electronic markets existed. Though its moving in the direction of automation, the NYSE is still at heart a manual system, with trades handled by specialists in particular stocks.

Nasdaq, however, is fully automated, so while a quote on a Nasdaq stock is currently executable, a quote on an NYSE stock is considered an indication and not a firm quote.

The trade-through rule as it stands means that if you place an order and the best possible quote is with a particular specialist on the floor of the NYSE, then your broker is required to route your order there. But a NYSE quote is not immediately executable–its more analogous to an advertised price than an actual price.

Specialists are allowed to hold an order for 30 seconds before either executing it or handing it off to another specialist—and during that time, the price may change.

Executives at the NYSE have defended the trade-through rule, saying its good for small investors. But Nasdaq members often charge NYSE specialists with bait-and-switch pricing tactics so that orders are routed to the NYSE, then executed at a worse price than what was available at the time the order was entered.

A consortium of online brokers, together with Nasdaq executives, would like to see the trade-through rule repealed rather than extended to other exchanges. Robert Greifeld, CEO and president of the Nasdaq Stock Market, said in his testimony, "We have grave concerns about the impact this rule could have on our market, and the SEC has expressed no need for the rule on our market other than that it would promote uniformity of regulation.

"Critically, the SEC has not analyzed or assessed the impact of the rule to the Nasdaq market, yet it seems prepared to dramatically alter the way our market works," Greifeld said.

Phylis Esposito, Ameritrades chief strategy officer, who testified on behalf of the consortium of online brokers, also would like to see the trade-through rule repealed. But if it is extended, Esposito and the consortium believe that all of the markets should be automated all of the time.

"Wed like to define an automated market to say that quoting and trading are synonymous," Esposito said. "A quote should be a firm quote, not an advertised quote—and immediately executable."

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The consortiums view would alter the way the NYSE operates and also would make the quotes that online brokers customers see on their screen more meaningful. As Esposito said, "When the NYSE looks out and sees the growth of the ECNs and electronic marketplaces and online investing, they have to see that they have to make some changes."

The problem with extending the trade-through rule from the NYSE to Nasdaq is that the two exchanges operate differently. The effect on the automated Nasdaq system would be to drastically slow it down, when one of the advantages of the system is the way it automatically matches buyers and sellers.

Changing the rules so that quotes on NYSE stocks are immediately executable—rather than merely indications of possible pricing—would level the investing playing field. The current incarnation of the NYSEs trade-through rule, given the vastly different rules that apply to the different exchanges, should not be extended to fully automated exchanges.

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