June 30, 2004
Recently, some alternative trading systems ATSs have begun a campaign to repeal what is called the trade-through rule for stocks traded on the New York Stock Exchange. The trade through rule sets price as the priority for routing orders to markets. Right now if an order to buy sell arrives in the market it must be routed to the venue quoting the lowest sale highest purchase price. Since the NYSE quotes the best prices over 90 of the time, most orders get routed there. The ATSs think that is unfair and argue that investors should be allowed to set other priorities for routing their orders such as speed. Therefore they have lobbied members of Congress to repeal or drastically alter the trade through rule.
There are two types of orders in markets market orders and limit orders. While market orders demand immediate execution at the best price hopefully, limit orders state the best price they are willing to trade at. Limit orders make up the bulk of the trading at the NYSE and most markets around the world. Limit orders are involved in over 80 of the trades on the NYSE.
Think of a limit order trader as a child selling lemonade outside their house. Theres not much business if the stand is on a dead-end street and more lemonade will be sold on a main road. In fact, more traffic on that road will probably result in more lemonade stands. Now imagine that a bypass is set up and drivers chose the faster bypass to move through town. Without that traffic, many of the lemonade stands will close and drivers on the old route looking for a drink will have less choice and will probably pay a higher price for the same product.
The analogy can easily be applied to limit order traders. They buy from and sell to market order traders. If enough market order traders choose to leave, then so too will the limit order traders. Limit orders are shock absorbers for liquidity events. Without limit orders to absorb trades from liquidity demanders, large orders will increasingly push prices away from current prices. While it may be argued that price impact is a fact of life for institutions, I am more concerned about the small trader that submits an order in the same direction, but just behind the large order. The small order will execute at an inferior price before sufficient liquidity can be sent to the market by traders.
Let me state unequivocally that I am against the repeal of the trade through rule. If the rule is repealed, it will further fragment our markets and hurt investors. It would be a large step backward in the modernization of US markets.
Repeal of the trade-through rule will then discourage limit order submission and in turn increase volatility in affected stocks. A few large players will benefit but it will be at the expense of the majority of long term investors stemming from higher effective execution costs for the average investor. These higher execution costs will translate into higher costs of capital for firms and in turn, stock prices will fall making it more difficult to raise capital and hence provide a drag on the economy.
Interestingly, an important endorsement for the benefits of the trade-through rule comes from a powerful source the SEC itself. While the ATS critics clamor for repeal of the trade-through rule for NYSE stocks, the SEC has recently suggested extending the trade-through rule to NASDAQ stocks products which are the province of ATSs.
If markets want to compete they should do so on price which is the current structure. However, the entire notion of markets competing is problematic. True competition is between natural buyers and sellers. I doubt if any member of the public has ever received a call from the Chicago Stock Exchange asking them to send their orders for NYSE listed stocks there but their brokers certainly have We all know the problems associated with preferencing of order flow. There are those that argue that it discourages price competition since quoting better prices does not result in more order flow. Allowing orders to be routed for reasons other than best price will increase the incidence of preferencing again taking a big step backward in efforts to modernize our markets. Repeal of the trade-through rule would be a real lemon of an idea for the NYSE and for our nations economy.