Wall Street Debates Rule Requiring Brokers to Seek Best Advertised Stock Prices

The headquarters of the U.S. Securities and Exchange Commission in Washington, D.C. (Saul Loeb / AFP / Getty Images)

A panel of Wall Street executives gathered at the U.S. Securities and Exchange Commission on Thursday to debate a rule designed to make sure investors get competitive prices.

It’s called the Trade-Through Rule and it is one of the ways regulators require stockbrokers to seek the best trade for their clients in a fragmented U.S. market where a stock or options order can go to any of 16 exchanges and 33 off-exchange dark pools.

Since 2005, the rule has forbid a broker from sending an order to one of those venues at a price worse than the best price displayed at another venue. By preventing such a “trade through,” the rule rewards exchanges for marshaling well-priced quotes and helps get the best execution for customers’ market orders.

And thanks to the rule, retail traders know that their limit orders won’t be ignored, said Pankil Patel, who runs electronic stock trading at BofA Securities, which handles about 15% of U.S. equity volume.

But the Trade-Through rule is one of many that has irked the SEC’s regulation-wary Chair Paul Atkins, and that was the reason for Thursday’s roundtable discussion on whether best execution can be obtained in other ways.

The rule has had unintended consequences. It was supposed to increase overall market liquidity, but it also fragmented that liquidity.

Most panelists agreed that the rule’s compelled order flow has inspired the formation of copycat exchanges that rack up trading and data fees, despite skimpy trading volumes. It has also contributed to an expensive technology arms race among brokers, in which fast-trading firms can skim profits from momentary price differences among the venues. These costs burden the industry, but they get passed on to customers.

The top five exchanges handle 41% of stock trading volume, while none of the other 11 have more than 3%, noted Dan Mathisson, an SEC policy advisor. Eight exchanges actually have less than 1% market share—and additional exchanges are on the way. The cost of connecting to all these places has driven half of all brokerage firms to outsource their execution. Only about 20 brokers now connect to all exchanges.

BofA’s Patel told the panel that it costs about $1.5 million to connect to each new exchange, plus maintenance of about $200,000 a year, per exchange.

Citadel Securities is the biggest U.S. market maker in stocks and options, so the broker has a lot of connections, said its head of execution services, Joe Mecane. Citadel estimates that the brokerage industry’s aggregate cost for connecting to all the small trading venues is about $375 million a year—with roughly half for stocks and half for options. Because the venues get some two-thirds of that amount as revenue, those dollars help explain why new exchanges keep forming.

Copycat exchanges don’t bring innovation or liquidity to the market, said Dave Lauer, a longtime advocate for retail investors who works at Urvin Finance. The fees charged by exchanges and the trading by speed-endowed brokers have become a kind of rent extracted from the market.

For all the panel’s hand-wringing about the Trade-Through rule, most agreed that it shouldn’t be abandoned altogether. The rule has become part of today’s market structure, and interacts with many other factors affecting trades.

“Figuring out the contributing factors in the positives and negatives of some of the rules that we have in place here are very difficult,” said Mecane. “As an industry and at the SEC, we need to be thoughtful about how all of those fit together.”

That doesn’t mean the Trade-Through rule can’t be improved.

An exchange’s best-priced quote should still get protection from trade-throughs, Mecane suggested. But the fees an exchange receives for its quote data should perhaps be tied to its trading volumes, he said. Until volume on an exchange reaches some threshold, those fees could be withheld or capped.

Lauer suggested a cost-plus model for data fees, which is an approach advocated by the exchange operator IEX Markets and some European locales.

These suggestions for price controls may not align with the policies of the Atkins commission. It remains to be seen how the SEC follows up on its roundtable.

Write to Bill Alpert at william.alpert@barrons.com