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Trade-Through: A Rule in Search of a Reason

Author: Benn Steil, Senior Fellow and Director of International Economics
May 17, 2004
Securities Industry News


The recent Baruch conference on “Electronic vs. Floor Based Trading” might as well have been titled “Electronic vs. Floor Based Trade-Throughs,” such was the passion invested in the debate over the famous rule’s possible demise. Trade-through mania, it seems, is sweeping the Street.

A befuddled German friend came up to me afterwards and said he couldn’t understand a single reason for the trade-through rule. Germans, of course, can’t understand a single reason for lots of stuff over here. Like Budweiser and Rumsfeld.

So to help him, I’ve put together a list of all the good reasons for a trade-through rule and translated them into German.

I’m kidding of course. I don’t actually know any good reasons. But I did write down stuff that the rule’s apostles say at conferences.

1. “Why should speed be more important than price?”

The whole debate is allegedly about whether traders should be allowed to sacrifice best-price in the pursuit of speed. In essence, those who wish to trade through are to be seen as crazed videogamers, lusting for the thrill of split-second executions, oblivious to how many teenies it costs to feed their reckless addiction.

The notion that investors would sacrifice price for “speed” is silliness. In the marketplace, it is always about price. It is about the price for the number of shares the trader wants to trade, not just the 100 shares advertised on the floor, and it is about the price that is really there when the trader wants to trade. Statistics about fill rates and response times make lovely input into a trader’s decision, but they are not substitutes for a decision.

2. “. . . but the rule is necessary to protect market orders!”

The normal fiduciary principle says that “the agent must act in the customer’s interests.” But the trade-through rule says that “the agent must ignore the customer’s interests.” In other words, to eliminate any possibility that a broker may abuse discretion, forbid not only his own but his customer’s!

Do you want 10,000 shares at 20 bucks a share, done at a key stroke? Tough. You get a hundred at $19.99 plus a floor auction . . .

Speaking of floor auctions, ever notice that the same folks who insist that brokers and their customers will abuse discretion will defend to the death the right of specialists to use discretion? This view, curiously, is entirely unburdened by knowledge of the $241.8 million in fines paid by five of the seven NYSE specialist firms for improper discretionary trading.

3. “. . . but the rule is necessary to protect limit orders!”

Whoa, target shift. Forget about market orders now, the really important thing is not to let a hundred-share limit order go unexecuted. This is an interesting principle for the NYSE to defend, given that the floor could not even exist were it not for the ability of specialists and floor brokers to trade in front of limit orders.

In a marketplace, it takes two to trade. The guy who puts in a limit order in market x has no moral standing over the gal who sees a better package deal in market y. Appeals to “fairness” are just a diversionary tactic in this debate.

4. “ . . . but if limit orders are traded through, no one will place them!”

No, they just won’t place them in that market. If limit orders get traded through in market x, they will move to market y, where they won’t get traded through.

5. “. . . but a fair compromise is to have a trade-through rule among ‘fast’ markets.”

Mind the gap. Those at the Baruch conference will have heard Cathy Kinney say repeatedly that in the fast NYSE of the future there must be a role for the floor auction. This means that the NYSE will only be “fast” for as few shares as the SEC will let them get away with. So you still want those 10,000 shares at 20 bucks a share? Still no dice. The NYSE will give you a few hundred at $19.99, lickety-split, but then – just like old times - the floor vultures dive in.

The most perverse thing about this debate is that the leading defender of the trade-through rule is its only systematic violator. The NYSE trades through other markets hundreds, even thousands of times a day. So to those who say that the worst thing in the world for the NYSE would be for the SEC to abolish the trade-through rule, I say - lighten up! What if the SEC were to enforce it instead?

Benn Steil is the André Meyer Senior Fellow in International Economics at the Council on Foreign Relations

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