A dubious rule, through and through

The SEC, says the AP, is set to approve an extension of the "trade-through rule" to electronic markets such as the NASDAQ. Which is a shame.

The rule, long a mainstay on the floor of the New York Stock Exchange (NYSE) requires brokers to execute trades at the lowest current price. Which sounds great in theory, but doesn't always work that well in practice. For one thing, it can make large trades complicated and uncertain. Hidden behind that price you see in the back pages of your Wall Street Journal every day is a constantly fluctuating auction of shares in a particular company. It arises from the interaction of many sellers and many buyers, each trading different-sized lots (clusters of shares) and coming to the table with different bids and asks (prices at which one is willing to buy and sell a share, respectively). The trade-through rule requires that your trade be executed at the best price, which it defines as the lowest price if you're buying and the highest price if you're selling.

What could be wrong with that? Potentially a lot, if you're a big investor (and those are the ones who count in this argument, since small investors aren't the ones who make the type of trade where this matters, and have no business trying to do so). If you are trying to buy a large block of shares quickly (say, 10,000) but the best price is only available on a 100-share lot, your broker will first have to buy that 100 shares, and then the 5,000-share lot that might offer the next-best price, then the 2,500-share lot with the next-best price after that, and so forth until he has cobbled together your 10,000 shares. This can be a time-consuming process, during which the price may continue to fluctuate. Meaning that you will have an angst-inducing period of up to a few minutes during which you will know that your broker is executing a big, expensive deal, but you won't know just how expensive the deal will be. Which will probably send shares of Pepto-Bismol's manufacturer skyrocketing.

But there's an even bigger philosophical question at stake. Why is the SEC so hell-bent on inflicting an NYSE rule on other stock markets? Currently, NASDAQ and a host of other electronic marketplaces operate without the trade-through rule, and there hasn't been any clamor there to introduce it. In fact, a lot of people who actually execute trades on a daily basis seem to like the flexibility that the NASDAQ system offers to execute a trade precisely how one wants to. (Although many brokerages have publicly supported the SEC's recent move, arguably for political reasons.) If anything, the trade-through rule is one of several unpopular features of the NYSE (another being its human "specialist" system, almost unique in the western world now, in which real people actually conduct the auctions described above on a trading floor).

This unpopularity is part of the reason why the NYSE has been antsy lately about the growing draw NASDAQ seems to be exercising in the equity market. But instead of changing their own rules to conform to what traders seem to want, the NYSE has found it easier to goad a compliant SEC into making the unpopular rule the law of the land.

Despite the polemical tone of the description above, the Cranky Economist is actually agnostic about the merits of the trade-through rule per se. Perhaps brokers really do find it useful. In which case, we would expect to see them taking their business to the NYSE trading floor. But that's just the point -- we should let the market decide this one.