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From: George Rutherfurd
April 24, 2006 Dear SEC: I wish to make two principal comments on the above-referenced rule submission:
The NYSE proposal would put the final nail in the coffin of the NYSE's historic auction market. A "Stopped Order", by Definition, Can Never Miss the Market, and the "Hybrid Market" in No Way Replicates Existing Opportunities for Price Improvement Stop orders are a well-known investment tool whereby an investor enters either a market or limit order which becomes executable only when the market reaches the "stop" price on the order. A "stopped order" is less well-known, as it is largely unique to the NYSE. Essentially, a "stopped order" is (typically) a market order that is guaranteed an execution at no worse price than the prevailing contra side market price, but which is exposed to the market for possible execution at an improved price. In its rule submission, the NYSE proposes to largely eliminate the process of "stopping" orders for possible price improvement. The NYSE contends that stopping stock in the "hybrid market" may prove cumbersome, and, in the event, is unnecessary in light of initiatives such as the NYSE's new "auction limit order." The NYSE also contends that, in the hybrid market environment, there is a substantial risk that a "stopped order" may "miss the market." Historically, the NYSE's order exposure rules, Rules 76 and 91, have required specialists to expose a buy order at a price one trading increment below an offer price, and a sell order one trading increment above a bid price, to attempt to obtain price improvement for the order. As I pointed out in several comment letters on the "hybrid market" proposal, this approach is historically rooted in the mechanism most likely to provide price improvement, and has resulted in hundreds of millions of dollars in price improvement for public investors over the years. "Stopped orders" are typically exposed for price improvement in the same fashion. (I am grateful to a recently retired NYSE specialist for some help on this). Unlike orders that are exposed for price improvement and then traded under Rules 76/91, a "stopped order" continues to be exposed as the NYSE's bid or offer until it either receives an improved price, or is executed at the price it was guaranteed to receive (the contra side price when the order entered the market). The NYSE's "auction market" and "auction limit" orders totally transform the dynamics of order exposure/price improvement to the detriment of public investors and the considerable advantage of specialists. These orders are exposed in a manner that the NYSE, per Rules 76/91, had never considered to be conducive for maximising the opportunities for price improvement. A buy "auction" order is exposed one trading increment above the bid (rather than, as historically, one trading increment below the offer) and a sell "auction" order is exposed one trading increment below the offer (rather than, as historically, one trading increment above the bid).(I present examples below). This procedure not only decreases the likelihood of an order receiving an improved price, but the NYSE has (incredibly) provided that these orders can in fact be executed at worse prices than the prevailing contra side prices existing when the orders entered the market, in the (often likely) situation where a subsequently arriving order trades with the contra side liquidity. This "price disimprovement" is a result that was impossible in the NYSE's historic auction, but will be all too common in the hybrid market for anyone foolish enough to enter these "auction" orders. The NYSE's "auction" orders obviously do not provide public investors with the same price improvement opportunities as Rule 76/91 and "stopping stock" provided in the NYSE's historic auction, and will in fact harm public investors. The notion that these "auction" orders provide a basis for dismantling the significant historic benefits received by "stopped orders" is untenable on its face. If the notion that "auction" orders obviate the need for "stopped orders" is untenable, the notion that "stopped orders" may "miss the market" is absurd. A "stopped order", by definition, can NEVER "miss the market" because it is the essence of a "stop" that the order is UNCONDITIONALLY GUARANTEED the market price prevailing when the order enters the market. The NYSE can easily program its systems to replicate electronically what is performed physically today in this regard. The NYSE is simply not playing fair when it foists this brainless nonsense upon the public. The SEC must refuse to acquiesce to the dismantling of a significant process which has historically been one of the principal vehicles whereby public investors may receive price improvement. The Economic Transformation/Dealerisation of the NYSE Market The NYSE's price improvement processes (Rules 76/91 and "stopping" stock) have worked so well over the years that it is shocking that the NYSE did not seek to replicate them in the hybrid market (particularly given the NYSE's marketing-driven assertions that the "hybrid market" maintains all the benefits of the physical auction, a position that borders on fraud). When one considers the "auction" orders and the proposal to eliminate "stopping stock" in light of the the specialist's ability to engage in algorithmic trading in the hybrid market, it becomes obvious that specialists have pushed a very aggressive economic agenda here. Not only have specialists been largely relieved of their responsibility to obtain price improvement for orders, they have been given the ability to trade in situations where historically they would have had to defer to public orders and give them the financial price improvement benefit that will now accrue to the dealer account. Example Assume that the quoted market in a stock is .20 bid, offered at .30, with the depth on each side of the market being 1000 shares of public orders on the public limit order book. Historically: If the specialist received a market order to buy 500 shares, the specialist would (pursuant to Rule 76) make a bid of .29. If no one provided an improved price to the buy order, the specialist would complete a trade at .30. The specialist would have no opportunity to buy stock at .29 or lower in this situation until the order seeking price improvement had been executed. Alternatively, the specialist might determine to "stop" the order, meaning that the specialist would guarantee the order an execution at .30, but then disseminate a bid (most likely at .29, but it could be lower) on behalf of the order. If someone provided price improvement, the order would be executed at .29, with the specialist having no opportunity to buy stock at that price or lower until the "stopped order" was executed. If no one provided price improvement at .29, and a trade took place at .30, the specialist would effectuate the guarantee and sell to the "stopped order" at .30. The "stopped order" could never miss the market, because it was guaranteed to receive no worse price than .30, the price prevailing when it entered the market. Hybrid Market: The hybrid market transforms the above dynamic to the proprietary advantage of the specialist, and the disadvantage of the public order seeking price improvement. An "auction market" order to buy 1000 shares will be displayed for as long as 15 seconds at a price of .21 (not .29 as under Rule 76). While this might appear to provide the prospect of greater price improvement for the public order, this is largely an illusion. If no sell order enters the market to provide price improvement, the order will simply be executed at .30 (the same result as under Rule 76). But if a non-auction market order to buy 1000 shares is subsequently entered, it will be automatically executed at .30. The "auction" order, which had been exposed at .21, will then be executed at the price of the next offer, which could be considerably higher than .30. This is a considerable disadvantage to the "auction" order, which is,in effect, punished for having the temerity to seek an improved price. So much for the notion that these absurd "auction" orders replicate the benefits of today's physical auction. But what if a sell order is entered that could provide price improvement to the "auction" order? This is where the NYSE's "hybrid market" is truly insidious. Once a bid is made at .21 on behalf of the auction order, the specialist's algorithm is free to electronically intercept any incoming sell order that would otherwise provide price improvement to the "auction" order. The specialist could, for example, buy the stock at .25 or .26, denying price improvement to the very "auction" order that attracted the incoming sell order. It is clear, in weighing the harm versus the benefits of "auction" orders, that public investors will be getting the short end of the stick a good deal of the time, whereas that ratio is entirely reversed in today's physical auction. And there is no reason (other than specialist self-interest) why today's benefits cannot be electronically replicated in a true hybrid market. It is obvious that the NYSE (with no discussion or justification whatsoever) totally gutted its "price improvement" processes to ensure that quote spreads remained wide enough for specialists to seize proprietary trading opportunities, with "auction" orders serving as the bait. In the "hybrid market" approval order, the SEC simply regurgitated the NYSE's formulaic pabulum about the benefits of "auction" orders, and presented no critical analysis on what is a nitty-gritty economic issue of fundamental importance to public investors. This issue is both stark and simple: Who gets to trade with those who would provide price improvement, the public that attracts the price improvers in the first place or the specialist? Shockingly, the SEC gave the wrong answer in the hybrid market approval order, notwithstanding the Commission's insistence on public order protection in the Regulation NMS releases. (See my March 27, 2006 comment letter on SR-NYSE-2004-05). The Commission, on behalf of public investors, must insist that the NYSE retain its "stopping stock" rules, and update them for maximum automated efficiency going forward. If the Commission nonetheless determines to approve the NYSE proposal, the public is entitled to a detailed analysis and justification (no conclusory assertions or simple regurgitation of the NYSE's position, as in the hybrid market approval order) as to why specialist self-interest should transform the economics of order execution on the NYSE to the detriment of public investors. Sincerely yours,
George Rutherfurd |