Donaldson's flawed stock exchange rule
Published: April 5 2005 03:00 | Last updated: April 5 2005 03:00
Tomorrow, the Securities and Exchange Commission is expected to pass a new set of regulations for stock market trading in the US. Having pondered long and hard over how to reform the "trade through" rule that has favoured the New York Stock Exchange, William Donaldson, SEC chairman, looks set to extend the rule to Nasdaq, thus upsetting many institutional investors and Nasdaq itself.
There is nothing wrong with upsetting Wall Street per se, but Mr Donaldson is not justified in this case. He has dropped an earlier version of his plan that would have been even more dirigiste in determining on which market a trade is executed. But the remaining proposal is a solution in search of a problem. To extend rather than to abolish the trade through rule is going in the wrong direction.
The trade through rule mandates that any order to buy or sell shares on an exchange must be directed to the marketplace that offers the best price at the time of the order. That has been to the benefit of the NYSE and its specialist market-makers because the Big Board usually offers the best price. It has equally hampered electronic networks such as Archipelago.
That sounds fair, if investors can get the best price by going to the NYSE. But the best price at one moment may not be obtainable the next. Even a retail investor with a small order can find the price moving against him before the trade is executed. The problem is far greater for an institution that wants to deal in a size that is likely to change the price.
The trade through rule makes it harder for institutional investors to agree a price for a block trade on an electronic exchange that offers a slightly worse price than the one theoretically available on the Big Board. But there are reasons - apart from the possibility of price volatility - why an institution might prefer speed and certainty to the "best price".
Mr Donaldson has managed to unite large institutional investors, brokers and his two fellow Republican commissioners against his position. He will require the backing of the Democrat minority to push through the reform. So far, he has failed to articulate why a cumbersome regulation is preferable to letting investors decide where and how they want to execute trades.
Mr Donaldson has suggested that an overall regulation is needed to maintain the confidence of individual investors that they obtain the same price as institutions. But the same end can be achieved more simply by ensuring that the best execution requirement on brokers is strictly enforced. An extended trade through rule is unnecessary and may do more harm than good.
The biggest danger is that, by restricting the use of alternatives to the NYSE and Nasdaq, the SEC limits innovation in stock market trading. Trading volumes have already risen sharply in recent years as it has become easier and cheaper to trade electronically. The electronic networks have contributed to this trend, which has helped to reduce trading spreads and make markets more liquid.
Mr Donaldson's tenure at the SEC has helped to restore a sense of momentum to the institution after it was caught off-guard by state activism, notably the crusading investigations of Eliot Spitzer, the New York attorney-general. But the SEC's role is to encourage transparency and the free flow of information in markets, not to dictate how investors must behave. That way, danger lies.
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