With the SEC poised to vote on what could be the biggest transformation to the New York Stock Exchange since its founding in 1792, fund companies still think the new rules are flawed.
While the goal is to update the national market system by executing orders at the best price regardless of which exchange that price exists on, even if that means taking the order off the live auction market and putting it on an electronic crossing network, the Investment Company Institute says the controversial broker agency interest file will defeat that objective by keeping hundreds of thousands of orders the private domain of NYSE floor brokers.
The proposed changes come amid a huge power play for market share between NYSE, Nasdaq, Archipelago and Instinet, as electronic exchanges continue to take away business from the Big Board. They also come amid growing complaints over the inefficiency of orders on the exchange, a situation alleviated in the last two years with the advent of decimalization, the process of quoting stock prices in decimals rather than fractions. Simultaneously, the SEC is considering a series of reforms to enhance and modernize the regulatory structure of the U.S. stock markets.
Although NYSE has amended the new hybrid market regulations three times since February, even in its latest amendment on Nov. 15, the exchange has not backed down on the broker agency interest file, which allows brokers to keep a separate, unpublished listing of orders that they can work privately at auction or electronically.
NYSE's hybrid market proposal amendments "are an improvement over the first draft of the proposal," said Ari Burstein, associate counsel at the ICI. "But it still causes us concern."
The ability for the floor broker to hide the full amount of the order is a necessary part of the live auction system, observers say. Otherwise, if an institutional investor, such as a mutual fund, were buying or selling a huge block of shares, everyone would know, and the markets would move dramatically. Under the proposed rule, a broker agency interest is only made public on NYSE's display book if it is the exchange's best bid or offer. Anything within that range can remain secret.
The New York Stock Exchange contends that this arrangement gives investors a choice and floor brokers flexibility, maximizing their ability to obtain the best possible price for clients. Under the latest amendments, NYSE is suggesting that at the best bid or offer, a minimum of 1,000 shares per floor broker may be displayed. Below the best bid or offer, all other shares may be hidden. So, if a floor broker has 30,000 shares to buy or sell, 29,000 may remain in his hands in his broker agency interest file.
The ICI doesn't necessarily object to providing floor brokers with the ability to place private orders on the exchange, Burstein said. "But for fundamental market fairness, a displayed order should be executed before these hidden orders." Other markets, including Nasdaq, he noted, also allow hidden orders, but those orders are executed after displayed orders.
"Executing orders in the floor broker interest file on parity with displayed orders could discourage mutual funds from displaying orders on the exchange in the first place," Burstein warned.
Another source of concern that fund companies have expressed in comment letters to the SEC is exactly how NYSE's hybrid market would interact with proposed trade-through rules in the Reg NMS proposal. Trade-through rules relate to the ability of the exchange to automatically route an order to another market center to secure a client the best bid or offer. Once that automated quote is displayed, no one on the floor can trade at a price that would disadvantage the customer.
Eric D. Roiter, senior vice president and general counsel at Fidelity Management & Research Co., questions how a trade-through rule would work alongside a hybrid market to always obtain the best deal for an investor.
"Fidelity opposes any rule that would deprive investors of the ability to make their own choices about the markets in which their trades will be executed," Roiter said in a comment letter to the SEC. "It is open to serious question whether the Commission will have achieved any meaningful protection of public-limit orders if NYSE is free, through its hybrid market proposal, to ignore prices offered by competing market centers that are better than prices offered on NYSE, simply because the competing markets' prices happen to be below their top of the book.'"
As for whether the New York Stock Exchange's latest proposals clarify or improve the situation, Fidelity spokesman Vin LaPorchio told MME: "This complicated proposal should be studied, and we encourage the SEC to hold off in going forward with changes on the trade-through rule until the Commission and interested parties get more information."
Michael Plunkett North American president of Instinet of New York, the largest electronic agency brokerage, thinks a hybrid market may not work simply because it is "trying to please everyone.
"If you only try to please clients, mutual funds and end consumers, I think you'd have a purely electronic model. If they created a plan that went 100% electronic, people on the exchange themselves would have a hard time adding value to the transaction. Over time, the exchange may lose some of its brand appeal," Plunkett said.
The SEC now expects to work on this new measure early next year and issue a revised proposal on Dec. 15. However, some believe the vote may be postponed because of Fidelity and at least two commissioners who have expressed opposition to Reg NMS, not to mention scores of comment letters demanding more information.
As with other controversial proposed rulemakings, there is some resistance among the five SEC commissioners on Reg NMS. Nonetheless, others believe SEC Chairman William Donaldson will push it through, as he did with mutual fund governance rules and hedge fund registration.