Front-runners penny-alizing big traders on NYSE

A penny for your thoughts?

When it comes to large institutional trades on the New York Stock Exchange, even that price may be too steep.

Ever since the exchange in January began listing stocks in dollars and cents instead of sixteenths of a dollar (about 12.5 cents), brokers have begun to front-run mutual fund trades by “increments of as little as one penny,” according to Craig Tyle, general counsel for the Investment Company Institute in Washington.

With the Big Board scheduled to start its planned system for executing large orders soon, the ICI is lobbying for changes.

In a letter earlier this month to NYSE chairman Richard Grasso, Mr. Tyle said, “The execution of large orders has been hampered” since the exchange began decimalization Jan. 29.

“Decimalization, by itself, is not the problem,” Mr. Tyle wrote. “Rather, it has simply made more apparent the difficulties that mutual funds and other institutions commonly face when trading on the exchange.”

The exchange’s system to facilitate trading large orders, called Institutional Xpress, is scheduled to go live in the second quarter.

Under the system, Big Board specialists will be required to hold orders of 25,000 shares or more on their books for at least 30 seconds to allow them to execute the trade.

“What that leads to is, it gives everybody else on the floor a free look at that order,” Mr. Tyle says.

Several independent broker-dealers have special access to the trading floor, and some brokers have been jumping in ahead of trades.

“If they see an order to buy 25,000 shares at $20 a share, they know there’s some real buying interest. They could pay $20.01, because they know big institutions are probably willing to pay more to get that security,” Mr. Tyle says.

“The person who first puts in the buy order isn’t going to be the first to get the shares. They’ve shown their hand and driven the price up.” The result, he says, is that “fewer institutions are showing large orders.”

Instead, they post only smaller orders, which results in less liquidity for securities. The ICI suggests that the exchange do away with the rule.

In addition, the exchange’s rules require that other orders executed in response to those large orders have to be given an opportunity for price improvement.

“But the person who has exposed themselves and taken the risk to put out that original purchase order, they’re not going to be able to buy the shares,” he says.

“So they don’t put in the big purchase order to begin with.” That also results in less liquidity, Mr. Tyle says.

“Our members tell us they would gladly forgo the opportunity for price improvement if they could get immediate execution, which would protect their orders so nobody could step ahead of them. They want transactions without having to wait for price improvement.”

Otherwise, Mr. Tyle told InvestmentNews, the ICI supports moving the stock market from trading in sixteenths of a dollar to dollars and cents.

Big Board spokesman Ray Pellechia says the ICI’s suggestions will be incorporated in a review of decimalization and product enhancements under way by various customer advisory committees.

unintended effects

The Securities and Exchange Commission also is looking closely at decimalization, acting Chairman Laura Unger said at a Senate Banking Committee hearing last month, and will hold a round table on the issue.

Nasdaq started a pilot decimalization program for 15 securities last week and is to have fully converted to decimals by April 9.

At the hearing, Ms. Unger also expressed concern that the move to trade stocks in dollars and cents is having unintended effects.

“The multiple price points that decimals produce could result in higher transaction costs for investors,” she said at the hearing, which was called primarily to discuss securities transaction fees.

“Institutional investors are finding that their orders are being stepped in front of by the specialists or market makers at only one cent – it’s a lot cheaper than it was in a sixteenths environment,” said Ms. Unger.

“I think it’s fair to say that decimalization is not a smashing success,” Sen. Charles Schumer, D-N.Y, said at the hearing.

After the hearing, Ms. Unger told InvestmentNews there is anecdotal evidence that “there are so many price points due to decimalization that it might take more transactions to fill a customer’s order.

“Therefore, you would have to pay for each of the costs associated with the transaction.”