TCS Daily

Trade Through Boo Boo

By Tad DeHaven - September 1, 2004 12:00 AM

In the latest example of why Republican control of Washington's corridors of power does not guarantee less government or freer markets, SEC Chairman William Donaldson recently cast the deciding vote in favor of yet more burdensome regulation of the economy -- twice.

On June 23, the SEC voted 3-2 (the two Democrats and Donaldson) to mandate that mutual fund boards have chairmen who are independent from the companies managing the funds. And, just a couple weeks later, Donaldson again joined the Commission's two Democrats in voting to thrust the heavy hand of government into the previously unregulated hedge fund market. Even The New York Times editorialized against the hedge fund regulations.

Most market watchers and economists agree that the new edicts will probably have little benefit beyond the assuaging of over-zealous regulatory minds at the SEC. Instead, the new hyper-regulations will lead to increased costs, inefficiencies, and a reduction in the capital accumulation that provides vital fuel for our economy.

Now Donaldson's SEC is considering extending 1970s-styled "trade through" rules from the traditional securities exchanges such as the NYSE to the over-the-counter market of NASDAQ.

The trade through requirement for NYSE listed securities, which has been in place since the Nixon years, requires an order to be routed to a better-priced market regardless of how long it will take to be executed. There is also no guarantee that when the order is finally completed the investor will get the price that was advertised. In fact, the risk exists that the order will not be filled at all.

Forcing orders to be routed to a slower, manual market such as the NYSE decreases efficiency and can undermine a broker's duty to obtain the best execution for the investor. While the trade through rule already in place for listed securities supposedly protects investors from inferior prices, it actually serves as monopoly protection for the outdated and rapidly aging manual market and its system of specialists.

On the other hand, the trading of NASDAQ securities occurs in an automated environment that does not have a trade through rule. Thus investors are offered faster executions and better overall pricing. Even though NASDAQ securities are not currently "protected" by a trade through requirement, there has been little complaint from the investing public that appropriate prices are not being obtained. After all, investors are protected by the broker-dealer's obligation to deliver the best trade for its customers.

Many interested parties have framed the debate as being a black-and-white question of whether it is more important for the investor to receive the best price or the quickest execution of the trade. But this would be a misrepresentation of reality. Securities subject to trade through rules do not always end up actually getting the "best" price and they certainly do not receive the most expeditious execution. On the other hand, securities not subject to trade through rules do tend to get the overall best price, due in large part to the faster trading nature of the less regulated automated market.

Perhaps a 'real' world example is in order. Let's suppose an individual is selling his car and receives two offers. The first potential buyer offers $10,000 in cash while the second buyer offers $10,500. However, the second buyer's offer is contingent upon his ability to secure a loan from the bank. It is not automatic that the seller will choose to accept the second buyer's offer even though it is for an extra $500. Why? Perhaps the seller needs the cash upfront and doesn't want to risk the bank rejecting the second buyer's loan. The key is that the seller should have the choice of deciding which of the buyers gets the sale.

Let's now suppose that a trade through type law exists which forces the seller to take the second buyer's offer. It is very possible that the second buyer might not be able to secure the loan and thus cannot purchase the car. Or perhaps he ends up only being able to come up with $9,500 to offer the seller. Thus the seller could be facing a situation where he would have been better off without a forced trade law. Although it is unlikely that such a law would exist in the used-car world, this is precisely the effect that trade through rules have in the securities market.

So, despite the complexities, technicalities, regulations and arcane terms that permeate the securities industry, the issue basically boils down to one of choice. Crusading regulators "looking out for the little guy" would be wise to consider the unintended consequences of their actions.

Let us hope that Chairman Donaldson discovers the virtues of competition, deregulation, and technological change. Voting to remove trade through rules or allowing investors to opt-out of them would be a welcomed move in that direction.

Tad DeHaven is an Economic Policy Analyst at the National Taxpayers Union.


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