TCS Daily

Trade Away Donaldson

By Desmond Lachman - April 5, 2005 12:00 AM

William Donaldson, the Chairman of the Securities and Exchange Commission, keeps reminding us of the big mistake President Bush made some two years ago in nominating him, a former Wall Street insider and CEO of the New York Stock Exchange, to reform the securities' industry. For on Wednesday April 6, Mr. Donaldson, together with the two Democratic members of the SEC, is almost certain to again cast his crucial vote in a split-vote decision, which will significantly undermine the competitiveness of the US securities' industry. It will do so at a considerable long run cost to both small and large investors.

The issue at hand is the so called trade-through rule, which requires that equity investors trade at the "best price" in the markets before trading at an "inferior price". The essence of the rule is that it requires all equity orders to be routed to a better-priced market regardless of how long that order might take to execute. At present, this rule, which has been in effect since the Nixon years, applies only to the New York Stock Exchange and to other registered exchanges.

In contrast to the New York Stock Exchange, trading of NASDAQ securities occur in a fully automated environment and are not subject to any trade-through rule. As a result, investors are offered very much faster execution and better overall pricing than they could obtain on the more manual-style markets like the NYSE. Despite NASDAQ securities not being "protected" by a trade-through requirement, there has been little complaint from the investing public that appropriate prices are not being obtained on that market.

Mr. Donaldson now wants to extend the trade-through rule to the NASDAQ. He wants to do so despite strong opposition not only from the NASDAQ market but also from the other electronic markets, which trade NASDAQ securities. In addition, this measure is being strongly opposed by institutional investors, which trade on behalf of the small investor and which find the NASDAQ market to be flexible and competitive precisely because of the absence of a trade-through rule.

On the surface, a "best price" rule across markets would appear to make eminent sense as a means to protect the small investor. After all, how can one argue against investors being protected by having their orders first filled at the best price available in the markets before moving on to less favorable prices? The basic flaw in this line of reasoning, however, is that it overlooks the fact that there might be very different speeds of execution across markets. It also overlooks the fact that for very many investors, best execution may be more important than best price.

The critical point is that the best price in a particular market at any moment in time might not be the best price for a particular investor. My colleague at the American Enterprise Institute, Peter Wallison, has offered the following example to illustrate this point. Suppose a buyer wants to pay $20.05 for 10,000 shares of the XYZ-corporation in one market where he can get instant execution of his order. Now suppose in a more manual manual-market like the NYSE, where execution might take up to a minute, 100 shares of the XYZ-corporation are being offered at $20.00 a share.

Under Mr. Donaldson's proposed trade-through rule, our hypothetical investor would be forced to buy 100 shares in the slower market before filling the rest of his order in the market where he can get instant execution However, by the time that his trade has been effected in the slower market, can we really be sure that the $20.05 offer for the remainder of his order will still be there in the automated market? If that is the case, in what way can Mr. Donaldson's rule be considered to have protected our hypothetical investor?

These considerations have led Rep. Richard Baker, who chairs the House Subcommittee on Capital Markets, to describe Mr. Donaldson's trade-through proposal as the worst public policy proposal that he has seen in his many years in Congress. While perhaps overstating his case, Rep. Baker is right to marshal all the opposition that he can muster against a proposal, which would be almost certain to stifle the type of market innovation and progress so necessary to keep American markets fair, efficient, and competitive.

The author is Resident Fellow, American Enterprise Institute.


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