What is the sub penny rule?

The Securities and Exchange Commission under new Chairman Gary Gensler intends to propose new regulations to modernize market structure. Of course, we welcome the opportunity to engage in the conversation. 

First Some Facts

The subject of Robinhood routing our customers’ orders to market makers rather than directly to the national exchanges has generated some controversy. Off-exchange market makers are able to provide our customers price improvement over the National Best Bid and Offer (NBBO), without charging exchange fees.

Here’s What We Think Could Change

The Sub-Penny Rule (SEC Rule 612) prevents exchanges from quoting in increments less than a penny. This limitation can result in an artificially wide NBBO, which is the pricing benchmark used by off-exchange market-makers. 

In a nutshell, exchanges cannot fairly compete with off-exchange market makers in executing our customers’ orders. As a first step toward better enabling our exchanges to compete fairly, we propose amending Rule 612 to allow exchanges to quote prices up to four decimal places for all stocks. 

Back in 2005, when Rule 612 was adopted, the consensus was that price increments of $0.0001 were economically insignificant. Supporters of the rule argued that sophisticated investors may use these smaller increments to step ahead of retail investors by trivial amounts. Some also argued that technology hadn’t advanced enough to properly handle an enormous increase in on-exchange quoting.

However, since that time, technology has advanced by leaps and bounds, and commission-free trading has become the industry norm. It’s now clear that customers value sub-penny price improvements and no longer consider them economically insignificant, especially in low-priced, high-volume stocks that may only trade with a penny spread. 

Chairman Gensler noted in a speech earlier this month that market makers – also known as wholesalers – are able to transact in sub-penny increments. “As a result,” he said, “wholesalers may operate on an unequal playing field when competing for order flow.”

Let’s try to level the playing field.

If the sub-penny limitation is removed, and exchanges reduce fees for retail orders, we could see a tighter NBBO, even better execution quality for retail investors, more transparency and perhaps more retail order flow executed on lit markets. 

It’s not lost upon us that brokers, including Robinhood, and other financial institutions benefit right now from spreads being wider. Others may not advocate for this proposal, but Robinhood will continue to fight for what we believe is right for customers and the long-term health of the markets.

US financial regulation

Regulation National Market System (or Reg NMS) is a 2005 US financial regulation promulgated and described by the Securities and Exchange Commission (SEC) as "a series of initiatives designed to modernize and strengthen the National Market System for equity securities". The Reg NMS is intended to assure that investors receive the best (NBBO) price executions for their orders by encouraging competition in the marketplace. Some contend that the rule has contributed to the rise of high-frequency trading,[1] which is sometimes regarded as controversial.

History

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Established in 2005, its aim was to foster both "competition among individual markets and competition among individual orders"[2] in order to promote efficient and fair price formation across securities markets.

In 1972, before the SEC began its pursuit of a national market system, the market for securities was quite fragmented. The same stock sometimes traded at different prices at different trading venues, and the NYSE ticker tape did not report transactions of NYSE-listed stocks that took place on regional exchanges or on other over-the-counter securities markets.[3] This fragmentation made it difficult for traders to comparison shop. In 1975, Congress passed the Securities Acts Amendments of 1975, authorizing the SEC to facilitate a national market system.

Consolidation of rules

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In 2005, the rules promoting the national market system were consolidated into REG NMS. Some of the more notable rules include:[4]

• Access Rule – addresses access to market data such as quotations (Rule 610)[5]
• Order Protection (or Trade Through) Rule – provides intermarket price priority for quotations that are immediately and automatically accessible (Rule 611)[6]
• Sub-Penny Rule – establishes minimum pricing increments (Rule 612)[7]
• Market Data Rules:
  • a) Allocation amendment – institutes a new Market Data Revenue Allocation Formula,
  • b) Governance amendment – creates advisory committees,
  • c) Distribution and Display Rules – governing market data (Rule 600, 601 & 603).

Impact

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Reg NMS has been described as a shift away from the SEC's historical role of defining and then enforcing general duties and obligations of market participants.[1] Instead, Reg NMS dictates the specifics of how the market should execute trades. This "micromanagement" of complicated market mechanics has been blamed for unintended consequences, including the rise of high-frequency trading.[1]

Within Reg NMS, a section called the order protection rule has further been controversial because it requires traders to transact on a trading venue at the lowest price rather than on a venue offering the quickest execution or the most reliability, which can result in a worse overall price for institutional orders after execution.[8] Additionally, the order protection rule has been blamed for exacerbating market fragmentation, resulting in rising technology and exchange costs for market makers.[9][1] Thus, some have described it as an improper government intervention into private business affairs.[10] Defenders of the rule argue that it really just requires what brokers should be doing if they are acting in their customer's best interests.[11] Still others have argued that the rule is too lax because it only protects the quotes at the top of the book.[11] For example, if the best two quotes in one market are superior to the best quote in another market, a portion of an incoming market order may still trade at the inferior market at the inferior price even though the second best quote on the superior market is still available.[citation needed] If more than just the top of the book (the best quote) were protected by the order rule, the market order would have transacted at a superior price and the limit order offering the superior price would have transacted more quickly.

Firms affected

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• SROs/Exchanges
• ECNs and other executing broker-dealers (e.g., market makers, block positioners)
• Broker-dealers routing ISOs

See also

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References

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