Stock Investors Can Handle the Truth; The ban on ‘locking’ markets has the effect of hiding the best prices

Stock Investors Can Handle the Truth

The ban on ‘locking’ markets has the effect of hiding the best prices.

CAMERON SMITH

June 2, 2014 7:33 p.m. ET

Most investors would be surprised to learn that current stock-market regulations actually prevent them from seeing and receiving the best price. Why? Well, in 2005 federal regulators at the Securities and Exchange Commission decided, in the immortal words of Jack Nicholson in “A Few Good Men,” that investors “can’t handle the truth” and that seeing true market prices would only confuse them.

Given the SEC’s willingness to conduct pilot programs to make U.S. markets more efficient and competitive, one would hope that eliminating a regulation that reduces transparency and thus harms investors would move to the top of the pilot-program list.

This can’t-handle-the-truth rule is a seemingly arcane part of the SEC’s Regulation NMS, implemented in 2007, that prohibits a market from displaying a quote that would “lock” the quote of another market. In other words, if one market is displaying, say an offer at $15.50 in IBM, IBM +0.72% then another market should not display a matching bid in IBM at $15.50.

The simple reason is that, in theory, if a bid is the same as an offer, it should result in a trade. Indeed, the stated purpose of the prohibition is that it promotes healthy interaction between buyers and sellers and contributes to a fair and orderly market.

But the reality is that locked markets occur routinely in today’s market, and the regulation only serves to hide that fact from the investing public. The market, however, is not truly locked because traders trying to “take” a quoted price have to pay a tax known as an exchange “access fee” that is attached to the displayed prices. So that $15.50 IBM offer is in reality an offer at $15.503.

While that extra cost of $.003 or 3/10ths of a penny doesn’t seem relevant to most investors, professional traders on average make less than half that amount per trade, turning that pebble of a fee into a boulder. As a result, a professional trader may conclude that while a buy at $15.50 is profitable, a buy at $15.503 is not. Not only does the trader avoid the tax when locking the market, but posting a locking $15.50 bid may result in a rebate of $.002 from the exchange, lowering his effective cost to $15.498.

Thanks to the economic incentives to lock markets, the prohibition does little to reduce their frequency but instead requires that locking quotes be hidden from the public, effectively censoring the market and preventing investors from seeing the best prices.

Exchanges constantly receive orders that would lock the market and have, consequently, been forced to develop scores of different ways to handle such orders. Most of the complex and confusing order types that have been the subject of recent criticism—such as the nefarious sounding “hide not slide” orders that hide orders that would otherwise lock the market—stem solely from the ban on locked markets.

Not only does the ban prevent investors from seeing the best price, it often results in their not receiving that price. Best execution obligations require “dark pools”—private exchanges that don’t publicly display bid and offer prices—and other off-exchange venues to match the best displayed price when executing orders. If these off-exchange venues, where an estimated 40% of U.S. stock trades now happen, are prevented from displaying the best price then they will trade at prices inferior to the true market.

In the IBM example, the displayed best bid would be $15.49 even though the true best bid is $15.50, needlessly costing investors executed off-exchange a penny per share. Ironically, while there is much regulatory hand-wringing about the proliferation of off-exchange trading and its potential to adversely impact price formation on exchanges, regulations are effectively subsidizing off-exchange trading to the detriment of investors.

While regulators are right to promote fair and orderly markets, the ban on locked markets undermines those goals. Investors have continued to behave rationally and lock the market, forcing marketplaces to hide these orders by coming up with complex order types. The main impact of the ban on locked markets, therefore, is to prevent investors from seeing and receiving the best price while subsidizing off-exchange trading.

It’s time to recognize the fact that today’s investors can handle the truth and eliminate the ban on the display of locked markets and all its market distorting impacts. While there are other parts of Regulation NMS that also have similar impacts on market quality (e.g. trade-through and sub-penny pricing bans) an SEC pilot program that permits locked markets would be a good place to start.

Mr. Smith is the president of Quantlab Financial, a Houston-based quantitative trading company.