The Investment Industry Regulatory Organization of Canada is defending the fundamental human right of lazy and incompetent traders to avoid punishment, in a Request for Comments titled Provisions Respecting Market Maker, Odd Lot and Other Marketplace Trading Obligations:
Under clause (d) of Part 1 of Policy 2.1, a Participant or Access Person may not when trading a security on a marketplace that is subject to Market Maker Obligations, intentionally enter on that marketplace on a particular trading day two or more orders which would impose an obligation on the Market Maker to:
- execute with one or more of the orders, or
- purchase at a higher price or sell at a lower price with one or more of the orders
in accordance with the Market Maker Obligations that would not be imposed on the Market Maker if the orders had been entered on the marketplace as a single order or entered at the same time. In essence, this provision stipulates that an order can not be “shredded” to intentionally trigger a market maker’s obligation to fill the “shredded portions” of the order.
IIROC would note that the examples listed in Policy 2.1 are not exclusive. IIROC is of the opinion that the intentional “shredding” of orders through the entry of multiple odd lot orders on a marketplace that has compulsory obligations on members, users or subscribers to execute against “odd-lot” orders is contrary to Rule 2.1.
So, in other words, if a market maker posts a bad price, he can only be punished by those not regulated by IIROC, not by other Participant or Access Persons – in other words, IIROC is seeking to continue the current practice of maintaining a heterogeneous market.
Rule 2.2 provides more protection for incompetent traders:
In addition, a Participant or Access Person shall not, directly or indirectly, enter an order or execute a trade on a marketplace if the Participant or Access Person knows or ought reasonably to know that the entry of the order or the execution of the trade will create or could reasonably be expected to create:
- a false or misleading appearance of trading activity in or interest in the purchase or sale of the security; or
- an artificial ask price, bid price or sale price for the security or a related security.
The new proposed rules will confirm these intrusive regulations:
The following is a summary of the most significant impacts of the adoption of the Proposed Amendments:
- confirm that the “abuse” of an odd-lot dealer is a violation of the requirement to conduct trading openly and fairly;
- confirm that Participants with contractual odd-lot arrangements are able to rely on various exemptions in UMIR principally related to short selling, client priority and trading during certain securities transactions; and
- provide marketplaces with more flexibility in structuring their market making systems by:
- allowing Exchanges and QTRSs to have Marketplace Rules that provide for an obligation to maintain reasonably continuous two-sided market and/or a guarantee of execution of orders which are less than a minimum number of units, or
o allowing marketplaces (including an Exchange or QTRS) to provide for an oddlot arrangement by a contract.
It should be apparent that the main intent of these proposals is to give the regulators some more authority, so they can ensure they get proper respect from the regulated. It is in the interest of a fair and efficient market that bad prices be punished as quickly and effectively as possible – but then IIROC would have a little less power. Never mind that the bad price will, for the period of its existence, provide a false and misleading signal to observers regarding the potential for transacting at that price.
We’ve all seen situations where a security is quoted at, say, 19.10-15, with the offering only 100 shares and the next offer at 19.50 or more. If the Market Maker – or anybody else – wants to defend that level, let him; but if it’s a bogus level, then make it cost him money.
A problem might arise when the original market is, in fact, fairly quoted at 19.10-50. Then Sharp Traders Inc. comes along and posts an offer for 100 shares at 19.15, then shreds a buy order for 10,000 shares into 101 odd-lots. I don’t see a problem with this … if the Market Maker is not prepared to defend an offer of 19.15, then he can input an algorithm so that if he gets lifted for 99 shares, he lifts the board lot offer that he’s defending.
Better yet, have the Market-Maker input the prices he will defend, and allow the odd-lot market orders to execute directly against the board-lot limits within that spread.
Best of all, don’t give any special treatment to odd-lot orders. Why should one class of marketplace participants be favoured over other classes? If Granny wants to play with the big boys, well and good – but there shouldn’t be any special rules giving her special treatment.
The trouble with favouratism is that it leads to a tangled web of rules and regulations that serve no legitimate purpose other than the employment of regulatory personnel.
And what about the poor old board lot offerer, who legitimately offered 100 shares at 19.15 and got filled for 99? Well … boohoohoo. In this new era of $10 commissions and book-based holdings, it’s no disaster to be left with an odd-lot. Annoying at worst. The guys paying $100 minimums at full service brokers will be hurt – but then, they should be hurt! It’s all part of the joys of entering limit orders. If the full-service broker wants to offer guaranteed fills – or order types that convert to market at a certain time if partially filled about a preset minimum – let them.
Comments are due by 2010-6-24.
Update: It occurs to me … the regulatory distaste for trader games that have the effect of masking intentions (very common in the bond world) has probably been a major factor behind the development of dark pools. Every regulation has an unforseen consequence … which leads to another regulation …
Update: And anyway, the Market-Making rules should be strictly a matter between the Exchanges / ATSs and their members; I find it very difficult to understand why it should be a matter of regulation.
Update: If the full-service broker wants to offer guaranteed fills – or order types that convert to market at a certain time if partially filled about a preset minimum – let them. Perhaps the best solution of all! They know their clients, they can restrict the service to orders for all shares in custodial accounts only – no problem. The trades can be crossed on the exchange of their choice. This is an opportunity for brokerages to differentiate themselves, while at the same time eliminating a few layers of rules.
I’m not sure if I agree with your assessment that “it’s the market maker’s own damn fault if he gets filled”. Isn’t the official market maker obliged to fill all odd lots at the (even lot) BBO?
So let’s say you have a relatively illiquid stock (with usually large bid/ask spread). Suppose that an attractive ask price is posted, but with only size 100 (perhaps you secretly nudged your friend to post it??). Now proceed to fleece the Market Maker by buying a few thousand shares in increments of 99 shares each. The Market Maker is obliged to fill them all at the attractive even lot ask price.
I suppose if the MM was “smart” then as soon as the first 99 was filled at the attractive ask price he would then himself lift the lot of 100 at the attractive ask price. This would eliminate his loss and remove the attractive ask price so that he was no longer obliged to fill odd lots at that price. But if the MM is a human rather than a computer and you send those orders of 99 in rapid succession he could get fleeced.
Anyway, perhaps I’m wrong as I haven’t read the odd-lot obligation rules of the MM in a while. But I seem to recall that this is how it would work.
You’re quite right and I’ve addressed that in edits to the post; in fact, I was editing the post at the same time you were commenting!
Okay, never mind, you basically said the same thing. Somehow I decided to comment without even having seen the second half of your post!
Ah, that explains why I missed the second half of your post… Probably it wasn’t there!
I guess great minds think alike.
I’m not sure how the MM’s odd-lot requirement is implemented technologically at the exchange. But if the exchange basically automatically assigns the trade to the MM without the MM having to explicitly post an odd lot bid/ask (it seems likely that this is how it would work) then even if the MM had a good and low-latency algorithm he could still get fleeced. The evil trader could presumably send many orders for 99 shares in immediate succession so that even if the MM responded to the first fill by lifting the attractive ask lot (100) that order would be received by the exchange later than all the odd-lot orders. Therefore the remaining odd-lot orders would be processed first and therefore at the “attractive price” before the MM would get a chance to lift the attractively priced lot…
You make a very good point; I will have to fall back on my position that this is not a regulatory matter; it is a matter for the exchanges.
If the exchanges want to have odd-lot servicing arrangements, then they should be implementing this kind of protection themselves; perhaps by limiting odd-lot executions to one per second and holding others in a queue.
One way or another, this should not be in UMIR. It’s strictly a contractual matter between the exchange and the market-maker – you can lose your license by violating UMIR! It has nothing to do with “market integrity”, particularly since it creates a dreaded two-tier market; it is solely concerned with market competition and IIROC should Keep Out.
I must say, I am enjoying this sequence of comments! I seldom get taken to task by Assiduous Readers, even when I say something particularly outrageous to encourage such things.