When you look at a Time and Sales feed from your broker, you will often come across odd looking prices quoted to four decimal places (e.g. 29.9999 or 30.0001). These are “sub-penny” prices and they are covered by special SEC regulation passed in 2005- SEC Rule 612. This rule was well intentioned and was meant to protect the integrity of the NBBO (National Best Bid and Offer). But the rule is being abused and high frequency trading programs can now front run the NBBO from dark pools. Here is a quick summary of SEC Rule 612-
1) For any stock trading above 1 dollar, it is a violation of SEC rules for a brokerage firm to accept or display a limit order with a sub-penny price. In other words, you can’t place a limit order at your retail broker and try to buy Citigroup at 3.5999 or 3.6001. You can only bid using prices rounded to the nearest penny. Let’s assume you bid $3.60 for 1000 shares of Citigroup and you are the National Best Bid (first in line of all the 3.60 bidders).
2) A broker/dealer is allowed to use a sub-penny price to provide price improvement to its clients that submit market orders. Suppose the broker/dealer receives a market order from a client to sell 1000 shares of Citigroup. If they did not intervene, you would be first in line and would be filled on your order to buy 1,000 shares at $3.60. But the broker is allowed to jump in front of you if they provide “price improvement” to their client with a sub-penny price and buy the 1,000 shares for 3.6001.
3) Another way that sub-penny prices can occur is from a dark pool. A “smart router” that manages a market order will check dark pools of liquidity for a better price. High frequency trading programs can place hidden orders in dark pools that automatically add or subtract a sub-penny increment to the NBBO price jumping in front of the displayed liquidity provider.
4) Flash trading can also cause a sub-penny price. Suppose you have a national best limit order to buy 1,000 Citigroup at $3.60. The exchange flashes a buy market order to the high frequency trading (HFT) firm’s computer. This gives the HFT firm a chance to trade against the market order. When favorable, the HFT firm’s computer places a buy order at $3.6001 to take the other side of the flashed market order. The 3.6001 quote is never displayed, so this does not violate SEC Rule 612. Your $3.60 buy order, the displayed liquidity, is once again bypassed.
In the previous scenario, the client of the broker/dealer only benefits by ten cents. But you lost the opportunity to buy Citigroup at $3.60. It is quite likely that a high frequency computer program was monitoring the S&P futures, noticed an uptick in the futures, so it jumped in front of you to provide the price improvement to the client. If the S&P futures had been trending lower, you can be sure they would NOT have jumped in front and your 1,000 share buy order would then be filled.
In other words, you get filled when it is highly unfavorable, but do not get filled when you would want to be filled. This is clearly a losing game for anyone who uses limit orders, discourages investors from offering liquidity and does not add to the integrity of the NBBO.
Since Citigroup normally trades with only a one cent spread, this may not seem like such a big deal, but because of the high daily trading volume, the money can add up. But where things really get bad is with less liquid stocks.
Here is an example from today’s trading in Alleghany (ticker:Y). Alleghany trades at around $270 a share and today’s volume was only 4,140 shares. At 12:19:07, there was a sub-penny trade for 250 shares at 273.2199. Before the trade occurred, this was the bid-asked and size for Alleghany:
Bid 270.87 (Size 100)- Asked 273.22 (Size 100)
A broker/dealer received the market buy order for 250 shares, and the broker or another HFT program jumped in front of the best asked price of 273.22 and sold the 250 shares for 273.2199. Soon after this occurred, Alleghany traded down below 271. The trade at 273.2199 was the high of the day, so the person with the limit order to sell at 273.22 is out of luck and remains unfilled.
- – The price improvement benefit to the buyer provided by the broker/dealer jumping ahead of the best limit sell order was a whopping 2.5 cents. Nowadays, you can’t even buy chewing gum with the savings.
- – The loss to the person with the 100 share limit sell order caused by the dealer or HFT computer (front running) was several hundred dollars since the sell order remained unfilled at the end of the trading day.
There is clearly something wrong with this situation. I invest in closed-end funds that are not always highly liquid, and sometimes trade with large spreads. I’ve recently noticed a much greater frequency of sub-penny price quotes. If this practice is not better regulated, it is possible that more and more executions will occur at sub-penny prices and limit orders will become completely useless. If this happen, liquidity will decrease and bid-asked spreads will widen considerably. Perhaps the most affected will be mutual funds, pension funds and other large buy side firms that need to trade with larger size.
There was an outstanding article by Dennis Dick in the latest issue of CFA magazine (“The Hidden Cost of Sub-Pennying”) that provides extensive background on this issue and much more details about sub-penny pricing. Dennis also started a web site that provides useful information on sub-pennying, flash trading and the proposed financial transation tax.