Fidelity Asks SEC to Review Regulation NMS on “Trade Through”

Economists in general and market theorists in particular have a habit of oversimplifying things. When it comes to determining what an investor’s interest is, they always default to “getting the best possible price.” As a result, regulators who rely on such theories often provide rules that, while logical and well-intentioned, cause more harm than good. One such is the “trade-through” rule that the SEC is proposing to broaden. Fidelity has asked it to reopen debate on the new plan, but investors would be better served by scrapping the rule altogether.

Simply put, the trade-through rule requires a stock broker to get the best possible price on an exchange for a client. And that seems a reasonable idea, since that is why people use brokers. But the implications of the rule diverge from the investor’s interest in some instances because the investor is not always prepared to sacrifice all other principles to that of getting the best possible price. Precise economists say that market participants try to maximize their utility, which is not completely interchangeable with the idea of best possible price. But since it isn’t quantifiable either, few appreciate the distinction.

As a real world example, suppose a man wishes to sell a car and receives two offers. The first is for $7,500 cash on the spot. The other is for $10,000 subject to a loan approval from a bank. The seller may really need the cash, say to prevent an eviction in the morning or pay for an operation that can’t wait. He may believe that the creditworthiness of the second bidder is such that is isn’t an offer at all. There are real-world compelling reasons why he may prefer the $7,500. No true disciple of freedom can argue that the seller should have to accept the higher price in this case.

Yet, the trade-through rule requires the best price to trump all other considerations. For institutions like Fidelity, best price often is the enemy of speed. When the market is moving particularly fast, either up or down, speed may be much more important than shopping around for a price that existed three minutes ago before stops were tripped and the markets moved well beyond that price. Best price has, in practice, resulted in orders going unfilled, which is the definition of market inefficiency.

Trade-through may have made sense before the arrival of electronic trading systems like NASDAQ’s. Now, though, it only serves to keep business as the New York Stock Exchange, which still relies heavily on human beings, and oddly, NASDAQ trades are treated as over-the-counter rather than exchange trades, which means NASDAQ isn’t treated the same as the NYSE. Reform is in the cards, but repeal just might make more sense.


© Copyright 2004 by The Kensington Review, J. Myhre, Editor. No part of this publication may be reproduced without written consent.


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