It is rare that a chairman of a regulatory commission defies the wishes of a powerful subcommittee chairman in Congress, and rarer still when he presses forward with a regulation opposed by his party, the administration who appointed him, and substantial portions of the regulated industry. But that's what appears to be happening at the Securities and Exchange Commission.
The issue is the so-called trade-through rule, which requires that an investor trade at the best price in the market before trading at inferior prices. SEC Chairman William Donaldson is pressing ahead with a plan to apply the rule--which now only applies to stocks listed on the New York Stock Exchange and other registered exchanges--to Nasdaq. His plan is opposed by Nasdaq itself, as well as the automated markets (known as ECNs) that trade Nasdaq securities, and many institutional and other investors who have found Nasdaq to be a flexible and competitive market because of the absence of a trade-through rule. Despite a request from Richard Baker, chair of the House Subcommittee on Capital Markets, who has called the rule "the worst public policy I have seen proposed for the markets in my years in Congress," Chairman Donaldson has scheduled a vote on the rule for April 6. And if he is successful in getting the rule adopted, it will only be with the support of the two Democratic commissioners. The Republicans appointed by President Bush will vote no.
In an effort to spiff-up his plan, Chairman Donaldson has rechristened the rule the "Best Price Rule," but this is misleading. The best price in the market at any moment may not be best price for a particular investor. For example, under the rule a buyer who wants to pay $20.05 for 10,000 shares of XYZ Corp cannot trade at that price in one market when another is offering 100 shares at $20.00. This sounds reasonable, if price is the sole determinant. But what if the market offering 10,000 shares at $20.05 can execute the trade in milliseconds, while the other takes minutes to buy 100 shares at $20? By the time that trade has been effected the offer of $20.05 may be gone, and the new market price for 10,000 shares is $20.10. Has the rule then really allowed the investor to get the best price? By dumbing down the choice to a single variable--price--the trade-through rule reduces the options of investors and undermines competition among markets for the trading interest of investors.
The interesting question in all this is why William Donaldson is willing to brave the humiliation that will come from defying Congress, the administration, and the views of much of the industry he regulates. None of his published arguments provides an answer, since the rationale is so weak. First, he sees the rule as a supplement to the broker's requirement to effect "best execution" of a customer's order--that's why he labels it the Best Price Rule--but for the aforementioned reasons best execution is not synonymous with the best price. And indeed, because of the difficulty of determining what is best execution for a particular investor, the SEC has never used the trade-through rule to bring a best execution case against a broker.
He also claims the rule will protect retail limit orders--orders to buy or sell at a specific price--from being bypassed. And perhaps it will, but at the cost of market efficiency. The SEC's own data shows that trade-throughs--where a limit order is bypassed in favor of an inferior price--are relatively rare events, occurring less than 2% of the time. To prevent this from happening, however, the entire market would have to be funneled to this 2%. It's as though no one could buy eggs at more than $1 a dozen, irrespective of quality, until all the eggs at that price have been bought. No wonder that the big retail discount brokers, Schwab and Ameritrade--whose customers place the limit orders that the rule is intended to protect--oppose the rule.
Finally, Chairman Donaldson argues that the rule encourages the placement of limit orders and thus enhances liquidity. The implication is that investors will not place limit orders without the protection of the rule. Oddly, however, those who place most of the limit orders and most rely on the existence of market liquidity--institutional investors like Fidelity--oppose extending the rule. They argue that the Nasdaq market, without a trade-through rule, is a better market than the NYSE--where the rule is now applicable.
Our securities markets serve as one of the cornerstones for President Bush's vision of an Ownership Society, a program that will in part reduce the role of the government in directing the choices Americans make about their lives. How ironic it would be if, in this administration, the SEC adopts a regulation that does the opposite, extending regulation to Nasdaq--a market that is functioning well without SEC intervention.
Peter J. Wallison is a resident fellow at AEI and a former general counsel of the Treasury. Mr. Selway is managing director of White Cap Trading.