SEC Says Wall Street Firms Are Mishandling Limit Orders
By Christopher H. Schmitt
Staff Reporter
5/4/00 8:30 PM ET
WASHINGTON -- Despite major stock market reforms in recent years, big Wall Street firms are mishandling key investor transactions, costing the public hundreds of millions of dollars a year, a Securities & Exchange Commission report suggested Thursday.
At issue is handling of investors' limit orders by Nasdaq market makers and trading firms at the New York Stock Exchange and other exchanges. Limit orders -- which have become a favorite tool of individual investors -- are instructions to buy and sell at specific prices.
Under the recent reforms, the interplay of limit order prices with prevailing market prices can produce better overall prices, reaping many millions for investors in cost savings or additional profit when they buy or sell. The reforms were aimed at getting investors better prices in general, and also reflected concern that Nasdaq market makers were colluding to prop up transaction costs borne by investors.
The criticism in the SEC report, based on a sample of unnamed Nasdaq and Exchange trading firms, was broad-brush: that firms often failed to display -- that is, integrate into their overall pricing -- proper sizes of limit orders; failed to display orders within 30 seconds, as required, and failed to re-route orders to another market that would display the price. It also found surveillance and enforcement of handling of limit orders to be weak.
SEC officials declined to estimate the cost of the noncompliance to investors across all stock trading. But additional trading costs pile up quickly -- a price difference of only 1/16th of a dollar on a 1,000-share order, for example, translates into an extra cost of $62.50.
If noncompliance is widespread across the industry, as the SEC report suggested, the cost to investors could well be hundreds of millions of dollars or more annually. And with U.S. stock ownership now broader than it has ever been, the burden reaches across all slices of the population.
"These findings are very troubling," said Lori Richards, director of the SEC's inspections and examinations office. "We're very concerned. This should be a wake-up call."
SEC Chairman Arthur Levitt called the results "a pattern of serious neglect among some market participants."
NYSE spokesman Ray Pellecchia defended the Big Board's limit order compliance as "very aggressive and comprehensive," but said the exchange will promptly review the report and make any necessary changes. A Nasdaq representative was unavailable for comment.
Spurred by the dismaying findings, the SEC will step up its efforts to monitor compliance at all firms, Richards said, and some firms examined thus far may find their cases referred to the SEC's enforcement division for investigation.
The SEC released the report in connection with a roundtable discussion among two dozen leading Wall Street executives on what's planned to be the next generation of reform based on limit orders.
Under so-called limit order transparency, trading firms will open their order books for individual stocks, allowing the investing public to see a fuller picture of the supply and demand for securities -- in particular, the number of shares buyers and sellers are willing to make available at particular prices.
With that more complete picture, investors could make more informed decisions about their trading strategies. Today, most trading firms keep that information to themselves.
"Limit orders have been absolutely integral to the empowerment of investors," Levitt said.
Roundtable participants generally agreed limit order transparency is an idea whose time has come, but indicated any changes will take awhile because of sticky implementation issues. One, for example: Will participation be mandatory, and if some players can opt out, doesn't that seriously compromise the very intent?
Despite the promise of additional reform, Thursday's SEC report underscored that Wall Street may have a long way to go to simply comply with existing rules, never mind adding new practices.
As reforms of recent years have encouraged investors to place limit orders, such orders have come to dominate trading. Today, limit orders constitute two-thirds of all orders on Nasdaq, and two-thirds of all system orders on the NYSE. Most quotes on the NYSE are set by limit orders, and Nasdaq "spreads" -- the difference between prices a dealer will buy and sell at, and one place where they earn their profit -- are narrower when set by limit orders.
The SEC acknowledged that limit order rules of recent years have improved prices. Nevertheless, the agency found specifically:
Not all limit order systems are fully automated and many Nasdaq market makers handle limit orders manually. When that happens, violations are frequent -- in the case of one Nasdaq firm, rules were violated in 92 percent of cases examined. "That's stunning," said the SEC's Richards.
Automated systems perform substantially better, but some are not programmed to properly comply with the rules.
Trading firms weren't even able to provide the basic information needed to ensure investors' limit orders were being properly handled -- the crucial first step in ensuring compliance.
Some firms don't even check to make sure rules are being followed.
The firms' failure to follow the rules hurts investors in three specific ways:
If limit orders aren't displayed, overall market prices will fail to adjust properly, and that could mean some of the orders end up never getting executed.
In general, buy prices remain too high and sell prices remain too low.
Investors who place "market orders" -- that is, orders to trade not at specific prices, but instead at whatever the prevailing price is -- end up paying more or getting less than they otherwise would have.
"By allowing all investors to become price-setters, limit orders improve the process of price discovery," said William Atkinson, the SEC's associate chief economist. "When displayed properly, they can increase competition."
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