The Securities and Exchange Commission (“SEC”), on
October 26, 2005, approved the adoption of new Exchange Rule 123G
(Order Entry Practices) which prohibits conduct known as “trade
shredding” or “tape shredding.” The SEC had previously expressed
its’ concern to the U.S. self-regulatory organizations that an
incentive existed for market participants to receive rebates to
engage in distortive behavior, such as trade shredding and other
similarly distortive behaviors, as a means to increase their share
of market data revenues and other forms of revenue.1 The
New York Stock Exchange (“NYSE” or “the Exchange”) responded to the
SEC in a letter dated February 24, 2005, indicating that the
Exchange would propose a new rule change to prohibit such
conduct.2 Further, the Exchange published an Information
Memo No. 05-15, dated March 8, 2005, to all members and
member organizations of the Exchange prohibiting trade shredding and
related conduct.3 The new Rule 123G, now effective,
prohibits all such distortive behavior as it is inconsistent with
just and equitable principles of trade.
Trade Shredding:
“Trade shredding” is the practice
of unbundling customer orders for securities into multiple smaller
orders for the primary purpose of maximizing payments to the member
or member organization, thereby disadvantaging the customer by, for
example, charging excessive fees or commissions, or failing to
obtain best execution of an order. Such payments may create a
conflict of interest between the customer and the member or member
organization. For example, as a result of the manner in which market
data revenues are calculated, market centers can derive a greater
share of market data revenue by increasing the number of trades that
they report to the consolidated tape. At the same time, some markets
have adopted a practice of sharing these increased revenues with
market participants, including non-members, who send in orders.
Other economic arrangements between members or member organizations
and their customers, such as bulk order commission discounts, may
create similar incentives to engage in similarly distortive
behavior.
The NYSE does not rebate revenues from tape reporting
to members or non-members, and thus, there is no incentive in this
area for NYSE order providers to engage in trade shredding on orders
sent to the Exchange. However, a member, member organization or an
associated person may engage in conduct that has an impact similar
to trade shredding, in that it unbundles a customer’s order for the
primary purpose of maximizing payments to the member, member
organization, or associated person at the customer’s expense and to
the customer’s detriment. Prohibited payments are “monetary or
in-kind amounts” received by the member, member organization, allied
members, approved person or registered or non-registered employee of
a member or member organization as a result of the execution of such
orders, and include commissions, gratuities, payments for or rebate
of fees, or any similar payments of value.
New Rule 123G is attached as Exhibit A.
Questions concerning any matters
discussed in this Information Memo may be addressed to Daniel M.
Labovitz, Market Surveillance, Rule Development, at (212) 656-2081
or Donald Siemer, Market Surveillance, Rule Development, at (212)
656-6940.
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