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News July 26, 2004 Issue

Donaldson Opts-Out

In testimony before the Senate Banking Committee last week, SEC Chairman William Donaldson indicated that he would not support the controversial trade-through opt-out exception.

Opt-out, he said, would disadvantage sellers who "stick [their] necks out" and post a limit order outside of the national bid-best offer (NBBO). "I think there’s a legitimate argument here for the institutional trader who says that ‘For me, the best price is not 100 shares [posting a limit order showing the best price], for me it’s the average price I get on executing a huge order’," said Donaldson. "But," he added, even then "I have difficulty . . . thinking that that one 100 share order that had the courage to post the limit order doesn’t get executed."

The problem might be solved, he said, if everything went electronic. He noted that the so-called "slow" markets (namely, the traditional floor-based auction markets such as the NYSE) have indicated that they will implement automated execution without human intervention. "If this electronic instantaneous capability can be developed by the so-called ‘slow’ markets, what do you have to opt-out for?" he said

Senator Charles Schumer (D-NY) agreed, warning that if "large players" are allowed to opt-out, "you can end up with a fragmented market system" and "even worse, an opaque system where there’s no ability to police or there’s policing after the action." He said small investors were most concerned with price, rather than speed. "I think you are right on trade-through," he told Donaldson, but added that "I’d be really careful before going to opt out."

Also in agreement: Senator Jon Corzine (D-NJ), who described the opt-out rule as having "a lot of . . . unintended consequences." He said that even institutional investors that go "to wherever the size is" may not get the best price as a result of "leaving out some of those better price bids and offers" when computing the average price on the trade. That, he said, "would be a very hard thing, I think, to justify after the fact." His parting words to Donaldson: "Good luck!"

Donaldson said that the SEC hopes to have a revised NMS proposal issued by the end of the year.