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Market Makers Report Gaming In Subdollar Stocks To SEC

By Jacob Bunge and Kristina Peterson Of DOW JONES NEWSWIRES Market makers and brokers are pushing regulators to address anomalous trading patterns in stocks that fall below $1 per share, targeting a strategy that is estimated to cost such firms thousands of dollars per day. Some stock traders are exploiting a five-year-old wrinkle in U.S. securities law to drive trading in low-priced shares like Sirius XM Radio Inc. (SIRI) and trucking company YRC Worldwide Inc. (YRCW) to dizzying levels when their prices fall below the $1 threshold. "This is a real, live problem in our current market structure today," said Christopher Nagy, head of order routing for TD Ameritrade Holding Corp. (AMTD). The legal loophole, which can drive trading activity in shares of stocks like Sirius far above the level seen when the stock is above $1, arises from rules that let traders quote prices to one-hundredth of a cent when the stock falls below that level. However, the rebates paid by exchanges to market participants who contribute liquidity do not scale in the same way, letting traders in cheap stocks reap relatively big profits on tiny movements in share prices, with little risk. For traders using retail brokerage accounts that pass along these exchange rebates to customers and charge a flat monthly fee no matter how many shares are traded, it's essentially a risk-free way to make money, according to Jamil Nazarali, head of electronic trading for Knight Capital Group Inc. (KCG). Nazarali, whose company has investigated the practice, said there's evidence that individuals using the strategy may be trading with themselves through multiple accounts maintained at separate online stock brokerages-- an illegal practice tracked by federal security agencies to prevent money laundering. "This is bad for the market, because these are not legitimate trades," he said. "It's also bad because it diverts a lot of time and resources from [stock order] wholesalers to deal with this problem. And some legitimate traders get caught up in all the measures we put in place to deal with this." Nazarali said that Knight met with regulators Thursday on the issue, alongside officials from major market makers Citadel, UBS AG (UBS), Citigroup Inc. (C) and brokerage firm E*Trade Financial Corp. (ETFC). "They seemed empathetic," Nazarali said. The issue first arose five years ago with the implementation of Regulation NMS, which allows market participants to quote stocks out to four decimal places in stocks that fall below $1 in price, allowing investors finer increments in which to trade very low-priced issues. For example, a trader could put in an order to buy shares of Sirius at 99.01 cents, and sell at 99.02 cents. But under Reg NMS, the maximum fee that exchanges can charge for trades in sub-dollar stocks only declined on a pro-rata basis, which lets market operators charge many times the price spread on stocks below $1. That also lets exchanges offer rebates that are nearly as big. In the early days of the rule, brokers saw the issue arise in shares of Futuremedia Plc, a maker of interactive training programs. After outcry from brokers, stock platforms got rid of the pricing and the issue was resolved for the time being. It resurfaced in January when New Jersey-based exchange operator Direct Edge rearranged its trading fees and began offering the outsized rebates for securities trading below $1. "We discovered this accidentally," said William O'Brien, Direct Edge chief executive. After trading volume gravitated toward Direct Edge's markets, rival exchanges run by NYSE Euronext (NYX) and Nasdaq OMX Group Inc. (NDAQ) moved to offer similar rebate schemes, but ended the practice after outcry from brokers and firms that handle order routing. "I think it's unfortunate that this cropped up again," said O'Brien. "But for this anomaly, this volume would not exist." The rebate structure currently is in place at CBSX, the stock exchange operated by CBOE Holdings Inc. (CBOE), parent of the Chicago Board Options Exchange. -By Jacob Bunge, Dow Jones Newswires; 312-750-4117; [email protected]

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