Traders.com

“These subpenny trades that you see taking place in front of your limit orders are actually orders executed off-exchange. There are privileged participants, known in the industry as ‘internalizers,’ that will actually buy marketable retail order flow from various brokerage houses in order to trade against it. This is known as payment for order flow. These marketable orders, which are intercepted, would otherwise execute against your publicly displayed order. This is a form of predatory market making and is a profitable business for those firms able to participate. It is a gray practice that has drawn a considerable amount of scrutiny from industry participants over the years, as the practice leaves displayed limit orders unexecuted. In order to justify the practice, the internalizer will often offer some type of subpenny price improvement to the retail market order. It is this subpenny price improvement that you see as subpenny trading on the consolidated tape.

“Our firm has argued to our regulators that the subpenny price improvement given by these internalizers is not enough to warrant taking a fill away from a displayed liquidity provider. We have argued there needs to be some type of meaningful price improvement requirement, greater than the 1/100^th of a cent you typically see, put into place. It looks like the Canadian regulator has been reading our SEC comments because they have done just that.

“Effective October 10, 2012, there will be a requirement in Canada that an internalizer must provide a minimum amount of price improvement over the NBBO. This minimum level of price improvement is defined as one trading increment (one cent), or half a trading increment for securities with a bid-ask spread of one cent.

“For stocks with a spread of one cent, you will still see subpenny trades, but at the midpoint, which is much better than price improvement of 1/100^th of a cent or nothing at all.

“The bottom line is that displayed orders in Canada will receive a bit more execution priority. This should lead to a lot more executions for limit order traders, which should leave Canadian traders a lot less frustrated. We applaud the Canadian regulator and can only hope the SEC is contemplating a similar move.”