Sub-Penny Trading

What Is Sub-Penny Trading?

Sub-penny trading is a practice where brokers and dealers trade in unseen, unregulated markets in increments of less than a penny through wholesalers, dark pools, and lit exchanges.

The Sub-Penny Rule (SEC Rule 612) of 2005 currently prevents exchanges governed by the SEC from quoting trades in increments less than a penny. This limitation can result in an artificially wide National Best Bid and Offer (NBBO), which is the pricing benchmark used by off-exchange market-makers. 

Key Takeaways

  • Sub-penny trading is completed in an undisplayed market center such as a dark pool.
  • Retail brokers accept sub-pennying orders because they’re allowed to secure the best possible price for their clients, even if the trade is not on an exchange.
  • The SEC introduced Rule 612 in 2005 which prevents exchanges from quoting in increments less than a penny.

Understanding Sub-Penny Trading

Exchanges and electronic communication networks (ECNs) charge access fees to any market participant taking a displayed offer or hitting a displayed bid in exchange for providing liquidity.

Participants who display the bid or offer are provided with a rebate in exchange for providing liquidity, which is capped at 0.3 cents per share by the Securities and Exchange Commission (SEC).

Sub-penny trading occurs when a market participant in an undisplayed market center, such as a dark pool, steps ahead of a displayed limit order by a fraction of a cent and captures the spread. While the buyer receives a better deal, the seller misses out on the opportunity to fill the order, and the liquidity provider doesn’t receive any rebates.

Retail brokers accept sub-pennying orders because they’re allowed to secure the best possible price for their clients, even if the trade is not on an exchange or ECN. And, the access fee is often included in a broker’s commission, which means that they’re incentivized to find orders that do not necessarily pay these fees.

New Rules and Regulations

The SEC introduced Rule 612, the Sub-Penny Rule, in 2005 to address the increment issue. In particular, the rule states that the minimum price increments for stocks over $1.00 must be $0.01, and stocks under $1.00 can increment by $0.0001.

The rule banned sub-penny quoting and not sub-penny trading, so the practice of sub-penny trading persisted following the new rule in the off-exchange markets.

When Rule 612 was adopted in 2005, the consensus stood that price increments of $0.0001 were economically insignificant and that only sophisticated investors would use these smaller increments to step ahead of retail investors. Others argued that technology hadn’t advanced enough to properly handle an increase in on-exchange quoting for sub-penny trading.

In June 2022, SEC Chair Gary Gensler directed SEC staff to potentially allow stock exchanges to quote shares in increments of less than $.01, enabling venues such as Nasdaq or the New York Stock Exchange to better compete with wholesalers, which often beat the publicly displayed prices on exchanges by adding or subtracting hundredths of a penny to the price of a stock.

The SEC introduced a study in 2015 that called for the widening of increments or ticks but changes did not occur until June 2022 when SEC Chair Gary Gensler addressed the future of sub-penny trading on exchanges including standardizing tick size across different market centers.

Considering the volume of off-exchange sub-penny trading, Gensler is evaluating the possibility of shrinking the minimum tick size to better align with off-exchange activity.

How Does a Sub-Penny Trade Work?

Currently completed only in dark pools or lit exchanges, assume a stock is quoted at .75 x .76 when a retail investor is looking to sell 1000 shares. While putting in a sell limit order at .75, a competing market maker has a hidden bid of .7510 for 1000 shares. When the customer submits the sell order, the hidden bid buys the 1000 shares and the customer is filled at .7510 on the 1000 shares, rather than .75 as shown in a regulated exchange market.

Where Can I Buy Sub-Penny Stocks?

Although changes are being considered in 2022 by the SEC to trade sub-penny stocks on the regulated exchanges, sub-penny trading only occurs now on dark pool markets, private exchanges for trading securities that are not accessible by the investing public.

Is Sub-Penny Trading Regulated?

Sub-penny trading is currently unregulated and completed in an undisplayed market.

"Sub-pennying" refers to bids floated by brokers, dealers, and high-frequency traders.

who often usurp a limit order with a hidden bid that is a fraction of a penny better.

By doing this, they get their transactions executed first, giving bidders the best chance to capture the spread.

Article Sources
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  1. Robinhood. "The Sub-Penny Opportunity."

  2. Wall Street Journal. "SEC's Revamp of Stock Trading Rules Faces Criticism from Wall Street."

  3. U.S. Securities and Exchange Commission. "Market Structure and the Retail Investor."

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