What Is Sub-Pennying?
Sub-pennying is a practice where brokers, dealers or high-frequency traders jump to the front of the line in the National Best Bid and Offer (NBBO), which is the highest posted bid and the lower posted offer for a trading instrument, by making a price improvement in 1/100 of a penny increments. This allows the transaction to be executed first and provides the best opportunity to capture the spread.
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.
Sub-pennying 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 in the situation actually receives a slightly better deal, the seller misses out on the opportunity to fill the order, and then the liquidity provider doesn’t receive any rebates.
Retail brokers will take 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 & Regulations
The SEC introduced Rule 612 – or the Sub-Penny Rule – in 2005 to address these issues. In particular, the rule states that the minimum price incrementing for stocks over $1.00 must be $0.01, and stocks under $1.00 can increment by $0.0001. The problem is that the rule only banned sub-penny quoting and not sub-penny trading, so the practice of sub-pennying persisted following the new rule.
In 2014 and 2015, the SEC introduced a study that called for the widening of increments – or ticks – at which smaller companies’ stock prices are priced to see if it helps improve market liquidity. A group of stocks in the study would also be subject to a controversial reform called the “trade at” rule, which would help drive more traffic on to exchanges and ECNs and away from alternative trading venues like dark pools.
Traders insist that these rules would be highly anti-competitive and have lobbied against them, which makes them unlikely to pass into law in the United States. Since the pilot study was commissioned, the "trade at" rule has largely faded into the background, particularly with President Trump's opposition to new financial regulations.