The Sub-Penny Rule

Understanding the Sub-Penny Rule

The Sub-Penny Rule, implemented as part of Regulation NMS, addresses specific challenges in modern electronic markets. The rule was designed to prevent practices that could degrade market quality and create unfair advantages through economically insignificant price improvements.

Key provisions

The rule contains two primary pricing tiers:

• For stocks priced $1.00 and above: Minimum increment of$0.01
• For stocks priced below $1.00: Minimum increment of$0.0001

Market structure implications

The Sub-Penny Rule significantly impacts market structure in several ways:

1. Quote competition: Forces meaningful price competition by preventing nominally better prices through microscopic improvements

2. Order queue priority: Helps maintain orderly limit order queues by preventing queue jumping through sub-penny pricing

3. Market data efficiency: Reduces quote traffic and system load by limiting the number of valid price points

Impact on trading strategies

The rule affects various trading strategies and market participants:

Market makers

• Must maintain quotes in penny increments for liquid stocks
• Affects spread capture strategies and risk management
• Influences market depth and liquidity provision

Algorithmic traders

• Must design order execution algorithms that comply with minimum tick sizes
• Cannot use sub-penny pricing for queue position advantages
• Need to adjust price improvement strategies

Dark pools

The rule has specific implications for dark pools:

• Can execute at sub-penny prices (midpoint executions)
• Must still comply when displaying actionable indications of interest
• Affects price improvement mechanisms

Regulatory considerations

Trading venues and market participants must implement various controls:

1. Pre-trade validation

• Price increment verification
• Order rejection for non-compliant prices
• System controls for different price tiers

2. Compliance monitoring

• Quote validation systems
• Audit trail requirements
• Exception reporting

3. Technology requirements

• Price formatting standards
• Data storage considerations
• System capacity planning

Market quality effects

The Sub-Penny Rule has several documented effects on market quality:

1. Reduced quote flickering
2. More meaningful price competition
3. Improved market depth at valid price points
4. Standardized minimum price improvements
5. Enhanced market stability

Exceptions and special cases

Certain exceptions exist to the Sub-Penny Rule:

1. Midpoint executions
2. Retail price improvement programs
3. Benchmark-based trades
4. Some options-related hedging activities

These exceptions allow for specific market mechanisms while maintaining the rule's core objectives.

The Sub-Penny Rule remains a fundamental component of U.S. market structure, helping to maintain orderly markets and fair price competition while preventing potentially disruptive trading practices.