What Is the Trade-or-Fade Rule?
The trade-or-fade rule was a requirement on options exchanges that required market makers to either trade with the market maker with the higher bid or match a better bid discovered on another exchange. The trade-or-fade rule was put in place to stop trade-throughs, which are transactions that are carried out at a lower price than the best offer, thus trading past or around the better market price.
The exchanges introduced the “trade-or-fade” regulations in 1994, which mandated that a market maker update its quotation if it is hesitant to execute an order at its published price with a market maker from another exchange. Later, it was changed to the firm quote rule.
- According to the trade-or-fade rule, a market maker must trade at the highest bid achievable.
- As prices move away from the initial bid-ask, a market maker or dealer who does not hold onto their bid or offer for very long is said to be fading their markets.
- The SEC changed the trade-or-fade rule in 2001 because it had too many flaws to be effective in preventing trade-throughs.
Understanding the Trade-or-Fade Rule
According to this regulation, a market maker may offer to trade with another market maker if a superior bid for an option is placed on another exchange and the market maker is unable or unable to match it for a customer order. The market maker who is giving the better price must accept it and execute the deal at that price, failing which the bid must be adjusted.
U.S. options exchanges proposed the trade-or-fade regulation to the Securities and Exchange Commission (SEC) in 1994 to encourage trading. Specifically, to avoid trade-throughs. Trade-throughs are orders that provide false appearances of “trading through” to higher bids. Therefore, the market maker with a superior quotation must trade at that price or alter their quote in order to avoid the appearance of trade-throughs.
The SEC changed the trade-or-fade regulation to the firm quote rule in 2001. The increase in the number of options classes posted and traded on exchanges contributed significantly to the adjustment of the trade-or-fade rule. According to the SEC, a national market system’s fundamental elements include the dependability and accessibility of accurate quotation information, both of which are necessary for broker-dealers to choose the best execution strategy for their customers’ orders and for customers to choose their order entry strategy.
The trade-or-fade rule included workarounds, including phantom quotations, so it didn’t really increase market efficiency.
Shortfalls of the Trade-or-Fade Rule
Despite being implemented to address trade-throughs, certain market players have objected to the restriction. The major problem for traders is that the regulation makes it difficult to utilize and access all marketplaces effectively. Another argument is that there is no incentive to shop around for a lower quotation because of the regulation.
Participants came up with solutions to the trade-or-fade regulation, which was put in place to stop trade-throughs. Phantom quotations are included in this, resulting in a two-tier market where prices are presented according to the buyer.
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