The US Securities and Exchange Commission (SEC) says its wants to make changes to how equities are traded in the US in order to increase transparency, efficiency and fairness, but critics fear the SEC could unnecessarily complicate markets. The so-called Regulation NMS (National Market System) represents the broadest set of market reforms since the 1975 Congressional mandate for a national market system. Proposed last February, the suggestions have unleashed a storm of controversy likely to delay their implementation if not completely eliminate some essential parts.

Providing Best Prices Across Markets
The reforms consist of four proposals regarding trading prices, market access, revenue models for market data and the elimination of sub-penny quotes. Of these, debate is most heated about proposed changes to the so-called “trade-through” rule, which prohibits the execution of an order in a market at a price that is lower than one displayed in another market. Supporters of the trade-through rule say it helps guarantee that investors have access to the best prices, regardless of the market. Institutional investors, however, point out that best price does not guarantee best execution, especially for their large orders. Still, the outcome of the discussion is likely to have far-reaching consequences for the floor trading model of the New York Stock Exchange (NYSE) as it competes with faster, automated pricing models.

Technology Creates Gap Between Fast and Slow Markets
Indeed, the SEC's proposals stem from the growing discrepancies technological changes have created between traditional manual trading models and automated electronic models. Regulation NMS seeks to address the challenges presented by innovative trading technologies, new market centers and changing investment practices. As Annette Nazareth, the director of the SEC's Division of Market Regulation says: “There is a fundamental tension when electronic trading intervenes with a floor-based system. The rules should provide sufficient operational flexibility.”¹ The SEC says the most serious shortcoming of the current system is the inability of buyers and sellers to interact directly and efficiently amid a multitude of competing markets.² The SEC's proposals are an attempt to bridge those gaps.

Divided Opinions
The SEC received more than 600 formal responses to the reforms during the official comment period. Representatives from the NYSE and the Chicago Stock Exchange publicly opposed the changes at a hearing in April, arguing that investors already enjoy sufficient regulatory protection for trading at the best price and that further SEC intervention could undermine confidence.

Even among SEC members there were different opinions. Chairman William Donaldson as well as Harvey Goldschmid and Roel Campos support Regulation NMS as a way to protect investors. Cynthia Glassman and Paul Atkins, on the other hand, have criticized the proposals for not going far enough and have called for a more thoroughgoing reassessment of the capital markets. According to Glassman: “There are significant stakeholders on every side of nearly every issue in the market structure arena. We need to make sure that our rules are not impeding efficient markets or subsidizing an inappropriate status quo.”³

Trade-Through Rule and Institutional Investors
The trade-through rule requires that brokers and dealers prevent stocks from being bought or sold at “inferior” prices.  It refers to the practice of “trading through” one exchange for stock being sold at a lower price on another. This happens, for example, when an institutional investor sends a large block order to the NYSE for better execution even though the Nasdaq may be quoting a better price. For institutional investors, best execution is often more important than price alone. Since transaction costs are an important factor for institutional investors, certainty of trade and liquidity are critical considerations.   Best execution also refers to the anonymity of a trade institutional investors get from so-called stock “specialist” firms or brokers that execute their buy and sell orders at competitive prices. That anonymity prevents other investors from trading against them and bidding up prices.

Recognizing that institutional investors may want to choose best execution over best price, the SEC has provided an opt-out choice for the trade-through rule However, it requires explicit customer consent on a trade-by-trade basis. Critics say that would unduly complicate trading procedures and require large system overhauls. Steve Swanson, CEO of the brokerage house Automated Trading Desk argues that: “You have to be able to flag opt-out on a per-order basis and to do that you have to change systems. That is not a trivial issue.”⁴

Another exception to the trade-through rule would allow bids available for automatic execution to bypass or “trade through” better-priced bids not available for automatic execution. This would further highlight trading discrepancies between automated and manual or fast and slow markets.

Implications for NYSE
In an attempt to save its manual stock trading floor while at the same time providing more automated trading, the NYSE has proposed a new hybrid market model to the SEC. This would enhance the exchange's Direct Plus automated system, which currently is constrained by several technical limitations. For example, trades are limited to a maximum of 1,099 shares; a 30-second delay is imposed on consecutive trades for the same account; and the system shuts down when a minimum 100-share buy or sell order is submitted.  Moreover, the NYSE is proposing to apply the automatic execution system only to best bid and offer prices at the top-of-the book, whereas other systems (such as Nasdaq's SuperMontage system) provide automatic execution on different price levels through the complete depth-of-book. For investors it typically is more valuable to be able to go through multiple price levels and have an automated market.

Some analysts believe the NYSE's traditional business model is at risk if the trade-through rule as it is proposed in Reg NMS is made final. The 112-year-old exchange could lose up to 50 percent of its market share if it does not qualify as a fast market.⁵ However, if the hybrid system leads to more customers choosing automatic execution over manual execution then the NYSE's specialists and floor brokers likely will become obsolete. Alternatively, if the hybrid system does not work, the exchange could increasingly lose market share to faster markets.

Market Access Changes
The SEC is also proposing a market access rule that would modernize the terms of access to quotations and execution of orders. It suggests eliminating the requirement to use the Intermarket Trading System (ITS), a network many consider outdated, through which market centers send orders to the venue that advertises the best price. Instead it recommends that private companies provide more advanced links. The proposed access standards would: 1) require market centers to allow all market participants access to published bids and offers; 2) limit access fees to agreed minimal amounts; and 3) require self-regulatory organizations (SROs) to establish rules to reduce locked or crossed markets.

New Revenue Model for Market Data
In an attempt to reward market centers that generate the highest quality quotes, the SEC has suggested changing the formulas for calculating revenue for real-time quotes and volume information. At the moment revenue from the sale of real-time quotes is based on the number of trades and volume actually executed. The proposed change would include both trades executed and bid/ask quotes placed. The aim is to encourage market makers to place more bid and ask orders, providing investors with broader price points.

Eliminating Sub-Penny Quotes
Perhaps the least controversial provision is the elimination of sub-penny quotes, except for securities with a share price of below $1.00. Since decimalization was introduced in 2001, electronic exchanges have been able to display quotations in sub-pennies. This has led to some market participants “stepping ahead” of customer limit orders by a small amount to gain execution priority. As a result, some investors were discouraged from placing limit orders, reducing market liquidity. Since there has been little opposition to this proposal, many observers expect this part of Regulation NMS could be passed separately from the other more controversial reforms.

Controversy Likely to Delay Implementation
Disagreement over how Regulation NMS could affect the markets is likely to delay its full implementation. Very few observers expect major changes before mid-2005. Institutional investors share the same goals of market transparency, liquidity and certainty of execution. Regulation NMS is unlikely to solve all the market's inconsistencies and inefficiencies, but at least it is focusing attention on ways to adapt to changes forced by new technologies and evolving markets.

¹  Christopher Westfall, “Traders Look Past Trade Through,” Banking Insider, October 7, 2004.

²  David F. Freeman Jr., Kevin A. Zambrowicz, Eunice Y. Kang, “The SEC's Proposed Regulation NMS,” Banking and Financial Services Policy Report, June 2004.

³   Kathie O'Donnell, “SEC's Glassman on Market Structure,” CBS MarketWatch, September 28, 2004.

⁴   Daniel Safarik, “Will the SEC Change the Rules?” Waters, October 20, 2004.

⁵   “Regulation NMS,” Celent Communications, September 2004, p. 34.

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Posted On: October 28, 2004