Regulation NMS Part I: Loved or Loathed and Why Many Want It to Die

Time to Determine the Fate of Reg NMS

After six years, there are a few distinct takeaways from the Reg. NMS rulemaking and implementation process. With the benefit of that hindsight, it’s time to decide whether to keep, tweak or even scrap the rules.
Larry Tabb

After six years of what often has seemed like a knock-down, drag-out fight, it’s finally time to determine the fate of Reg. NMS. While the debate over whether the regulation helps or hurts the markets is subject to interpretation, there needs to be a concerted effort to create success criteria, gather data, and measure this data against success metrics to make a reasonable assessment of the rules and their consequences, both intended and unintended. It is time to decide whether to keep, tweak or even scrap Reg. NMS.

Regulation National Market Structure is the collection of SEC rules implemented in 2007 that redefined how the US equity markets operate. The rules were intended to create a framework to protect retail investors, make market centers more competitive, and bring the US equity markets into the 21st century. While Reg. NMS has clearly made life better for individual investors directly buying equity shares (demonstrated by cheaper trades, tighter spreads and quicker executions), however, a number of market participants vehemently believe Reg. NMS should be relegated to the scrap heap.

The Reg. NMS rules revolve around four key themes: a prioritization of fast over slow markets; the elimination of the Intermarket Trading System (ITS), a mandated routing network between markets; a realignment of market data rebates; and top-of-book trade-through protection to ensure that the best-priced bid or offer is executed before a lesser-priced order. The core of the regulation was developed by the SEC to assure investors that we have a fair and equitable marketplace.

In reality, however, Reg. NMS started a progression of technology changes that has exacerbated execution complexity, crippled the NYSE floor, prioritized speed over liquidity, and virtually put a bullet in the head of smaller, less-technology-adroit brokers and floor traders. It also fragmented the markets, drove ever-increasing messaging rates, created order-type complexity, and arguably enabled high-frequency traders to take advantage of the very investors Reg. NMS was intended to protect, while actually making the markets less transparent for regulators.

Reg. NMS was always controversial. Long-only institutional investors, in particular, have never fully supported it. In a 2005 TABB Group study, based on conversations with 53 US head traders, only 19% actually supported the current implementation of the trade-through rule.

With the benefit of hindsight, however, there are a few distinct takeaways from the Reg. NMS rulemaking and implementation process: One, mandating a market structure creates many unintended consequences. Two, in mandating a market structure, there will be winners and losers. Three, creating change may actually hurt the people you are trying to help. And four, it may take years for the markets to stabilize.

The markets need guidelines and rules that should be policed. But we need to be careful when we change how the markets actually work. We need to ask the right questions, determine our priorities, and develop fair rules. And to do that, we need to implement pilot programs to gather the right data, analyze it in controlled and meaningful ways, and create a discussion as to not only how to develop the right market structure, but how to implement it as well.

While change comes with unintended consequences, sometimes it’s necessary. And right now, the markets do not seem to be fully serving our economy or a vast swath of our investing and trading communities. It’s time to take a hard look at Reg. NMS and the lessons we’ve learned over the past six years.

For more on the path of Reg. NMS – and where it veered it off course – download TABB Group’s Vision Note, “Reg. NMS Part I: Loved or Loathed, and Why Many Want It to Die.”