Regulation NMS Part II, Plugging the Gaps: Where You Stand Depends Upon Where You Sit

Different investors and firms look at the market differently, and how to fix the market depends upon their perspective ¾ what do they deem broken and in need of repair? The challenge of finding a communal solution to solve all of the industry’s problems together is next to impossible. Where you sit dictates the answer to many of these issues.

While fragmentation makes it more difficult to see the complete picture, fragmentation can also be thought of as competition. While most of us understand venue fragmentation, markets can also be fragmented through speed and price. Price fragmentation occurs when buyers and sellers cannot come together or do not match because they are sitting at different pricing levels, while the race to go faster requires increasing investments in technology, data centers, and communication while simultaneously reducing the amount of money that can be deployed in the market. When data and news can be interpreted faster than the market can trade, price discovery and perceived value move out of alignment. Reducing the importance of speed, such as widening spreads, faces the tradeoff between lower costs and less-displayed liquidity and greater costs and greater-displayed liquidity.

Modifying the order-protection rules also creates problems. Should we mandate depth-of-book trade-through or get rid of trade-through protection altogether? While trade-through protection sounds great, it has a number of counterintuitive effects, caused by latencies between exchanges and a significant increase in message traffic, for example. Conversely, eliminating top-of-book order protection has the ability to provide investors with better executions, reduce market linkage, lower complexity, and reduce market fragmentation. Likewise a reduction in order types may reduce complexities but will not resolve the race between the technology haves and have-nots.

Access fees, trading rebates, inverted pricing and volume tiers are all nuanced aspects of exchange pricing strategies that affect trading behavior. Also under debate are order routing practices; the order execution process is inherently complex and the economic model for order execution can run the gamut, from receiving payment for the order flow to paying for execution. With dark execution in the high 30 percent range, there are competitive advantages and disadvantages for different constituents and escalating concerns that too much order flow is being traded off exchange. While a Trade-at rule would definitely push more order flow into the exchange, many antagonists argue the benefits of doing so. If orders are being executed quickly, efficiently and at or better than the NBBO, why should regulators force brokers to pay more, risk greater information leakage, and push more flow into the more predatory trading environment?

The bottom line: Fixing Reg NMS is not simple. While few markets have significant challenges with the realignment of market-data fees, just about all of the other tenets of Reg NMS are controversial to one or many market demographics. Depending upon your role in the market, these rules can swing from significantly beneficial to very detrimental. The SEC’s mandate is not to protect brokers, exchanges, or intermediaries, but to protect individuals, market quality, and capital formation. If it could be proven beyond a reasonable doubt that one of these key pillars were clearly impaired, the SEC would have more ammunition to make a radical market structure change.

This report follows on from “Regulation NMS Part I: Loved or Loathed and Why Many Want It to Die,” and focuses predominantly on speed, routing, sub-pennies, data rebates, and the challenges with order protection rules. The report includes 16 Exhibits including eight Score Cards outlining the competitive advantages and disadvantages for different constituents with regard to: speed, spreads, order protection, order types, access fees, order routing, off-exchange trading, and a Trade-At rule.