No More Secrets
By Lisa Dallmer

The SEC largely left it up to each Self Regulatory Organization (SRO) on how to handle the trading once the top-of-book is satisfied and the depth-of-book is exposed. Here, competition amongst exchanges to craft new order types, and to manage the matching of orders in a manner consistent with the rules and suitable to the interests of its broker member firms, should play out to the benefit of investors.

Certain exceptions to the Order Protection rule do exist, such as Intermarket Sweep Orders (ISO) (described below), single priced opening and closing auction executions, and benchmark orders such as VWAP orders, where the execution price is not based on where securities are trading at the time of execution.

An ISO is a limit order for automatic execution sent to a specific exchange, even when another market center is publishing a superior quote. When sending an ISO, the sender fulfills the Reg NMS order-protection obligations by concurrently sending additional limit orders to "clear out" the superior top-of-book quotes at all market centers. Using the ISO, the broker assumes the responsibility for Order Protection from the exchange by handling the routing, thus the exchange's execution behavior is expressly permitted.

A serious new twist is the inclusion of Nasdaq stocks in the Order Protection Rule. Previously, the trade-through rules only applied to securities listed on exchanges, like the New York Stock Exchange (NYSE) and the American Stock Exchange (Amex). Now, Nasdaq stocks are included as well.

Trading centers such as NYSE Arca and Nasdaq already operate "fast" markets by providing automatic execution and multiple order types for users to manage the routing and sweeping obligations with respect to away markets. ETFs are a great example of the traction that these electronic exchanges have gathered recently. The nature of ETFs, being derivatively priced with totally transparent holdings, lends itself to electronic trading. During the first nine months of 2006, 87 percent of ETF shares traded (market-wide) were handled by fully electronic market centers.4

The NYSE's technology modernization has resulted in a new system called NYSE Hybrid®. As a Reg NMS compliant system, Hybrid® integrates the specialist liquidity provision process in the display book through automated quoting capabilities allowing the specialist to enter multiple bids or offers at different price points. Not to be lost here is the specialists' continued role as the buyer or seller of last resort, which, along with quoting functionality, is a critical feature to managing volatility. Hybrid® has set Liquidity Replenishment Points (LRPs) to trap erroneous trades and to permit "auction only" trades to curb wide price movements.

Early reports from the NYSE on the stocks trading using the new Hybrid® technology indicate positive results. As of November 2, 2006, the NYSE released performance statistics5 on the 109 stocks taking part in the initial Hybrid® rollout:

• Quoted spread declined to 14.16 basis points from 16.23 basis points
• 91 percent of trades were auto-executed, up from 29 percent pre-Hybrid®
• Fill rates at the NYSE, measuring certainty of order execution, rose to 80.5 percent from 73.5 percent pre-Hybrid®

There Are No Velvet Ropes
The Market Access Rule (Rule 610) develops new standards governing access to quotations in NMS stocks. The standards are based on three new rules.

First, exchanges may now utilize private linkages to access quotations at away markets, as opposed to using the Intermarket Trading System (ITS), a centralized utility. Private linkages provide for a higher degree of flexibility and a less expensive cost structure, and align the economics of design and bandwidth with the consuming exchange. For example, if an exchange does very little routing of orders to the NYSE, then the exchange might choose not to invest in an expensive connectivity model to reach the NYSE. Rather, with the flexibility of Reg NMS, the exchange is likely to invest in faster and greater connectivity to those destinations they do expect to be routing to frequently. Of course, the tolerance of these choices is borne out by the members, and any miscalculations will be apparent—since we know that the market votes with its order flow.

The second aspect of the Market Access rule limits the linkage fee a market center can charge for accessing its quotes to $0.003 per share. The SEC believes that the $0.003 limit will support the Order Protection Rule. Without a linkage fee cap, trading centers could charge excessive fees to competing trading centers that are merely obeying the Order Protection rules.

Lastly, revisions to Market Access rules now require SROs to develop rules that prohibit member-trading firms from engaging in a pattern of displaying quotations that lock or cross the automatic protected quotations from other trading centers. Keeping with the spirit of Reg NMS, the new Market Access rule does not protect manually entered quotations from being locked or crossed by another market center.

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