Journal Of Indexes
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The sound bytes are everywhere … faster executions, automatic trading, Reg NMS. Not sure what the details of Reg NMS really are? Well, let's not gloss over it; let's itemize the market structure changes in more detail. The regulatory management of market structure is done through Securities and Exchange Commission (SEC) rule making, and there are certain unique rules applicable to either broker dealers or exchanges depending on the role each plays when routing and filling customer orders. Reg NMS is a significant rewrite of certain rules. If you can get past both the legalese and the broad generalizations, you can start to see how the equity markets will look in the future. And that is pretty exciting indeed.
What Is Market Structure The finer points of market structure have become increasingly visible over the past 10 years, as technology and competition for handling orders and trades has kicked into high gear. Seeking to improve their competitive positions in this era of technological change, brokers, exchanges and buy-side firms all marched down to Washington, D.C., in recent years, lobbying for an overhaul of several critical rules of engagement. Each had a different opinion about how to modify the rules, and after much deliberation, public hearings, floggings and over 700 comment letters (some verbose-paint-drying manuscripts, others are engaging editorials complete with sport analogies and humor), the SEC took action. By a 3-2 vote taken on April 6, 2005, the SEC commissioners approved the adoption of new substantive rules designed to modernize the structure of the U.S. equity markets.1 Aside from the Order Display Rules adopted in 1996, these are the first significant revisions to the NMS since it was established in 1975. In large part, Reg NMS can be thought of as new plumbing to an old house. Most of the heavy lifting is being handled by the exchanges and broker dealers, as they are the portal to the equity markets for fund managers and individual investors.
Four Major Rule Revisions2 For most users, those 523 pages can be boiled down into four important rules revisions, each with varying implementation dates, as shown in Figure 1.
Fractions Of A Penny Although orders cannot be entered at sub-penny prices, executions may occur for less than a penny under certain conditions. For example, the rule permits the continued use of the NYSE Arca Midpoint Cross order type, where a user enters a cross order, unpriced, and the exchange immediately executes the order at the National Best Bid and Offer (NBBO) midpoint, even if the midpoint is less than a penny.
Protecting Orders In the end, Reg NMS now protects the best bid and offer (known as top-of-book) displayed by each market center from being traded through by another market center, providing certain conditions are met. The SEC generally recognized there is an opportunity cost to the accessibility of quotes and the speed of execution, and these opportunity costs can be balanced with best price protection. A "trade through" is an execution that occurs at a price that is inferior to a displayed limit order on another market center. Previously, the rules regarding trade-throughs largely evolved from the exchange practices inherent in the ITS Plan, which advised against permitting such trades, and created a post-trade complaint and satisfaction process. The new Order Protection Rule creates an obligation to protect top-of-book "fast" or auto-executable quotes. Importantly, manual quotes marked "slow" for any reason are not protected, meaning a slow quote may not trade through a fast quote, but a fast quote may trade through a slow quote. Trading centers must use the quote identifiers at all times to indicate the status of their quotes, and a quote must be continuously marked "slow" if the trading center has reason to believe that it is not capable of displaying automated quotations. Here's an example of the top-of-book order protection: If a trader has 50,000 shares to buy and is willing to pay more than the national best offer to get it all done in one shot, that trader can no longer just reach up to the desired displayed offer (a few cents up) without first interacting with the better offer at each market center. Once all the top-of-book superior quotes are cleared, the order can then trade up into the book, since there is no depth-of-book protection for away market orders.
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:
There Are No Velvet Ropes 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.
Quotes, Trades And The Market Data Model There are three market data or "tape" plans for equities that govern the consolidation and dissemination of quote and trade data: Tape A for data on NYSE-listed securities; Tape B for data on securities listed on the Amex, NYSE Arca and regional exchanges; and Tape C for Nasdaq-listed securities. Prior to Reg NMS rule revisions, the Tape C plan allocated market data revenues to the exchange participants slightly differently than the Tape A and B plans. The SEC revisions standardized those allocations, putting in place three rules to make the system more equitable: (1) It placed a new emphasis on allocating revenues based on the quotes contributed by each exchange; (2) It ended the policy of basing revenue sharing on trade counts, which previously had rewarded a 200-share trade equal revenue value as a 10,000- share trade; (3) It set the maximum any particular trade may recapture in market data revenue in an attempt equalize high-volume stocks with low-volume stocks. Under the new order, all three plans are subject to the same revenue distribution formulae and rules. The expected effect of these changes will be an allocation of revenues equally split between trading activity and quoting activity at an exchange's best bid and offer, but capped for high-volume stocks. Some industry participants argued this might create an economic incentive for market participants to quote in a stock they otherwise would not be interested in trading. To counter this concern, a qualified trade value threshold of $5,000 was incorporated in the model to minimize quoting manipulation in thinly traded securities. The new model excludes manual quotes—another reason you see the exchanges working furiously to implement technology to qualify their quotes as "fast." Overall, the SEC is hopeful the economic incentives are level enough to drive trading behavior in a manner they feel promotes wider and more efficient distribution of market data. Regardless, there are countless mathematicians, industry consultants and economists all modeled-up to predict the outcome and identify any unintended consequences of the tail wagging the dog in market data revenue.
Conclusion For some exchanges, such as NYSE Arca and Nasdaq, becoming Reg NMS-compliant is not a significant departure from their current business model. The all-electronic exchanges already managed private connectivity to multiple pools of liquidity, and provided order types that were bound by the NBBO, thus offering top-of-book protection to those that chose to utilize the order. Of course, the electronic exchanges now have done work to identify their quotes as "fast" or "slow" depending on system status and availability; read the quote identifiers from other SROs; and process the inter-market sweep orders. Users of a fully electronic exchange can largely expect a better experience under Reg NMS when electronic exchanges are routing to/from the formerly manual exchanges. This will come as a direct result of the implementation of more technology and auto execution tools in systems like the NYSE Hybrid® and the Amex AEMI (SM). It is largely expected that the greatest gains from Reg NMS will be as a result of the massive technology investment and increased competition for order flow, which ultimately leads to greater certainty of executions for all investors. Welcome to the "arms race," where the modernization of a marketplace involves people and their intelligent implementation of technology. Endnotes
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