Proposed Regulation NMS: Tuning Up the Markets
by Richard Y. Roberts and Edward L. Pittman

Introduction

On February 26, 2004, the Securities and Exchange Commission announced its plan to modernize the securities markets with the proposal of four substantive initiatives under the Securities Exchange Act of 1934 (the “February NMS Release”).¹ While Chairman Donaldson characterized these proposals as the most significant amendments to market structure since 1975, Commissioner Atkins compared them to giving a new paint job and tune-up to a 1975 Gremlin.

Each of the substantive proposals attempts to address issues that have generated significant controversy in recent years. While characterized as formal rulemaking proposals, the Commission was careful to note that the more controversial provisions were largely conceptual in nature and were intended to fuel a dialogue that will likely encompass public hearings and further rulemaking. Although not discussed in this article, the February NMS Release also offers a number of alternatives to the primary proposals.

Comments on the proposals initially were due May 24, 2004. However, a subsequent Commission release (the “May NMS Release”)² extended the comment period until the end of June, and proposed for comment a number of new ideas presented at a public hearing on April 21, 2004, in New York (the “New York Hearing”). ³ Congressional hearings on the proposals have been scheduled.

The four substantive initiatives described in the February NMS Release are as follows:

• Extending the trade-through restrictions to all markets, including the Nasdaq market, but providing exceptions that will not require a market center or broker, among other things, to route orders to manual markets under certain circumstances;
• Requiring market centers, including ECNs, to provide non-discriminatory access to their quotes, and limiting any access fees to $.001;
• Prohibiting market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny, except for securities with a share price below $1.00; and
• Amending the rules and current joint industry plans providing for dissemination of market information to the public to modify formulas for allocating income among participants, create an advisory committee, and expressly permit the resale of data by exclusive processors on non-discriminatory terms.

Overview

Each of the four basic initiatives reflects a significant debate regarding the structure of the capital markets that has been taking shape for over a decade. In recent years, numerous Congressional hearings and Commission releases have generated comment decrying the ancient systems and policies that connect the markets.

Probably the most controversial of the proposals relates to the alteration of the current standards concerning “trade-throughs.” The Commission proposes to relax the current rules for transactions conducted on exchanges, and, at the same time, to expand the rules to include transactions in Nasdaq securities. The concept of a so-called trade-through, while obscure, has been a significant element of the current market structure.

Following the 1975 amendments to the Exchange Act, which were intended to strengthen the transparency of the market and eliminate fragmentation, the Commission approved a plan creating the Inter-Market Trading System (“ITS”). The ITS is a system of linkages that connects exchange markets and was designed to ensure that investors sending orders for execution at one market would have access to a superior quote offered by another market. The plan itself established rules, approved by the Commission, regarding the governance structure. Initial members of the ITS were the dominant securities exchanges at the time. New members had to be approved by unanimous vote.

To add teeth to the ITS system, the Commission approved rules that restricted the ability of any exchange to “trade-through” a better quote available on another market. In order to avoid sanctions, the exchange specialist had to either match the price quoted by the other market, or route the order out for execution at the market offering the superior price.

With the advent of new technology and changes in the structure of the securities market, the ITS system and the trade-through requirements have come under attack. While laudatory in spirit, the system has been described as akin to a “tin cup and string” communication structure. Detractors have complained that, in many cases, the seemingly superior quotes disappear when orders are routed out for execution. Moreover, the 30-second window that specialists have to determine whether to execute against the quote has proven to be exceedingly long in a market now characterized by nanosecond executions.

Attempts to generate support for modernizing the ITS have been criticized because the current governance system excludes new entrants, and because of concerns that forcing all market centers to employ the same technology— that created by the ITS—would stifle innovation and competition. Further, there has been considerable debate about whether best execution permits fiduciaries, including exchanges and brokers, to consider certainty and speed of execution in addition to the mere possibility of price improvement on an order routed out through the ITS system.

The debate regarding the merits of the ITS system and the trade-through requirements has been exacerbated in recent years by the development of private order routing systems and the movement to decimalization. With assured access, competitively designed private order routing systems in many cases offer a better method of aligning prices among markets, affording arbitrageurs the opportunity to take advantage of quote disparities. In addition, the implementation of decimalization has resulted in significantly narrower minimum price variations for stocks, causing the Commission and others to question the definition of a “superior” quote.

Trade-Through Reform

As noted above, the most controversial proposal, and the proposal that affects the greatest segment of the market, relates to trade-through reform. For some time now, the Commission has been under pressure from market participants and Congress to modernize the current linkage system in the United States to permit greater competition and to meet the demands of investors that desire certainty and speed of execution over the possibility of best price. The Commission attempts to address the controversy by proposing Rule 611 under the Exchange Act.

Proposed Rule 611 will affect all “order execution facilities,” a term that is broadly defined to include “all national securities exchanges and national securities associations that operate a facility that executes orders, ATSs, exchange specialists and market makers, OTC market makers, block positioners and any other broker or dealer that executes orders internally by trading as principal or crossing orders as agent.” Under the rule all “order execution facilities,” including for the first time Nasdaq, would be required to establish, maintain, and enforce policies and procedures reasonably designed to prevent the execution of trade-throughs in their markets.⁴

In crafting the rule, the Commission drew concepts from the current ITS rules as well as the rules of the NYSE and other SROs.⁵ One of the concerns with the existing ITS trade-through rule is that it is not enforced in a consistent manner. Some commenters already have noted that the new trade-through proposal is just as complicated as the existing one, and could prove to be as difficult to enforce with consistency. Under the proposed rules, a trade-through is defined as:

the purchase or sale of an NMS stock during regular trading hours, either as principal or agent, at a price that is lower than the best bid or higher than the best offer of any order execution facility that is disseminated pursuant to an effective national market system plan at the time the transaction was executed. ⁶

There are nine enumerated exceptions to the trade-through restrictions. The two most controversial of these exceptions relate to certain executions on automated order execution facilities, or “fast markets,” and instances in which customers “opt out” of the trade-through rules. A third exception applies to block transactions and transactions routed through smart order routing systems.⁷ Each of these three exceptions is discussed below.

The proposal to extend the trade-through rules to Nasdaq is accompanied by provisions requiring greater access to ECN quotes. The Commission indicates that the access either can be achieved through a hard-wired system, like ITS, or through competing private linkages. The Commission suggests that by routing to one market that has linkages, a firm may meet its obligation. However, the Commission also notes that the burden of ensuring best execution remains on the routing firm. As discussed below, the Commission attempts to create non-discriminatory access standards to encourage the development of private linkages.

Fast markets—fast quotes

One of the consistent complaints raised in recent years relates to the requirement to route orders through ITS to slower markets with putatively better quotes, but that offer manual executions and may utilize the 30-second window to accept or reject an order. Automated markets argue that the current trade-through rules compromise the integrity of the national market system and offer an embedded option to slower markets. To address this issue, the Commission seeks to draw a distinction between “automated” and “non-automated” order execution facilities (“fast markets” versus “slow markets”) in applying the trade-through requirements.

Under the proposed rule, an automated market will not have to route its transactions to a manual (traditional specialist), non-automated market if the spread does not exceed “trade-through limit amounts” that range from one to five cents (depending on the price at which the security trades).⁸ The exception builds on the August 2002 exemptions offered to QQQs and SPDRs previously approved by the Commission. Fast markets would still need to match the best price quoted on the slower market, however.

It is likely that the NYSE, through Direct+, and all other exchanges will effect changes in their current systems to qualify as “fast” or automated markets. Because the NYSE would be designated a “fast market,” orders could only trade through the NYSE quote at an inferior price when there is an express “opt-out” by the customer (discussed below), or when another exception from the rule is available.

An automated market will not be defined based on exact standards, but instead will have to fall within a definition that the Commission’s staff suggested includes “virtually simultaneous, immediate, and without human intervention.”⁹ Nevertheless, in the February NMS Release, the Commission requests comment on whether the definition should include any system in which the automated execution feature can be turned off, as well as whether certain other performance standards should apply. In addition, the Commission asks for comment on what delays would be acceptable in an automated system.

In the May NMS Release, based on comments made during the New York Hearing, the Commission also requested comment on whether the distinction should be made between manual and automated quotes, rather than the markets themselves. The exception would apply on a quote-by-quote basis. The Commission suggests that the definition of an “automated quote” presented at the New York Hearing encompassed the ability to immediately interact with the quote: “knowing instantaneously whether an order was executed (in full or in part) or cancelled —is key.”¹⁰ In this regard, the Commission has requested additional comment on whether performance standards of less than one second should be applied in determining whether a quote or market is automated. The Commission also suggests in the May NMS Release that automatic updating of quotes and cancellation functionality should be required.

Customer opt-out

Because of the debate between certainty of execution and best price, the Commission has afforded an exception to the trade-through requirements for customers that “opt out” of trade-through protection. To opt out, the customer must receive “clear” disclosure and give “informed consent,”¹¹ and a record must be made on a “transaction-by-transaction” basis. There would be no blanket opt-outs. Given the onerous burden of a transaction-by-transaction condition, this requirement likely will be vigorously resisted by commenters offering direct access to retail customers.

If the transaction is a purchase, the Commission will require that the corresponding national best offer be disclosed. If the transaction is a sale, there must be disclosure of the national best bid. Either disclosure would have to be reflected in equal prominence and close proximity to the execution price on the customer’s confirmation or monthly account statement. Importantly, the Commission notes that a broker need not offer its customers the opportunity to opt out or accommodate requests to opt out. A number of commenters at the New York Hearing addressed concerns about the implementation of the opt-out provisions; the Commission requested further comment.¹²

Smart order routing—block transactions

Rule 611 also provides an exception that permits a firm to facilitate orders based on size at the top-of-book across markets at the time the transaction is effected. This exception allows a firm to take a “snapshot” of the market at a particular point, and to execute at prices reflected in multiple markets based on the size displayed by those markets, without regard to depth of book. Thus, using a smart order routing system, a broker may route a single order to multiple market centers.

Even though a portion of the trade may occur at a price inferior to the best displayed quote, there would be no violation of the rule. The Commission views this exception, and the optout exception, as the alternatives for block transactions. However, as noted below, the Commission’s staff has indicated that a firm may not take the same approach when pricing an internalized order.

Internalization

Although significant, the practice of internalizing orders receives little attention in the February NMS Release. As proposed, however, Regulation NMS would not prohibit internalization so long as the price offered customers is not inferior to the national best bid or offer. But, the proposal does have the effect of extending the current trade-through restrictions into the Nasdaq marketplace and also applies the limitations to a broader set of market participants. If adopted, Regulation NMS would make any transaction that does not match the NBBO a trade-through violation, without regard to whether there is an argument that best execution was achieved.

Absent from discussions of the best quote is any reference to size in the context of internalization. While not addressed in the February NMS Release, the Commission’s staff has indicated that in order to avoid violating the new trade-through rule, the entire order must be executed at the national best bid or offer or the market center must route the order out for execution. Thus, for a thousand share order, the entire thousand shares must be executed at the NBBO, even though the best quote may only be for 100 shares.

Market Access Proposal

Overview of current environment

The Commission points out in the February NMS Release that brokers in many instances may not be able to access large pools of liquidity. Accordingly, the Commission is proposing three measures under new Rule 610 designed to ensure fair market access. These proposals are premised on support for the longstanding argument that private linkages should be permitted to compete against the institutionally-sponsored ITS system. As noted earlier, the ITS system has been criticized in recent years because of its lengthy execution delays, antiquated one-size-fits all approach, and exclusive governance system.

As discussed below, the measures proposed by the Commission to encourage competition include requiring all market centers¹³ to permit all market participants¹⁴ access to their limit order books, at least indirectly, on a non-discriminatory basis. In addition, fees charged by market centers and broker-dealers for access to their quotations would be limited to a de minimis amount. Finally, SROs would be required to establish rules intended to reduce the incidence of locked and crossed markets.

Proposed amendments

Uniform standards. Under proposed Rule 610, the Commission seeks to open the doors to competition by barring quoting market participants from inhibiting a non-member or non-customer from accessing its quotes by imposing unfairly discriminatory terms. In addition, a market participant is required to make its quotations available for execution to other market centers and market participants on terms as favorable as those it grants to its most preferred members or customers.

Access fees. Access fees have become a subject of intense debate. ECNs may not charge fees that have the effect of creating barriers to access for non-subscribers. Currently, the Commission limits ECN fees to “those that they charge a substantial proportion of their active broker-dealer subscribers,” but no more than $.009 per share.

Access fees have been criticized because they may result in artificial quotes. In addition, the Commission notes in the February NMS Release that the fees are used to support rebates for liquidity providers to ECNs, which the Commission contends has led to an increase in crossed and locked markets. To address these concerns, the Commission is proposing to cap access fees at $.001 per share, and not more than $.002 per share accumulation for any transaction. These proposals will effectively limit rebates.¹⁵

Amendments to access standards for Regulation ATS. The proposal also would make conforming changes to Rule 301 of Regulation ATS. Under current Regulation ATS, brokers need not provide their quotes to the market if they represent less than 20% of the trading volume in a security. Under the proposed rules, the threshold would be reduced to 5%, although the Commission is doubtful that most ATSs will cross even the lower threshold.\

No Sub-Penny Quotes

Since the movement to decimals in April 2001, spreads across markets have declined substantially. However, while consumers have benefited, market participants have been challenged by outdated rules that were designed for markets quoting 1/8 increments. In addition, there has been some disparity in practices: some markets and securities information processors round quotes to the closest decimal, while ECNs continue to offer quotations in sub-penny increments. In part, the Commission’s proposal is intended to address concerns relating to the formation of “hidden markets” and also the practice of some market participants attempting to achieve price priority over customer orders by “stepping ahead” with quotes in price variations that have no economic significance.

There is extensive discussion in the February NMS Release concerning the effect of decimalization on the markets, including the challenges imposed in applying rules, such as the short sale rules, that are based on bids.¹⁶ The Commission states that most of its goals in moving to decimals have been obtained.

Economic studies by the Commission staff show that, in most instances, sub-penny quotes were just a fraction above or below the market and offered no real price improvement. Thus, the staff has inferred that the primary purpose of sub-penny quotes often is merely to obtain price priority. To circumvent that strategy, the rule generally would prohibit market participants from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny in any NMS stock (except those trading below a dollar).

Market Data Proposals

Once a sleepy backwater of the securities industry, issues affecting the collection and sale of market information have garnered significant attention in recent years. The SROs participate in three joint industry plans (“Plans”) that gather and disseminate data for each security, including the NBBO, the best bids and offers from each SRO, and a consolidated set of trade reports. The February NMS Release indicates that in 2003, the Plans collected $424 million in revenues derived from market data fees and, after deducting expenses, distributed $386 million to their individual SRO participants.

Although all fees established by the Plans must be approved by the Commission, there has been considerable controversy about the lack of review accorded fee filings and the monopolistic system in which the fees are set. Criticism of the system spawned the creation of the Advisory Committee on Market Information, which in 2001 made a number of recommendations. The central recommendations of the Committee are addressed by the Commission (without much enthusiasm) in the February NMS Release.¹⁷ Instead, the Commission offers a proposal that will appear to many as a band-aid rather than a solution to the current problems.

Modification of income allocation

Currently, all fees for market data are set by the Plans with the approval of the Commission. The Plans are the exclusive processors of consolidated information for NMS stocks, and the consolidated display requirement necessarily means that all users of market information must purchase data at the established fees. The lack of competition and the volume of fees generated has led to considerable pressure for reform.

Rather than introduce additional competition, the Commission proposes to address the concerns of individual members of the Plans by creating a new formula for income allocation. The Commission suggests that the current method of income allocation, with the “exclusive focus on trade reporting, has distorted SRO competition and created incentives for ‘print facilities,’ ‘wash’ trades and ‘shredded’ trades solely to maximize market data revenues.”¹⁸ The formula the Commission proposes is complex and emphasizes the quality of the quotes (best price and largest size) provided by a Plan member over sheer volume.

The Commission states that only the SROs affected by the formula will need to know the details, and “[n]o matter what formula ultimately is adopted, those parties most affected by it will soon know its details intimately.” The Commission seems almost to ignore the fact that the firms and individual investors paying the fees may also have an interest in the monopolistic rate-setting process. Since the Commission does not intend to require SROs to publicly disclose the cost of providing market data to the public, there is no way for anyone to determine whether $386 million is realistic and fair. It is likely that this proposal will generate negative comments from within the industry.¹⁹

Creation of a non-voting advisory committee

To add insight to the governing process of the Plans, the Commission proposes the formation of an advisory committee that would submit its views to the operating committee on Plan matters. The Commission suggests that these matters would include new or modified products, fees, procedures for fee administration, and pilot programs. The committee would “have the right to attend regular meetings of the operating committee and to receive any information relating to Plan business that was provided to members of the operating committee,” except when the operating committee chooses to meet in executive session. The advisory committee would comprise at least one representative from each of the following five categories: (1) a broker-dealer with a substantial retail investor customer base, (2) a broker-dealer with a substantial institutional investor customer base, (3) an ATS, (4) a data vendor, and (5) an investor. In addition, each SRO participant would have the right to select one committee member that is not employed by or affiliated with any participant.²⁰

Modification of requirements for consolidation and display of market data

Another requirement that became controversial in recent years concerns the consolidated display of information. Under current law, market centers are required to submit information to SROs, which have plans that specify what information will be made available to the public. The proposed amendments would expressly allow any market center, exclusive processor, or broker that is the exclusive source of quotes to make the information available to others on terms that are fair and reasonable, and not unreasonably discriminatory. Additional proposals would narrow the scope of data and circumstances in which consolidated information must be supplied. Except where the data is likely to result in a trading or order routing decision, market forces would be left to decide the nature of information provided.

Conclusion

The foregoing is a brief summary of the Commission’s initiatives. In the February NMS Release, the Commission provides significant historical background and economic justification for the proposals. In addition, it raises a number of alternatives and asks questions relating to a host of issues. As the Commission suggested at the open meeting authorizing the issuance of the February NMS Release, many of the issues are complex and likely will not be addressed without further comment and the consideration of new proposals. In fact, based on the diversity of viewpoints already reflected in the comment process, and at the Commission’s New York Hearing, it seems likely that any changes will come only after a protracted period of debate.

About the Authors

Both Richard Y. Roberts (rroberts@thelenreid.com) and Edward L. Pittman (epittman@thelenreid.com) are attorneys with the firm of Thelen Reid & Priest LLP in its Washington, D.C. office. Mr. Roberts served as a Commissioner of the Securities and Exchange Commission from 1990-1995; Mr. Pittman served as Assistant Chief Counsel of the Division of Market Regulation.

Notes

1. SEC Release No. 34-49325 (Feb. 26, 2004), available at <www.sec.gov/rules/proposed/34-49325.htm>.

2. SEC Release No. 34-49749 (May 20, 2004), available at <www.sec.gov/rules/proposed/34-49749.htm>.

3. Testimony and a transcript can be found at <www.sec.gov/spotlight/regnms.htm>. After opening statements by Chairman Donaldson and Annette Nazareth, the Commission’s Director of the Division of Market Regulation, the Commission and its staff heard testimony from seven panels of individuals representing a broad spectrum of the securities industry. There were two panels addressing the trade-through rule proposal, and one panel each on the aspects of the proposal relating to a hybrid floor/electronic market structure, market access or linkages, access fees, subpenny quoting, and market data. There was little agreement with respect to potential benefits from the proposed trade-through rule, and the market data proposal was roundly criticized.

4. Interestingly, the Commission also gives consideration to the notion of flickering quotes and the problems encountered by a market participant that “took all reasonable precautions and legitimately did not think that it was trading through the best bid or best offer of any other market participant.” SEC Release No. 34-49325, supra note 1, at Section III.C.5.

5. There is no formal proposal to amend either the ITS or NYSE rules, but the Commission states that it expects that conforming amendments will be proposed by the SROs. See Id.at Section III.E.

6. Proposed Rule 600(b)(75).

7. Additional exceptions are provided when: (1) the facility displaying the better price is experiencing a failure, material delay, or malfunction; (2) the facility that initiated the tradethrough made every reasonable effort to avoid the trade-through but was unable to do so because of a system or equipment failure, material delay, or malfunction in its own market; (3) the transaction that constituted the trade-through was not a “regular way” contract; (4) the bid or offer that is traded-through was displayed by an order execution facility that was, or whose members were, relieved of their obligations under § 242.602(b)(2) with respect to such bid or offer pursuant to § 242.602(a)(3); (5) the transaction that constituted the trade-through was an opening or reopening transaction; and (6) the transaction that constituted the trade-through was executed at a time when there was a crossed market.

8. The price increments begin at one cent for stocks priced less than $10 per share, and increase by one cent at $10, $30, $50, and $100 dollars (e.g., five cents). The measurement is the national best offer at the time of execution for buy orders, and the national best bid at the time of execution for sell orders.

9. “Automated order execution facility” is defined as “an order execution facility that provides for an immediate automated response to all incoming subject orders for up to the full size of its best bid and offer disseminated pursuant to an effective national market system plan, without any restrictions on executions.” SEC Release No. 34-49325, supra note 1, at Section III.D.2.

10. SEC Release No. 34-49749, supra note 2, at Section II.A.1.

11. The Commission indicates that the way in which a broker-dealer obtains informed consent may differ from investor to investor. However, “a broker-dealer at a minimum should explain in clear and concise terms to any customer from whom it accepts consent, for each order, that: (1) the customer’s order would be executed in the market to which it is sent without regard to prices displayed in other markets, even if those prices are better; (2) the customer affirmatively would be agreeing to forego the possibility of obtaining a better price that may be available in another market at the time its order is executed; and (3) this could result in the customer’s order receiving an execution at a price that is inferior to the best bid or offer displayed at the time his or her order is executed. Each time a customer consents, the broker-dealer must be confident that the customer fully understands this disclosure and the nature of the consent.” Id.at Section III.D.1 (emphasis added).

12. Further discussion of the opt-out exception was presented in the May NMS Release. SEC Release No. 34-49749, supra note 2, at Section II.B.

13. A “quoting market center” is defined as “an order execution facility of any exchange or association that is required to make available to a quotation vendor its best bid or best offer in a security pursuant to the Quote Rule.” SEC Release No. 34-49325, supra note 1, at Section IV.B.1.

14. A “quoting market participant” is defined as “any broker-dealer that provides its best bid or best offer in a security to an exchange or association pursuant to the Quote Rule or Regulation ATS, and whose best bid or best offer is not otherwise available through a quoting market center.” Id.

15. Id.at Section IV.A.3. The May NMS Release contains additional discussion of the access limitations, and a renewed request for comment. SEC Release No. 34-49749, supra note 2, at Section III.A.2.

16. SEC Release No. 34-49325, supra note 1, at Section V.B.

17. Id.at Section VI.

18. Id.at Section VI.A.

19. In the New York Hearings, commenters questioned whether the current charges were reasonable in relation to the cost of providing market data. In the May NMS Release, the Commission requested comment on whether it should become more actively engaged in reviewing fees.

20. SEC Release No. 34-49325, supra note 1, at Section VI.D.