What Does Reg NMS Mean for Stock Exchanges?

By Theresa Carey  |  Posted 04-18-2005
A set of rules called the Regulation National Market System intends to modernize and strengthen the markets for equity securities. One of its more controversial provisions, which will have a significant IT effect on U.S. exchanges, is the trade-through rule, which is currently used at the New York Stock Exchange.

With the passage of Reg NMS, the trade-through rule will be extended to all U.S. exchanges that trade equities—including the NYSE (New York Stock Exchange), Nasdaq and AMEX (the American Stock Exchange) —by April 2006.

"This is the most sweeping and controversial change to U.S. markets in 30 years," said Bill Cline, a senior analyst at Accenture.

Cline said he thinks the NYSE is clearly the big winner, as the extension of the trade-through rule to the Nasdaq will help it retain its dominant share in trading listed stocks, as well as helping it gain share in trading Nasdaq stocks.

Some say the trade-through rule, which was first instituted in 1975, guarantees that investors will get the best price for their trade executions. A market system would not allow one customer to "trade through" an existing order without first matching that order. A customer's order has to be routed to the destination with the best price at the moment the order is entered.

The problem with extending the trade-through rule from the NYSE to Nasdaq and other exchanges is that the NYSE is not a fully automated system. The effect on the automated Nasdaq system, for example, would be to drastically slow it down, when one of the advantages of the system is the way it automatically matches buyers and sellers.

Many online brokers have implemented "smart order routing" technology, which scans the markets and finds the best place to execute a customer's order, based on price and liquidity. Extending the trade-through rule most likely will negate much of that innovative development.

"The passage of Reg NMS was expected, but in our view it's not a good thing for our investors," said Vince Phillips, CEO of CyberTrader, an online brokerage that caters to very active traders. Phillips said he thinks their smart order routing technology will be made ineffective next April.

"One of the major drivers of price reductions in our industry has been the automation of order entry and execution," Phillips said. "Reg NMS is a blip on that ongoing evolutionary process."

The majority of retail brokers came out against Reg NMS because routing orders to the Nasdaq has given them lower costs as well as faster transaction processing. "Brokers will have to spend money to accommodate the rule, and those costs will be passed on to customers," Phillips said.

Click here to read about the New York Stock Exchange eyeing a more automated future.

Accenture's Cline said he observed similar companies coming down on opposite sides of the Reg NMS discussion. "The diversity of opinion on Reg NMS, particularly when it comes to the extension of the trade-through rule, illustrates the difficulty inherent in legislating best execution," Cline said.

Highlighting some of the problems inherent in the way the NYSE operates, by combining some automation with manual handling of orders by specialists who focus on particular stocks, are charges filed against 15 of those specialists, accusing them of violating the exchange's rules when executing trades.

The specialists, prosecutors claim, acted against the best interests of investors while handling thousands of transactions between 1999 and April 2003, generating as much as $13.5 million in illegal profits.

The specialists are supposed to maintain orderly markets in the stocks they handle, often trading from their firms' inventories to make stock available that is in demand, or buying up shares that are on the market.

What this means for investors is that a quote shown on the NYSE is not immediately executable, since specialists are allowed to hold an order for 30 seconds before either executing it or handing it off to another specialist.

Regulators say the specialists charged with fraudulent trading bid stock prices up or down by a few pennies to make a profit. In some cases, the profits amounted to small change, less than $100 per trade.

But in other instances, the specialists are accused of "interpositioning," which involves jumping in between a buyer and a seller who were going to trade at a given price and making a few pennies per share of profit on the trade.

The SEC said in a statement that the specialists charged "treated customer orders that should have been paired off as personal trading opportunities, often to the detriment of customer orders." Similar issues during the 1980s led to the automation of the Nasdaq market, which electronically pairs buyers and sellers with no human interaction.

While a quote on a Nasdaq stock is immediately executable, a quote on an NYSE stock is considered an indication and not a firm quote. Executives at the NYSE have defended the trade-through rule, saying it's good for small investors.

But Nasdaq members often charge NYSE specialists with bait-and-switch pricing tactics so that orders are routed to the NYSE, then executed at a worse price than what was available at the time the order was entered. These are issues that will have to be worked out via technology once the trade-through rule extension goes into effect in April 2006.

Retail brokers, in the meantime, will probably have to divert their IT resources away from enhancing the client experience in order to rework the trading infrastructure. At the exchange level, the Nasdaq and the ECNs (electronic communications networks) also will be reworking their intermarket communications.

The NYSE must crank its automation campaign into high gear so that it meets the SEC definition of a "fast market" by the time the trade-through rule is extended.

Theresa Carey is finance editor for Ziff Davis Internet's Enterprise Edit group. She's been writing about financial technology issues since 1990 for a wide variety of publications.

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