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April 30, 2004

The Winners and Losers In the Reg NMS Stakes: Proposed Rules Rekindle Debates of the 1990s

By Steve Swanson

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  • The Winners and Losers In the Reg NMS Stakes: Proposed Rules Rekindle Debates of the 1990s
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Market structure is at a critical crossroads. And the road that could be taken is fraught with potential danger for some of the heavyweights of the trading industry.

Which direction will the Securities and Exchange Commission go? Will it go down the road that modifies the controversial trade-through rule? Will it set price limits on ECN access fees? Will it change market data rules?

The answers to these questions will have a critical impact on many dealers, alternative trading businesses and other interested players. Indeed, what the regulators do - or don't do - with their landmark proposed Regulation NMS will likely be the most important set of decisions in the trading industry in almost a decade.

Back in 1996, prior to the enactment of the Order Handling Rules, a colleague from an ECN said that major structural changes occur in the market every seven years. The SEC today is on the brink of making the most fundamental series of changes since then.

Reg NMS, as it is now structured, will profoundly change the trading dynamic. It will set the stage for our industry for years to come.

Reg NMS has four primary components: 1) A new industry-wide trade-through rule; 2) A market access proposal; 3) A sub-penny quoting proposal; and 4) A market data proposal.


The SEC's proposal to modify the existing trade-through rule has caused more tempers to flare than any of the other proposals. In many ways, discussing the trade-through rule is like discussing religion. You are either a believer or you are not.

The revised trade-through rule would prevent trading through the best bid or offer that is disseminated to the public quotation system. The revision applies not only to the listed market, but also to the Nasdaq market. At the first Reg NMS press conference, the SEC looked at how this rule would affect the Nasdaq, which does not have a trade-through rule. Depending upon your opinion, this will either be a fundamental change in Nasdaq trading, or it will be meaningless.

Many would argue that competition, and the publication of quality of execution statistics, already enforce a de facto trade-through rule in the Nasdaq market. Of course, there is no disputing that trade-throughs do occur in Nasdaq, just as they do in the listed world. The SEC's trade-through proposals are intended to address these circumstances.

The proposed rule is different from the current trade-through rule. The proposal amounts to a pre-trade rule as opposed to the current post-trade complaint system. Today, when a violation occurs in the listed market, the offended party must complain and file for remediation. The proposed rule is intended to prevent trade-throughs before they occur.

The proposal includes several exceptions: (1) A de minimis exception similar to the current ETF exception; (2) An exception for automated vs. manual markets (fast markets can trade through slow markets but not vice versa); and (3) A proposed opt-out exception. Here a customer may decide to trade through another's quote.

The trade-through rule finally adopted will likely be far different than the one under debate. History may soon be about to repeat with harsh consequences for the Big Board. The NYSE has the most to lose if the rule is adopted in its current form.