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July 27, 2005

SEC Explains: Reg NMS Passage
Order Protection Rule Finally Clarified

By Gregory Bresiger

Also in this article

  • SEC Explains: Reg NMS Passage
    Order Protection Rule Finally Clarified

(Traders Magazine, July 2005) -- The long-term needs of individual investors must trump those of professional traders.

That was the gist of the reasoning used by the SEC in explaining and justifying its huge Reg NMS market structure reform. It argued that the regulation would provide "strengthened assurance that orders will be filled at the best prices," according to the SEC Reg NMS release.

This will give retail investors, "greater confidence that they will be treated fairly when they participate in equity markets," according to the SEC.

Reg NMS is a package of reforms (See "The Basics of Reg NMS") that includes order protections, limiting sub-penny trading and access fees. It is a package that constitutes the most comprehensive market structure changes since the mid-1970s, market observers said.

The jewel in the Reg NMS crown is the reform of the controversial trade-through rule-or what the SEC calls the order protection rule-for top of the book quotations and the extension of the rule to all Nasdaq stocks.

A trade-through happens when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor's limit order displayed by another trading center.

The SEC staff, in a study of Big Board and Nasdaq trades, found that one in 40 listed and non-listed trades are executed by some form of a trade-through. The SEC contended that this is a significant number. This is burdening individual investors with superfluous costs and decreased investment returns, the SEC said.

"The transaction costs associated with the prices at which their orders are executed represent a continual drain on their (individual investors') savings," according to the SEC.

The expansion of the limit order rule, which will have a few exceptions but no opt-out provisions, will encourage the use of limit orders, the SEC said. It will also promote greater market depth and liquidity, the regulators claimed. This will lead to more competition between orders as well as competition between exchanges, regulators said.

But officials of several electronic trading venues had implored the SEC to junk the controversial rule or permit significant exceptions to the rule. The latter was called "a relic" by U.S. Representative Richard Baker (R-La.), the chairman of a key House subcommittee. (See "Baker Q&A").

The SEC staff released the much-awaited Reg NMS order in early June some two months after the SEC approved the NMS policy.

This came after a three-to-two vote in which dissenting commissioners bitterly complained NMS constituted "excessive" regulation. The maverick commissioners insisted on publishing a minority opinion. (See "Dissenting").

But the majority commissioners and the staff held, in an adopting release of huge length, that the needs of the general public outweighed those of professional traders.

"Should the overall efficiency of the NMS defer to the needs of the professional traders, many of whom rarely intend to hold a position overnight?" the SEC rhetorically asked.

The regulators answered the question by arguing that their mandate was to "avoid excessively volatile markets." These are markets that short-term traders can exploit, but put long-term investors at a disadvantage, the SEC wrote.