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December 6, 2006

Reg NMS To Drive Tighter Markets?

By Nina Mehta

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Tighter spreads and more size at the inside-that's what many are predicting once new rules governing the sharing of market data fees by self-regulatory organizations kick in next April. Regulation NMS will shift the current methodology of allocating market data revenues to SROs based solely on trades to one based on quotes and trades. The shift was driven by the Securities and Exchange Commission's desire to reward market centers for their contribution to the price discovery process and to curtail distorting practices such as "tape shredding."

"If the formula works as intended, it will have a positive impact on the market," says Dan Mathisson, head of Credit Suisse's Advanced Execution Services, the firm's algorithmic trading business, and a market structure expert.

Other industry executives agree. "The new formula will make a fairer market," says Tom Jordan, president of Jordan & Jordan, a New York-based financial technology consulting firm that focuses on market data and other industry issues. "The people who benefit will be those adding value to the market, rather than those just doing the reporting."

Revenue Shakeup

For SROs, what's at stake is how a big pot of money gets divvied. In 2004, the last year for which data is publicly available, market data revenues totaled $434 million. Ninety percent of that was shared by the SROs.

Here's how the system works: Three industry plans consolidate and disseminate market data for the three separate NMS networks. Network A includes securities listed on the New York Stock Exchange, Network B includes those listed on the American Stock Exchange and the regional exchanges, and Network C includes those listed on Nasdaq. Each network has its own separate market data revenue pool.

The plans' securities information processors (SIPs) collect market data revenues from Reuters, Bloomberg and other data vendors and allocate those revenues to SROs based on each SRO's trading activity.

For securities in Networks A and B, the calculation is based on each SRO's share of reported trades. For Nasdaq securities, an SRO's revenues are based on the average of its reported trades and share volume.

Under the current formula, if an SRO reports 10 percent of the trades for NYSE-listed stocks, it gets 10 percent of the market data revenues distributed for NYSE-listed stocks. That allocation is the same whether the SRO's average print is for 100 shares or 10,000 shares.

In Reg NMS, the SEC altered this new formula for the first time since 1975. The new formula eliminates the print disparity and encourages aggressive quoting by rewarding SROs for automated and accessible limit orders. Half the tape revenues will now be allocated based on an SRO's so-called quoting share. The other half will be distributed according to its trading share. The latter is computed in a way that does not assign equal value to small and large trades.

Although the new market data revenue allocation formula is not as momentous a change as Reg NMS's quote-protection rule and mandated linkages between markets, it will produce significant changes.

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