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December 19, 2007

2007 Review: Reg NMS Trade-Through Rule Leaves Mark

The Year in Trading

By James Ramage

Regulation National Market System is here. Now what? The past year witnessed the implementation of what was called the most sweeping rule changes to hit the securities industry in decades. Reg NMS not only forced the once-manual New York Stock Exchange to go electronic, it created competition among market centers and prompted investments in the regionals and ECNs like BATS and Direct Edge.

Industry watchers acknowledge that the Securities and Exchange Commission's plan to make the markets more electronic has succeeded. And for the coming year, they say, the market dynamics Reg NMS helped accelerate--such as liquidity moving to more alternative trading systems--should continue unabated.

Reg NMS went into effect for exchanges in March, became operative for brokers in July and was fully implemented in October. Its centerpiece Order Protection Rule--also known as the trade-through rule--had two results: the decline of NYSE market share and an overall explosion in listed trading. The trade-through rule requires that the best electronically available bid or offer in each market be protected. This means no exchange or broker can trade through--execute an order at a price inferior to--a protected quote, wherever that quote resides.

With Reg NMS, the NYSE stood to lose the most from the SEC's decree that liquidity go to the best automated quote. Reg NMS also created opportunities for alternative market venues to compete on the basis of price, rather than relationships, history and habit. And by pushing the ruling through, the SEC cut the NYSE down to size.

Both NYSE and NYSE Arca combined traded on average 1.8 billion of the industry's 3.4 billion NYSE-listed shares per day in October. That gave NYSE Group a market share of 54 percent, down from almost 79 percent two years earlier.

Many predicted there would be an increase in trading volume of Big Board-listed stocks once it went electronic. The industry's NYSE-listed shares traded per day jumped to 3.4 billion in October, a 41.7 percent increase from two years earlier.

Increased electronic trading at aggressive competing market centers had long been making inroads into the Big Board's market share, and even necessitated the hybrid. But Reg NMS further decreased NYSE's market share, says Adam Sussman, a senior analyst with consultant TABB Group.

"The hybrid, as well as Reg NMS, allows for different kinds of investors to more efficiently implement their investment strategies in listed stocks that they may not have been able to before," Sussman says. "High-frequency trading needs low-cost infrastructure and guaranteed speed. When orders make their way onto the floor, the feedback from a canceled request used to be slower. That really hampered people's ability to implement these kinds of strategies in listed stocks."

Still, some think the new rule was a mistake. "I think the trade-through rule has become largely irrelevant," says Jamie Selway, managing director at institutional agency broker White Cap Trading. "Now that everyone's electronic, no one's got an incentive to trade through."

The trade-through rule change essentially gives NYSE competitors relevance, he adds, by enabling them to establish themselves quickly and easily. Witness BATS's success. "That's a pretty powerful gimme to hand to your new entry competitors,Ó Selway says.

But the SEC has also allowed exemptions to the modified trade-through rule--too many, according to Selway. There are already exemptions for derivative trades, benchmark trades, stopped stocks and print protection, he says. "If I have a prediction for NMS, or the trade-through rule," Selway says, "it will continue to be whittled away by exemptions until it's essentially meaningless."