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March 7, 2008

Reg NMS Is a Winner, SEC Says

By Peter Chapman

The Securities and Exchange Commission, despite trader complaints about market fragmentation, pronounced Regulation NMS a triumph.

According to an analysis conducted by SEC economists, key market metrics such as speed, width of spreads and depth have all improved since Reg NMS went into effect. On top of that, institutional trading costs, as measured by independent researchers, came down as well, according to a top SEC official.

"All the statistics run counter to the commonly heard impression that increased fragmentation since Reg NMS has led to reduced liquidity," Dan Gray, market structure counsel in the SEC's Division of Trading and Markets, said in a speech at this year's Security Traders Association of Chicago (STAC) conference.

Regulation NMS, which went into effect a year ago, was crafted primarily to remove the protections that allowed the New York Stock Exchange to operate as a virtual monopoly. It has had the effect of making automated trading of NYSE-listed stocks the norm; it has also driven trading away from the Big Board.

In their investigation, SEC economists examined Rule 605 data, which measure market quality at exchanges, ECNs, market makers and other market centers, for the months of April 2005 and April 2007. They looked at execution speeds, quoted and effective spreads, and displayed depth.

The economists found execution speeds dropped, primarily for NYSE-listed securities. At the NYSE itself, the average speed for a market order fell from 12 seconds in April 2005 to two-tenths of a second in April 2007. They also found that spreads at the NYSE-both quoted and effective-narrowed by 10 percent.

Displayed depth increased substantially from April 2005 to April 2007, the SEC determined. For the Russell 1000 stocks, average consolidated depth at the inside quotes increased by more than 50 percent, according to Gray. "Promoting greater depth was one of the commission's major policy goals for NMS," Gray told STAC attendees.

Still, a common complaint among traders is the difficulty of getting large blocks done as the average trade size in the public markets has fallen to less than 300 shares. With that in mind, the SEC also took a look at trade-cost surveys from Investment Technology Group/Plexus and Elkins/McSherry.

ITG/Plexus reported a drop in U.S. trading costs of 29 percent in the second quarter of 2007 from the same period in 2006. Elkins/McSherry reported that total transaction costs for institutional investors fell 15 percent for the year ending June 2007 versus the same period a year prior. These studies measured both explicit costs, such as commissions, and implicit costs, such as market impact and opportunity costs.

The studies appear to bolster the SEC's case that Reg NMS has benefited the equities market. "There is no correlation between average trade size in the public markets and efficiency of trading for institutional investors," Gray said. "Rather, the use of algorithms and other sophisticated trading strategies has enabled large investors to deal with and benefit from automated markets."

Not everyone is convinced the stock-trading world is a better place. Cheryl Cargie, head trader at Ariel Capital Management, told STAC attendees that it was much harder to find liquidity "because the market is so fragmented." She added: "You can't go down to the floor anymore. You can't say Give me a look on this.' Where do I go? How do I do this? How do I tell the portfolio manager that I didn't get anything done?"

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