The decision by the Securities and Exchange Commission last month to exempt two more types of transactions from Regulation NMS’ Order Protection Rule. (See Rules & Regs section for details) brings to 13 the number of the rule’s exceptions and exemptions. That’s nine exceptions and four exemptions. Some are arcane. Some are likely to be used frequently.
The exceptions fall under Subsection (b) of Rule 611. The exemptions fall under Subsection (d). Traders Magazine summarizes them below.
The Order Protection Rule generally requires trading centers to take the necessary actions to avoid trading at a price inferior to another market center’s immediately accessible best quote. That involves either (a) not trading or (b) simultaneously taking out the better-price protected quote. The term “trading center” can apply to exchanges, ATSs and broker-dealers.
The Exceptions
Intermarket Sweep Order (Incoming)
This exception makes it possible for a trading center, likely an exchange or ATS, to execute immediately any incoming order identified as an intermarket sweep order (ISO) even if a better-priced protected quote exists at another market center. Market centers are likely to receive ISOs from traders trying to fill their customers’ block orders.
Intermarket Sweep Order (Outgoing)
This exception relates to the market center, likely a broker-dealer, transmitting the intermarket sweep order. It lets the broker-dealer execute an ISO at a price inferior to a protected quote. Brokers are likely to use these order types when printing blocks for customers away from the inside. The SEC will allow the broker to use the ISO as long as he simultaneously attempts to take out those better-priced protected quotations.
Self-Help
This one is already getting some use. The exception permits trading centers to fill orders at prices worse than protected quotes posted on other market centers if it appears those market centers are malfunctioning or taking too long to fill incoming orders. Taking more than one second to respond to an incoming order is too long under Reg NMS. A trading center making use of this exception must notify the non-responding trading center immediately after or at the same time as electing self-help. Nasdaq says it evokes the self-help exception three or four times per week. Other marketplaces accuse it of being “trigger happy,” according to Nasdaq executives.
Benchmark Trades
Trading centers, most likely broker-dealers, may execute an order at a certain benchmark price such as volume-weighted average or market close without regard to better-priced protected quotes. These trades are often negotiated with institutional customers well before the price can be known and the trade is actually printed. According to the SEC, they are trades where “the material terms were not reasonably determinable at the time the commitment to execute the order was made.” They are also “not priced with reference to the quoted price of the NMS stock at the time of execution.”
Stopped Orders
Block traders will sometimes use stopped orders to guarantee a maximum or minimum price on a trade for a money manager. It gives the institution comfort to know it won’t pay more than a certain amount when buying stock or receive less when selling.
Once completed however, the print may be outside the market’s best quote. That’s called an “underwater stop.” Without an exception, it’s also a trade-through. Without an exception, the broker would have to take out all the better-priced protected quotes.
That though would give him a loss on the trade. So the SEC decided to allow him to ignore those quotes. Given the exception, trading execs predict an increase in the usage of stops.
Flickering quotes
The SEC gave trading centers a one second “window” to evaluate the quotes of other trading centers. If they are flickering then the first trading center is permitted to trade at the “least aggressive” best bid or offer displayed by the flickering market center. If the best bid on that market center is flickering between $10.00 and $10.01, for example, then the first trading center can execute at $10.00 without violating Rule 611.
Not “Regular Way”
A regular-way, or standardized, trade is one without any unusual conditions attached. Examples of trades that are not regular-way are those that are reported late after other prints have occurred; trades that occur outside of normal market hours -opening and closing trades, prior day trades, and next day trades; or trades that have special delivery or sale conditions attached. Also those with extended settlement terms
Single-price reopenings
After a trading halt, if a market center reopens trading in the security at a single-price, then that trade is considered an exception if the price is inferior to another market center’s best-priced protected quote.
Crossed market
Trades done when the protected quotes were crossed are excepted from the Order Protection Rule. This exception does not apply when a protected quotation crosses a non-protected, or manual, quote.
The Exemptions
Contingent trades
Contingent trades are those with two or more sides. Typically, they involve a stock and a derivative; a stock and another type of security issued by the same company; or the stocks of two different companies involved in a merger. In other words, the successful trade of one security is contingent upon the successful trade of the other. Achieving that success can mean not altering the pricing dynamics of the marketplace. The Securities Industry & Financial Markets Association argued that contingent trades contribute to the stability of the marketplace, but would become an endangered species if traders had to comply with Rule 611 when handling them. The SEC agreed, stating the two-part trade could become “too risky and costly to be employed successfully if they were required to meet the trade-through provisions.”
Sub-penny trades
The order protection rule does not apply when (a) the price of the protected quote that is traded through is one dollar or less and (b) the price of the trade-through transaction is less than one cent away from the price of that protected quote.
Error correction transactions
Trading centers, most likely broker-dealers, will be able to put up prints inferior to the market’s best-priced protected quotes in instances where they are correcting trading errors. That covers customer orders that have been mishandled with either incorrect prices, share quantities, names or market sides.
Print protection transactions
Trading centers, most likely broker-dealers, will be able to put up prints inferior to the market’s best-priced protected quotes in instances where a customer order is (a) not at the top of the book and (b) has been traded through. Brokers asked for this exemption so as to be able to price improve those orders. Without this exemption, the price improvement transaction could trade through a better-priced protected quote. Brokers did not want to have to take out those quotes at the time they put up the price-improved print.
