FLASH FRIDAY: Re-Imagining Reg NMS

As much a topic of lively conversation today as it ever was.

Re-imaging or revamping the landmark equity-market ruleset that is most definitely showing its age these days is at the forefront of the industry’s collective mind. But like four years ago when Traders Magazine first looked at the issue, the question remains on just how to update it?

Don’t worry – hold on, its coming.

Jay Clayton, SEC

Back in April of 2019 Jay Clayton, Chairman of the U.S. Securities and Exchange Commission, said that if he has his druthers, there will be a review of Regulation National Market System or Reg NMS.

Clayton agrees that the SEC and rulemakers need to at least revisit the bedrock regulations and that the current rules “may have missed their mark while some others are completely with some parts of the rule, while adding that other portions of Reg NMS are extraneous.

“As technology and business practices evolve, so must our regulatory framework,” Clayton, who joined the SEC in 2017 after being nominated by President Donald Trump, said during a recent speech at Fordham University. “It is clear that the market challenges we faced in the early 2000s are not the same as the issues that we confront over a decade later.”

At the time, Clayton said there are several things the regulator would explore this year to address the current market structure. Two of the most important items under review are the consolidated audit trail and another are market data fees and costs associated with them charged by exchanges.

“We currently have a two-tiered system of market data and market access in the United States – core data and proprietary data,” Redfearn said. “I believe we must assess whether the current core data system is contributing to a bifurcated landscape of market data that calls into question whether access to markets remains fair and not unreasonably discriminatory.”

“Some of the challenges we face today may, in fact, be consequences of Regulation NMS and other rules,” Clayton said. “It is important that we reassess Regulation NMS, now 14 years old, as well as whether the dissemination of, and access to, market data can be improved to better facilitate Exchange Act objectives.”

Fast forward to just a few weeks ago and the SEC put forth its first public comments on how to prop up or improve Reg NMS by voting to propose amendments to the national market system plan governing the Consolidated Audit Trail (the “CAT NMS Plan”). 

The proposed amendments to the CAT NMS Plan would require self-regulatory organizations that are participants to the CAT NMS Plan (the “Participants”) to file with the Commission and publish a complete implementation plan for the Consolidated Audit Trail (“CAT”) and quarterly progress reports, each of which must be approved by the Operating Committee established by the CAT NMS Plan and submitted to the CEO, President, or equivalently situated senior officer at each Participant.  In addition, the proposed amendments would include financial accountability provisions that establish target deadlines for four implementation milestones and reduce the amount of fee recovery available to the Participants if those target deadlines are missed.

“CAT needs to be implemented without further delays,” Clayton said. “The proposed amendments are designed to bring greater transparency and accountability to the implementation of the CAT.”

A major point of contention is the Order Protection Rule that mandates stocks must be traded on exchanges that show the best-quoted prices. One of the criticisms is that the rule gives an advantage to high-speed traders. There is also a perception that the rule makes the market more expensive. Pension funds and other institutions can also find it more difficult to execute trades.

To that end, the recent SEC statement also said the group would be meeting to discuss whether to solicit public comment for a proposed order that “would require the SROs to propose a single, new NMS plan that would increase transparency and address inefficiencies, conflicts of interest and other issues presented by the current governance structure of the three NMS plans that govern the public dissemination of real-time, consolidated equity market data for NMS stocks.”

And immediately after Toes’ comments, the SEC voted voted three-to-two to indeed propose a new rule that would direct the self-regulatory organizations to submit a new National Market Systems Plan regarding consolidated equity market data. 

In short, the proposed rule seeks to consolidate the Consolidated Tape Association’s Tapes A & B with Nasdaq’s Tape C while opening the plan’s governance to non-SRO entities.

SEC Chairman Jay Clayton and Brett Redfearn, director of the SEC’s Division of Trading & Markets, deserve kudos for getting the regulatory ball rolling on the much-needed reform and modernization. However, it is doubtful that the equities market will see the New Consolidated Data Plan before the end of the decade.

As Commissioners Robert Jackson and Allison Herren Lee noted in their dissenting votes on the Division of Trading & Market’s proposal, it will be a long, drawn-out process steered by those whose conflicts-of-interest precipitated the need for the change in the first place.

The SROs have an economic interest to delay the new plan as long as possible, but modernizing the consolidated tapes is not a light lift for the industry: There is more involved than adding names to email-distribution and datacenter-access lists. It is an opportunity to include new data, such as odd lot, as well as future-proof the consolidated tape for at least the next decade or two.

Not taking into account possible litigation and advances in processing power and network throughput that could incur additional delays for the new plan’s development, the industry could face a timeline similar to the unfinished Consolidated Audit Trail.

One could imagine something like this:

  • January 14, 2020: The SEC’s proposed rule appears in the Federal Register, which begins a 45-day comment period.
  • February 28, 2020: The New Consolidated Data Plan’s initial comment period ends, but the SEC extends the comment period for another 45 days to address industry concerns.
  • April 13, 2020: The plan’s second comment period ends.
  • June 2020: The SEC approves the new rule.
  • November 3, 2020: The US holds its presidential election.
  • February 2021: The Administration nominates, and the US Senate confirms candidates to replace Commissioners Robert Jackson and Hester Pierce.
  • May 4, 2021: SEC Chairman Jay Clayton’s term expires.
  • June 2021: Administration nominates, and US Senate confirms a candidate to replace Jay Clayton as SEC Chair.
  • June 2021: The SROs form the Securities Information Processor Advisory Group.
  • May 2022: The SIP Advisory Group publish its vendor-selection plan for the New Consolidated Data Plan.
  • July 8, 2022: Commissioner Allison Heren Lee’s term expires.
  • November 2022: The SIP Advisory Group issues a cost study for the New Consolidated Data Plan.
  • December 2022: The SIP Advisory Group publishes a shortlist of prospective vendors to manage the SIP migration.
  • February 2023: The SIP Advisory Group submits its draft of the New Consolidated Data Plan to the SEC.
  • March 2023: The SEC returns the draft to the SIP Advisory Group to be re-worked.
  • September 11, 2023:, Commissioner Elad Roisman’s term expires.
  • November 2023: The Administration nominates, and the US Senate confirms candidates to replace Commissioners Allison Heren Lee and Elad Roisman.
  • January 2024: The SIP Advisory Group re-submits its draft of the New Consolidated Data Plan.
  • May 2024 SEC approves plans.
  • November 5, 2024: The US holds its presidential election.
  • May 2025: The SIP Advisory Group selects a vendor.
  • February 2026: Administration nominates, and Senate confirms the replacements for the replacements of Commissioners Robert Jacks and Hester Pierce.
  • May 2026: The SIP Advisory Group requests a deadline extension.
  • January 2027: Administration nominates, and Senate confirms a candidate to replace the replacement of Jay Clayton as SEC Chair.
  • November 7, 2028: The US holds its presidential election.
  • March 2029: Administration nominates, and Senate confirms the replacements for the replacements of Commissioners Allison Heren Lee and Elad Roisman.
  • May 2029: The SROs launch The New Consolidated Data Plan.

Throughout the process, there are three presidential and five Congressional elections that will have unknown effects on the Commission and its staffing. Future SEC Chairs could be in favor of such changes, cool to the idea, or forced to put it on a back burner as the Commission deals with the latest financial crisis.

It will be a long slog for the SROs, market-data consumers, and the Commission to adopt The New Consolidated Data Plan, but a journey of a thousand miles begins with a single step.

The original article appeared four years ago in the September 2016 edition of Traders Magazine

When Regulation National Market System was established in 2005, George W. Bush was five months into his second term as U.S. President. Lehman Brothers was reporting record quarterly earnings. The iPhone didnt exist.

A lot has changed in 11 years, both in the world at large and in financial markets. So it stands to reason that Reg NMS, the sweeping ruleset that was aimed at modernizing and strengthening equity market structure, has passed its best by date.

If the U.S. Securities and Exchange Commission were today tasked with drawing up equity regulations from scratch, its safe to say Reg NMS wouldnt be the end result. But though some of its pages are yellowing, the playbook still has its utility, and market participants and observers say the notion of a full scrapping goes too far.

That begs the questions of how Reg NMS should be changed.

It is important that a review of Reg NMS is conducted with an understanding of the diversity of market participants (retail, institutional, professional) and securities (small-/mid-/large-cap, ETPs), and an assessment of how well the current regulations are serving their needs, said Doug Cifu, chief executive officer of electronic market maker Virtu Financial. If the goal is to evaluate the efficacy of our current one-size-fits-all regulation, lets continue with what the regulators have begun, that is, using a data-driven approach to identify what is working before they make any changes.

A review of Reg NMS should consider the advances in transparency and the amount of information and tools available to market participants since Reg NMS was written, Cifu told Markets Media. With these advances, certain market participants now have far greater visibility and insight through their own best execution analysis, which in turn enables them to make better routing decisions. We believe that, where possible, prescriptive regulation should make way for principles-based regulation, which tends to be more future-proof.

Competition Fostered

Reg NMS sought to improve the execution experience of investors by opening up the trading-venue business – which had been dominated by incumbents New York Stock Exchange and Nasdaq – to competition. The idea was that competition among markets would promote fair and efficient price formation.

The overarching aim of fostering competition was achieved, in a big way. When IEX transitioned to an exchange in August, it became the 13th U.S. equity exchange. Bats Global Markets has emerged as a formidable competitor to NYSE and Nasdaq, as the operator now executes about one-fifth of all exchange-traded volume. Off-exchange, the universe of alternative trading systems has swelled to more than 40, some of which are established players operated by the biggest Wall Street banks.

So investors have plenty of choice. And a more competitive landscape presumably has kept the trading venues themselves on their toes, resulting in improved performance.

Those are a couple of the high-level pros of Reg NMS. On the con side, market participants and observers most often cite complexity and fragmentation – which gets back to the existential question around the ruleset.

While the equity marketplace has certainly grown more complex since the creation and implementation of Reg NMS, a complete overhaul of the rules governing equity markets is unnecessary and fraught with unintended consequences, said Steve Komon, senior passive equities portfolio manager and senior trader at Colorado Public Employees Retirement Association, a $45 billion pension plan. Tweaking or adding to the regulation is a more reasonable, and potentially attainable, option.

Any changes to Reg NMS should consider the costs and benefits of the fragmented marketplace, Komon told Markets Media. Are the various exchanges providing a truly differentiated offering? If so, this legitimate competition should be fostered. New exchanges that mimic existing choices, however, only add complexity rather than unique value to investors.

One flashpoint within Reg NMS is the Order Protection Rule, or NMS Rule 611, which requires traders to transact on the trading venue with the best price; reliability and speed of execution are secondary considerations. The OPR only protects quotes at the top of the book, which can result in a portion of an order being executed at an inferior price if one markets bench players are better than another markets starter.

Given the proliferation of exchanges, which are of varying depth, does this rule need to be adjusted? Komon asked. Maybe larger blocks need different rules than best displayed price. Perhaps market-based solutions like IEX will alleviate some of the issues for investors trying to trade larger orders, such as quote fading.

The SEC is aware of Reg NMSs age. In a June 2016 speech, SEC Chair Mary Jo White noted that Reg NMS was the culmination of a five-year effort, and she called it a landmark body of rules that govern all aspects of todays national market system.

But time marches on. The Commission is now in the midst of another significant phase of market structure review, as technology advancements continue to accelerate the pace of change in how orders are generated and executed, White said. It is critical that we, as regulators, keep pace with these changes with a keen focus on the fundamentals driving them. We must fully understand the evolving marketplace, identify the issues with precision before making any fundamental changes, and assess the likely consequences that may follow.

Reg NMS was meant to consolidate many of the disjointed rules set forth in 1975, when the SEC first facilitated a national market system. Wall Street wasnt thrilled to have the task of reading, understanding and complying with the 371-page opus, but the industry adapted, and the equity market enjoyed some of its best years (in terms of commissions, trading volume and profits) shortly after Reg NMS was adopted.

Stacey Cunningham, chief operating officer at IntercontinentalExchanges NYSE Group, told Markets Media that the exchange operator supports Reg NMS reform. We strongly believe that any changes to equity market regulation should be focused on prioritizing displayed liquidity and reducing complexity for market participants and investors, she said.

There will be disagreements among market participants, market operators, and regulators as to how Reg NMS should be changed. One area of consensus is that the SECs task is a substantial one, which will take years to complete.

Yesterdays Tomorrow

There needs to be a very rigorous, deep dive into what do markets need today, and how are those needs not being handled by existing regulations, said Bill Harts, a long-time trader and currently chief executive officer at Modern Markets Initiative, an high-frequency trading advocacy group.

Harts worked in corporate strategy for Nasdaq when Reg NMS was being developed, and he was in electronic trading at Bank of America when the ruleset was enacted. He recalls from those front-row seats a general acknowledgement that Reg NMS was not perfect and some aspects would need to be returned to, especially given the rapid evolution of equity markets.

We just sort of said, well come back and revisit that in the future, Harts said. Now here we are in the future.

Reg NMSs influence has extended beyond U.S. market centers. The rest of the world is moving towards a Reg NMS framework, said James Angel, associate professor at Georgetown Universitys McDonough School of Business. Europe is trying to harmonize banks, and there have been similar efforts in Canada, Australia, and Japan, Angel noted. Regulatory thinking has gone towards a Reg NMS world.

According to Angel, Reg NMS forced exchanges to go electronic, created interconnections between exchanges and forced traders to execute at the best price. It ushered in the era of the penny tick across all NMS securities, and it also brought many other sub rules, such as Rule 605 and 606.

But as with any sweeping regulation thats more than a decade old, there are problem areas.

If I had to put my finger on probably the most important thing that people should look at right now, it would be the prohibition against locked markets, Modern Markets Harts said. It was created in a time when people quoted by hand. It was created to solve a problem that doesnt exist any longer.

A New York-based trader opined that the use of protected quotes by public exchanges should be abolished. Why is it I should be forced to trade on an exchange if Id rather not? the trader asked. Even if the exchange has the best price, why should I be forced to route there if I dont want to? That is one thing Id want carefully examined.

Fixing Reg NMS, according to many, will require a full-up, completely thorough examination of the regulation and market structure. This would need to be undertaken at the highest levels – not by trade groups or the self-regulatory organizations, but by the SEC itself. Already faced with budget constraints and personnel issues, the financial markets top regulator would have to orchestrate this entire review and reform process, something Wall Street says wont take months.

Harts declined to speculate on the length of the process but did say fixing Reg NMS needs to be a formal process that probably will take a significant amount of time. He recalled that back in 1997. the SEC put together a 500-page report called Markets 2000 which was a concept-type paper that examined 21st-century trading. This type of magnum opus might be in order to diagnose and repair NMS.

Look, lets get it right this time, Harts said. Lets not try to rush something through only to find ourselves having debates about 1 millisecond versus 300 microseconds versus whatever just a few years down the road. Lets get it right once and for all.

But Georgetowns Angel said that the SEC can be paralyzed by fear of judicial action as a result of its changing the extant system. The SEC is afraid to do anything, reasonable or fast, and so all of their rulemakings are extraordinary slow, Angel said.

The SEC would rather rule-make by enforcement actions when an egregious infraction occurs, or lean on the Self-Regulatory Organizations, such as the exchanges or Finra, to work out of the spotlight and police the markets quietly from within. Finra and the exchanges dont have to go through the same level of legal scrutiny with cost benefit analysis as the SEC, so they can basically do what they want, Angel said. I look at the SROs as delegated enforcement organizations.

Harts was optimistic on the outlook for true reform. I have a lot of sympathy for SEC staff – I think they get a tremendous amount of pressure from different constituencies and different market participants, he said. It must be hard for them to arbitrate amongst all the noise. I think what they need to do is put the process in motion and then get the best minds in the industry to weigh in on the different aspects of it.

Reg NMS 1.5?

The legacy of Reg NMS is that it brought market structure to the forefront and it was successful in bringing about competition, both dark and lit, said Tal Cohen, senior vice president of U.S. equities at Nasdaq. It absolutely facilitated the growth of electronic trading.

It has served large-cap companies well. But on the other hand, small-cap and emerging growth companies got somewhat left behind, Cohen added. It did introduce some complexity and some systemic risk that were still trying to work through. If you look at it as a whole, it was a positive. We have a very efficient market. Retail has never had it better. The key was that it brought about competition.

Drafting Reg NMS 2.0 wont be easy. A workable compromise may more closely resemble Reg NMS 1.5, or even Reg NMS 1.25.

Tweaking, enhancing, or overhauling Reg NMS requires achieving a broad consensus among disparate market participants, said Komon of Colorado PERA. Given the wide range of perspective on any potential changes, incremental improvement seems the more realistic goal.

In addition, we must consider whether any new system truly improves the marketplace compared to Reg NMS, or simply trades one set of issues for another, Komon continued. No easy fix will satisfy all market participants, so finding common ground on improving current rules is the best course of action.