FLASHBACK FRIDAY: Order Protection Rule Tug-of-War

A lot can happen in just two years.

Just take a look at the Order Protection Rule. The market still doesnt know exactly what to do about the OPR – still.

OPR – the Order Protection Rule – has been depending on ones point-of-view either a good thing when trading or not. For the institutional buy-side and brokers that must comply with best execution requirements it has been good but for the sell side it has added to their duties and added to their technology spend and compliance responsibilities. It has also helped level the playing field between Mom and Pop investors and the Vanguards of the world.

One of the key arguments for keeping the trade-through rule is that it has served as a back-stop protection for displayed limit orders particularly from retail investors. A second argument is fear of a new compliance burden that would fall on brokers if the rule were scrapped. If 611 were eliminated, firms would need to prove that limit orders posted on a trading venue were not getting traded through.

Retail brokerages have come to rely on Rule 611 to ensure they are providing individual investors with the best price available across all exchanges and off-exchange trading venues.

In a recent thought leadership paper, NASDAQ outlined some important suggestions for improving market structure. While the paper is comprehensive it is not exhaustive in covering all myriad market structure topics, but it focusses on three central areas the exchange operator thinks need closer and immediate scrutiny:

– Suspending unlisted trading privileges (UTP) for thinly traded securities

– Reform of the Order Protection Rule

– More intelligent tick regime to combat a one size fits all market structure

– Changing the definition of professional and non-professional market data users

– Reform of Securities Information Processors (SIP)

It is number two that is the subject here – the OPR. Nasdaqs position is that it should be reformed or fixed. Phil Mackintosh, Chief Economist, Nasdaq spoke to Traders Magazine and said reformation makes the most sense.

Updating the Order Protection Rule makes sense to most in the market as it would help reduce the fragmentation in the market and the forced connection costs. This is an example of where a one size fits all regulation, although equal to all, is considered unfair by some participants, Mackintosh said. Some might not find this proposal popular, believing it reduces protections for small investors, but we think modern markets have enough data and transparency to still hold those handling orders accountable.

Nasdaq and Mackintosh believe there is a better way to maintain the benefits of the Order Protection Rule while creating a better balance between value and obligation. Nasdaq proposes to give investors some freedom to choose the small markets in which to trade by excluding the smallest markets from the Order Protection Rule. At the same time, exchanges like Nasdaq would unlock exchange innovation by giving the smaller markets the freedom to innovate, create differentiated market models, and compete on a more level playing field with non-exchange dark pools, all within the conventions of Best Execution and SEC Rule 605.

Remember – the Order Protection Rule was designed to promote market efficiency and further the interests of both investors who submit displayed limit orders and investors who submit marketable orders. In particular, individual investor limit orders are protected, which makes the fragmented market less of a concern to those individual investors. Nasdaq argues that brokers no longer receive calls from individual investors asking why another trade occurred at a price that was worse than their limit price. If OPR was eliminated, the confusion would return and many individual investors would be calling their brokers with questions. In essence this led to a sort of renaissance period for individual retail investors and trading commissions and costs went down.

But many on the Street arent so sure what to do when it comes to the OPR. According to an ongoing Traders Magazine online poll that asked if the OPR should be revised, scrapped or left alone, 31% of respondents said to revise it, 31% said to scrap it altogether while 38% wanted to leave it alone.

David Weisberger, co-founder of CoinRoutes and market structure sage, told Traders Magazine that his thoughts on the Order Protection Rule (OPR) are simple:

Abolish the OPR and strengthen best execution obligations via an overhaul of Rule 605, Weisberger said.

As for some of the ideas put forth by Nasdaq in its whitepaper, Weisberger said that they are well- crafted to potentially improve markets while serving their (Nasdaqs)own interests.

Flexibility in the OPR would likely encourage innovations in market structure such as freeing block trading or auction venues to aggregate liquidity without having to sweep other markets, he said. It would not, however, stop the locked market problem that creates the competitive ISO orders that occur today and provides a lot of the need for ultrafast collocation and data services.

James Angel, Associate Professor of Finance at Georgetown University’s McDonough School of Business, agreed with CoinRoutes Weisberger and said he too was in favor of scrapping the OPR altogether and replacing it with enhanced broker best-ex reporting.

A lot of the lunacy in our current markets is a result of protected quotes, Angel said. As long as brokers are trying to get best ex, there is no need for exchanges to be in the business of routing orders to their competitors.

Jack Miller, Head of Trading at Baird, was more circumspect about Rule 611 and what should be done. He told Traders Magazine that clearly Rule 611 is a hot button topic in the conversation around equity market structure and one of the more controversial features of Reg NMS. Its supporters – mainly speaking on behalf of retail investors – point to the rules success in limiting trade-throughs, reducing the negative outcomes associated with missed trading opportunities for those willing to display their orders. Its detractors – mainly speaking on behalf of institutional investors – point to the rules role increasing market complexity and making it more difficult to trade blocks. And in a lot of ways they are both right – creating difficult tradeoffs that address one symptom while potentially creating another.

A minimum market share requirement (1.5% as recently proposed by NASDAQ) would directly address one element of this complexity by increasing barriers to entry for new exchanges wishing to display protected quotes and thereby reducing the systematic costs and risks imposed by requiring other market participants to connect to those new venues, Miller said. Besides creating a bit of a chicken-and-egg problem that strongly favors incumbents, this proposal has the benefit of being simple and objective (market share being straightforward to measure). While market share alone may not capture the subjective concept of value added to the markets, some kind of de minimis exemption makes sense in my view.

Miller disagrees with CoinRoutes Weisberger and Georgetowns Angel on dumping the OPR.

Ultimately an outright repeal of the Order Protection Rule could lead to a regression into some of the market features that gave rise to its implementation in the first place – clients missing opportunities to trade or trading at inferior prices, he began. There are no simple answers but capturing the spirit of this rule while enhancing liquidity discovery and removing impediments to trading in size are worthwhile goals. One issue with Rule 611 is it applies the same way across stocks with very different liquidity and price characteristics. Its worth considering whether the rule can be tuned to better balance the needs of retail and institutional investors across a wider variety of securities.

In the words of Miller, stay tuned for more.

The following article originally appeared in the April 2017 edition of Traders Magazine

Order Protection Rule Tug-of-War

Ivy Schmerken

There is still uncertainty around the fate of the Order Protection Rule, a key rule governing U.S. stock trading that has led to more complexity, speed and order types, but also protects retail investors from receiving inferior prices on their orders.

Also known as the trade-through rule, Rule 611 has been and still is a central tenet of Regulation National Market Structure (Reg NMS), which requires brokers to route orders to the venue displaying the best price. It ensures that investors receive an execution price that is equivalent to what is being quoted on other exchanges.

On April 5, the Securities and Exchange Commissions Equity Market Structure Advisory Committee (EMSAC) held an open meeting to hear findings from its subcommittee on Regulation NMS.

Rather than recommend a clear direction on whether to keep or remove the trade-through rule, representatives of buy- and sell-side firms indicated they had struggled to come to produce conclusive evidence that would drive a clear or compelling future direction.

We are not at the stage of making any recommendations, said Kevin Cronin, head of global trading at Invesco, who noted there were strong arguments on both sides of the issue.

As it pertains to 611, I think its less clear that people conclude something needs to be done. Even for the crowd that believes something needs to be done, its much less clear what is the something that needs to be done, added Cronin.

Instead, the subcommittee provided a framework for conducting a potential pilot on the order protection rule, should the SEC prioritize the initiative, which would help the agency gather data for a quantitative assessment of the impact and effectiveness of Reg NMS.

The no. 1 issue we struggled with was its difficult to resolve the 611 question in a data driven capacity, said Joseph Mecane, Managing Director in the Electronic Equities and Credit Product Business at Barclays. It wasnt necessarily clear whether 611 had a meaningful impact on displayed limit orders or whether the burdens of compliance with 611 would outweigh those benefits, said Mecane at the meeting.

One of the key arguments for keeping the trade-through rule is that it has served as a back-stop protection for displayed limit orders particularly from retail investors. A second argument is fear of a new compliance burden that would fall on brokers if the rule were scrapped. If 611 were eliminated, firms would need to prove that limit orders posted on a trading venue were not getting traded through, noted Mecane.

Retail brokerages have come to rely on rule 611 to ensure they are providing individual investors with the best price available across all exchanges and off-exchange trading venues.