Reg NMS: A Pox on All Your Houses
Two major news stories came out last month that I can't get out of my mind. First, the SIA announced that the industry spends more than $25 billion a year on compliance. Second, Joseph Weber of Business Week wrote a story titled "From Dinosaur to Dynamo?" that glowed about the NYSE's transformation to an automated powerhouse. What do these stories have to do with Regulation NMS? A lot.
First, $25 billion is a staggering amount. That is more money than the industry spends on technology. It's even more than I spend at Starbucks. And, unfortunately, it will only get worse before it gets better. Second, while I have nothing against the NYSE, regulation will make it very difficult for the NYSE (and, for that matter, Nasdaq) to retain its dominant market share.
The SEC's Reg NMS will significantly alter the way the markets and the industry as a whole operate. No. 1, it establishes a trade-through rule (i.e., the Order Protection Rule), which states that an exchange cannot execute an order at a price that is inferior to one listed on another exchange. No. 2, it reinforces a best-execution policy for brokers. And No. 3, it liberalizes market data and access-fee rebate policies.
The Order Protection Rule is valid only for the top of book (the best price) within an exchange or ECN. So if you want your limit order to be protected, you will need to be at the top of book at an electronic exchange. If there are only a few exchanges (e.g., NYSE, Nasdaq, Arca and Bloomberg's Tradebook), there are only a few places to protect your order. If there are a dozen venues, there are a dozen places to protect your order. NMS also allows exchanges to cut more-lucrative order-flow rebate deals, providing incentives for brokers to route limit orders to preferred venues.
That sucking sound you hear is liquidity moving from primary markets (i.e., the NYSE and Nasdaq) to secondary markets as brokers and buy-side firms jockey their limit orders around the exchange fabric to be top of book and park their limit orders at venues that provide the most-lucrative incentives.
So instead of the market consolidation we have seen over the past few years, we are seeing a market fragmentation, as regional exchanges retool and ECNs proliferate. The Philadelphia, Boston, Chicago, American and National Exchanges are rebuilding their infrastructures to be "fast." These exchanges also are soliciting broker investment. And two floundering ECNs, Attain and NextTrade, were acquired by brokers.
This is where best execution and compliance come in. As the markets become more fragmented and orders are jockeyed around a dozen venues, the amount of market data will explode. Brokers will be required to continuously monitor real-time market data looking for the best place to execute. They also will need to capture this data to vet their algorithms and routing decisions, and demonstrate to both customers and the SEC that they have fulfilled their best-execution obligations. This will require significant computing power and terabytes of storage, and teams of very well-trained technologists and analysts.
So the bottom line is that under NMS, we will look back longingly on paying only $25 billion for compliance, and the ECN fragmentation of the '90s will look like child's play as firms will be forced to reinvest in their execution infrastructures as markets disaggregate. While in another five to seven years the markets will consolidate again, in the meantime -- and I am in no way a proponent of centralized market structure -- the fragmentation we are likely to see over the next few years will be traumatic for all. <<<
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
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