SEC Shocks the Industry With Revisions to Reg NMS

Sources say the new plan may jeopardize the NYSE's proposal for a hybrid market.

After market participants voiced concerns and outrage over the new market structure revamp reported last week, The Securities and Exchange Commission (SEC) said it will publish its revised version of Reg NMS on Dec. 15. A story published in the Wall Street Journal last week leaking out details of the revised rule said that the commission would vote on Dec. 15. If the vote is postponed, the SEC will allow for comment period, and the commissioners will likely vote on the proposed Reg NMS plan in early 2005.

The new Reg NMS -- which stands for national market system -- includes a best-price rule mandating expansion of the trade-through rule to apply across New York Stock Exchange-listed stocks and Nasdaq stocks. The trade-through rule has been a controversial aspect of Reg NMS because critics like Fidelity Investments, Nasdaq and Instinet contend that the Nasdaq market works fine without the rule.

Currently, the trade-through rule protects investors in listed stocks but does not apply to Nasdaq stocks. It requires market centers to route customer orders to markets displaying the best price. But the new Reg NMS will create uniformity across the whole market.

The SEC posted a press release on its Web site late Tuesday afternoon after being pressured by industry participants who mainly learned about the revised rule in the Wall Street Journal last week.

"This process should be exposed to a lot more sunshine. It is frustrating that my source of information for this proposal is not the SEC but the Wall Street Journal," says Jodi Burns, senior analyst at Celent Communications, who says, "This does seem like a stricter version of Reg NMS."

Though the revised plan has not been disclosed, many market participants say they are shocked by some of the details leaked out -- in particular -- an inter-market depth-of-book sweeping function that will require market centers to hit bids and offers displayed on other stock exchanges and ECNs, away from the best price.

"Not only are they saying the trade-through rule applies to everybody's top-of-book, now it applies to everybody's depth-of-book," says Steve Swanson, president of Automated Trading Book, a Mount Pleasant South Carolina trading firm.

"I think it's caught the entire industry off guard," says Swanson. Everybody was looking along the lines of protecting their top of book -- the best price -- and that's technologically achievable," says Swanson. But the new sweep rule will introduce a magnitude of complexity from a technological perspective, says Swanson, adding that it will ensure an extra year for the industry to implement.

One industry source warns that if market centers were required to sweep every other market at every price point, liquidity would disappear because participants will cancel their orders as they see the market move down the book.

Some industry sources say the mandatory sweep is unnecessary since broker-dealers currently have smart-order routing technology that allows them to sweep multiple markets and search for hidden liquidity. It's more efficient to have broker-dealers do this, says an industry source; imposing this responsibility on market centers would take away from broker-dealers' flexibility, the source argues.

Celent's Burns says smart order routers do look out for hidden liquidity, citing Lava Trading's Dark Book. "This product allows you to ping another ECN to see if there is liquidity that is hidden. What does this do to that kind of smart technology?" she asks referring to the new Reg NMS.

In the original Reg NMS proposal, published in February, the sweep was intended to protect top-of-book. This means if Archipelago has five price points that sit side by side with the NYSE, the NYSE (specialist or floor broker) would be forced to take out Arca at the top level and they would then blow down their own book, says Swanson. With the new proposed Reg NMS, the NYSE would need to "protect these books side by side," says Swanson. Industry sources say the plan is at odds with the New York Stock Exchange's hybrid market proposal, which blends the human auction with the electronic platform. While the SEC's overhaul of Reg NMS advocates public display of all customer orders, the NYSE's hybrid market proposal allows floor brokers to hold customer orders in a broker interest file until they are ready to work the order.

"The way that hybrid works now, the access to the book is very limited," says Swanson. With the new Reg NMS, that book has to be open to the world. That is going to take a huge piece of information advantage away from the floor," he says.

If a broker has a 200,000 share order to buy stock at the inside quote, the broker is required to display 1,000 shares, but has the discretion to keep the rest in reserve, according to the NYSE's Nov. 8 filing. But under the new Reg NMS, the amount in reserve can be traded through because only displayed orders will receive best-price protection. If this is the case, industry sources say the NYSE may have to go back to the drawing board and revise its hybrid market filing a third time.

"That change to the proposal will directly impact the NYSE's hybrid market plans where there were certain categories of orders that were not going to be displayed in order to allow the price improvement characteristics of an auction market to co-exist with auto-ex," says Joe Gawronski, chief operating officer at Rosenblatt Securities, an institutional agency broker that is also a member of the NYSE.

Reg NMS' treatment of reserve books will also impact ECNs, whose entire model is based on reserves and price discretion -- features that are not advertised, says Rosenblatt's COO. "The proposal is problematic if it doesn't take into account reserves on the ECNs or the broker interest file on the hybrid. I just think that investors end up with worse prices," he adds. Even though the SEC is trying to give institutions the incentive to display large limit orders, Gawronski contends that institutions won't disclose large orders. "Rewarding limit orders is a great goal but you have to look at the reality of the market. Institutions, whatever rewards you give them, are not going to post one million shares of stock, letting the whole world know of their intentions, because the information could move many stocks a couple of dollars," says Gawronski.

Institutions want a reserve function, whether that's an electronic set-up in a reserve book of the ECN or in the broker interest file or in a broker's hands, he says.

Yet, with the new Reg NMS, institutions are going to be very reluctant to put orders in a reserve book on an ECN or in a reserve book on the NYSE because those orders could be traded through, says Gawronski.

Instead, they may turn to alternative trading systems like Liquidnet and Pipeline or give orders to floor brokers or upstairs traders for capital commitment. "There would be physical orders and brokers would keep them in their hands more than in a system," he says.

Burns says if the new regulation turns out to be what has been reported in bits and pieces, then it completely changes the Reg NMS debate and it makes the whole NYSE hybrid system obsolete. "It potentially makes floor brokers obsolete if this is essentially a CLOB (central limit order book) because all limit orders have to be disclosed," says Burns.

"Potentially there will be floor brokers put out of business, so the potential of this new version should not be underestimated," says the analyst. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio