The SEC Passes Reg NMS

In a divided vote, the SEC passed Reg NMS, ushering in a new and improved trade-through rule that will make best price and fast quotations a requirement for U.S. equities trading.

The Securities and Exchange Commission voted yesterday to approve Reg NMS, a set of market-structure reforms that will force brokers and exchanges to guarantee investors the best available price, which must be automatically executable.

Despite opposition from electronic markets, such as The Nasdaq Stock Market, Archipelago and Instinet, and from big institutions, such as Fidelity Investments and Charles Schwab, that wanted the freedom to choose speed and certainty of execution over best price, SEC Chairman William Donaldson, a Republican appointee, pushed through the initiative by voting with the two Democratic commissioners in a 3-2 vote.

Rather than scrapping the controversial trade-through rule -- which prevents market centers from ignoring best prices displayed on other markets -- the Commission extended the rule to cover Nasdaq-listed securities.

Market centers will need to display an automated quotation that is both electronically accessible and instantaneously executable, or they will risk having their prices ignored by other market centers.

"In order for the NYSE and other floor-based systems to be able to do that, they need to increase their automation," says George Rodriguez, managing director at TradeTrek Securities, an institutional broker in Newark, N.J.

In February 2004, the NYSE announced a plan to lift the restrictions on Direct+, its automatic execution system, and to develop a Hybrid Market plan that would combine the automated market with the floor-based specialists conducting an auction.

If exchanges must route orders to other market centers that have a better price, one of the major changes will be the need for exchanges to link with electronic communications networks (ECNs).

"First, you're going to see a step up in the degree of electronic linkages among the different ECNs and exchanges," predicts Brennan Carley, chief strategy officer and chief technology officer (CTO) at Radianz, a global connectivity provider to the financial industry. "A lot of those private linkages already exist," he says. "Some are through us and through leased lines."

Meanwhile, in another win for the NYSE, market centers will have to protect quotations that are displayed at the top of book, meaning those at the best price, as opposed to the full depth of book -- all the orders further down the book that are displayed. The full depth-of-book alternative, or so-called voluntary depth alternative, would have derailed the NYSE's Hybrid plans and jeopardized the role of floor brokers by requiring them to display all of their orders.

"The reasoning behind the Hybrid Market was the increasing demands from institutional customers for automatic executions," said Roger Burkhardt, CTO of the NYSE, speaking at the TradeTech conference on the day Reg NMS was passed.

But one analyst questions whether the Hybrid Market will be ready by April 6, 2006, the timetable set by the SEC for phasing in Reg NMS.

"We automatically assume the Hybrid Market works," says Sang Lee, managing partner of The Aite Group, a financial services research firm, noting that he's seen the tentative release dates. "It appears the functionality that will be made available to nonmembers and buy-side institutions won't be ready until early 2006."

In addition, Lee notes the Hybrid platform still hasn't been approved by the SEC. "That needs to be taken care of as well," he says.

According to the NYSE's Burkhardt, "The Hybrid market is something we've been working on for well over a year. We can launch it, but we're still waiting on our filing to be approved so we will know exactly what we're building."

Based on the SEC's timetable, the initial phase of testing will include 100 stocks from each of the NYSE and the Nasdaq markets and 50 from the American Stock Exchange, and will last until June 2006. "We have to be ready by April 10, 2006, for 100 stocks to start with," said Burkhardt.

Meanwhile, The Aite Group's Lee cautions that changing the Direct+ electronic platform may not be as simple as getting rid of the restrictions around that, adding that it may not be a minor adjustment. "This is essentially going to be the core of the exchange and it's incredibly important that they get this right and do it in a timely manner," he says.