The Principal Traders Group of the Futures Industry Association (FIA PTG) recently offered its thoughts on market structure, outlining one direction of reform for the Securities and Exchange Commission’s Reg NMS.
Reg NMS (National Market System) was promulgated in 2005, in order to ensure competition among markets, and in the process to mandate best price execution.
Rule 611, an important component of the Reg, provides “A trading center shall establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs on that trading center of protected quotations in NMS stocks….”
A trade-through is a trade at a price higher than a protected bid or lower than a protected offer–in other words, a trade where someone pays “too much” or receives “too little” relative to the national system as a whole.
There has been much criticism of Reg NMS, and Rule 611. It is seen as an example of the principle of unintended consequences. Bradley Bondi, of Cadwalader, Wickersham & Taft LLP, for example, made the case in a column in Forbes in 2014 that this has been an “awful example of regulatory micromanagement” which has led to the manipulation and games playing associated with high-frequency trading, where the traders with the fanciest tech jump ahead of those without it.
What does FIA PTG propose?
In two words: end it. Rule 611 ought to be repealed because it has increased costs, “as market participants are compelled to build connectivity to thirteen protected venues, irrespective of available liquidity.” That has also made markets “more fragile and less resilient” and it has reduced the incentive for innovation.
The FIA PTG maintains, further, that in the absence of Rule 611 the number of exchange venues will likely decrease, which will prove a good thing, as it will reduce complexity and lessen the costs that must be borne by the investors.
Parts of Rule 610, the ban on locked or crossed markets, should also be repealed, the paper says. A “locked market” is a spread of zero—bid and offer are the same. A “crossed market” is a negative spread—the bid is greater than the offer. The natural sort of market, the kind Rule 610 demands, is one in which the most recent unfilled bid is somewhat lower than the most recent offer, so that somebody must “cross the spread” to get a deal done.
If things aren’t working that way, then something is wrong. That, at any rate, is one premise and an intuitively plausible premise of the regulatory system.
Solution in Search of a Problem
But the FIA PTG contends that neither “locked,” nor “crossed” markets are problems that require regulatory solution. A crossed market in particular “represents an arbitrage that market participants will typically resolve fairly simply and quickly.” Trying to prevent such situations had led the NMS into a quagmire of special exchange order types, which allow for a hold on such orders until they can be displayed consistent with the reg. This represents unnecessary complexity: a repeal would do the work of Ockham’s razor.
The paper also discusses Rule 608, which provides that some regulatory policy initiatives can be implemented via NMS Plans, as an alternative to the standard rule-making process. Such NMS Plans were responsible for development of the cross-market policy initiatives, such as the Tick Size Pilot and the “limit up/limit down” regime created after the Flash Crash of eight years ago.
The FIA PTG is not an enthusiastic supporter of this system. The paper proposes that the system for SRO buy-in on such plans suffers from “governance frailties” that are particularly problematic where commercial issues are concerned,” such as the rates that ought to be charged for market data, though it does seem to concede that the system has some value for more technical issues, such as the details of that up/down limit regime. It proposes, then, reform rather than repeal of Rule 608. Mend it; don’t end it.
Less Liquid Securities
The paper concludes with a general observation about less liquid securities. The FIA PTG is “open to proposals to improve market quality” for such securities, “but believes that such proposals must not harm market quality for highly liquid securities, must be grounded in transparency and competition, and must have well-defined and realistic goals.”