Speech by SEC Staff:
Opening Statement before the Open Meeting regarding Regulation NMS
Annette L. Nazareth
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
April 6, 2005
Thank you, Chairman Donaldson. The Division of Market Regulation recommends that the Commission adopt Regulation NMS substantially as re-proposed last December. As you indicated in your initial remarks, Regulation NMS is composed of several rules, including those relating to Access, Sub-Penny Quoting, Market Data, and Order Protection (often referred to as Trade-Throughs). I will briefly describe the first three rules, and then focus the majority of my remarks on the Order Protection Rule.
The Access Rule establishes new standards governing access to quotations in National Market System stocks. The rule promotes access to a market's quotations in three ways. First, it enables the use of private linkages offered by a variety of commercial vendors rather than mandating a collective linkage facility, such as the Intermarket Trading System, to facilitate access to quotations. The lower cost and increased flexibility of connectivity in recent years has made private linkages a feasible alternative to hard, centralized linkages. Second, the rule limits the fees that any trading center can charge for accessing its best bid or offer to no more than 3 tenths of a cent per share. The purpose of this fee limitation is to ensure that displayed quotations more accurately reflect the true price of a stock by establishing an outer limit on the cost of accessing such quotations. Finally, the rule requires self regulatory organizations to establish and enforce rules that prohibit their members from displaying quotations that lock or cross the quotations of other trading centers. Trading centers will be allowed, however, to display automated quotations that lock or cross the manual quotations of other trading centers.
The Sub-Penny Rule prohibits market participants from displaying, ranking or accepting quotations in NMS stocks that are priced in an increment of less than 1 cent, unless the price of the quotation is less than $1.00, in which case the minimum increment is a hundredth of a cent ($.0001). A great many commenters supported the sub-penny proposal as a means to promote greater price transparency and consistency, as well as to protect displayed limit orders. In particular, the rule addresses the practice of "stepping ahead" of displayed limit orders by trivial amounts. It therefore should further encourage the display of limit orders and improve the depth and liquidity of trading.
The Market Data Rules and Plan Amendments are designed to promote the wide availability of market data and to allocate revenues to self-regulatory organizations that produce the most useful data for investors. One Plan Amendment updates the formulas for allocating revenues generated by market data fees to the various SROs that are participants in the market data plans. The current plan formulas are seriously flawed by an excessive focus on the number of trades, no matter how small the size, reported by an SRO. These formulas create an incentive for distortive behavior, such as wash sales and trade shredding and fail to reflect an SRO's contribution to the best displayed quotations in NMS stocks. The formula in the Plan Amendment corrects these flaws. Another Plan Amendment is designed to improve the transparency and effective operation of the Plans by broadening participation in Plan governance. The Amendment requires the creation of advisory committees composed of non-SRO representatives. Such committees will give interested parties the opportunity to be heard on Plan business. Finally, the new Market Data Rule promotes the wide availability of market data by authorizing markets to distribute their own data independently (while still providing their best quotes and trades for consolidated dissemination through the Plans).
We are aware of the frustration expressed by many commenters with the current operation of the market data plans. Some commenters, primarily individual markets that receive market data fees, believe that the current model of consolidation of market data should be discarded in favor of a new model such as a "multiple consolidator" model under which each SRO would sell its own data separately. Others, primarily securities industry participants who pay market data fees, believe that the level of fees is too high. This group believes that the Commission should focus its efforts on the level of fees before modifying the formula for allocating such fees among the various SROs.
As you know, the Commission has considered these concerns at length in the recent past. Undoubtedly a drawback of the current system is that, by requiring all SROs to utilize a single consolidator, market forces do not fully determine the overall level of fees. The Commission has previously considered the alternatives for disseminating market data in an effort to identify a better model, but each was found to have serious weaknesses. A primary consideration is that the integrity and reliability of the consolidated data stream not be compromised by any changes to the market data structure. Several commenters argue that market data fees should be limited to the cost of the plans to collect and disseminate market data. But given the role that market data has traditionally played in SRO funding, the Commission determined that this issue was more appropriately addressed in the context of its concept release on SRO structure. Thus, the Commission has set in train a process for analyzing the concerns of commenters by raising a number of issues for comment in the concept release. The recently proposed rules to improve SRO transparency will, if adopted, also assist the public in assessing the level and use of market data fees by the various SROs.
The fourth area covered by Regulation NMS and the one that has generated the most public attention is the Order Protection Rule. This Rule reinforces the fundamental principle of obtaining the best price for investors when such price is immediately accessible through automated execution. Many commenters, particularly large institutional investors, strongly support the need for enhanced protection of limit orders against trade-throughs. We firmly believe that the Order Protection Rule would enhance the fairness and efficiency of the markets for investors. The execution of trades at prices inferior to those offered by displayed and immediately accessible limit orders is inconsistent with basic notions of fairness and orderliness, particularly for investors, both large and small, who post limit orders only to see other orders executed at worse prices. These trade-throughs also can undermine incentives to display limit orders, which are the building blocks of price formation. In addition, many of the investors whose market orders are executed at inferior prices may not even be aware they received an inferior price. A uniform rule establishing strong price protection on an order-by-order basis would both protect the interests of investors by reinforcing the duty of best execution and promote the display of limit orders, and thereby improve the fairness and efficiency of the marketplace as a whole.
The Order Protection Rule is radically different from its antiquated predecessor, the trade-through rule under the ITS Plan. The Order Protection Rule is stricter and more comprehensive in significant respects. It requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs or, if an exception is being relied upon, that are reasonably designed to ensure compliance with the exception. Such policies and procedures will typically involve objective standards coded into a trading center's automated systems, and the trading center will be required to regularly monitor the effectiveness of its policies and procedures and to take action to remedy deficiencies. The Rule eliminates gaps in the coverage of the ITS provisions that have undermined their protection of limit orders - namely the exceptions for non-exchange block transactions and for 100 share quotations.
We recommend that the Order Protection Rule apply to both the listed and the Nasdaq markets. The Division believes that effective intermarket price protection would benefit investors and strengthen the national market system in all NMS stocks. Analysis of trading by the Office of Economic Analysis showed that trade-through rates are significant in both listed and Nasdaq stocks. The current trade-through rates are not lower for Nasdaq stocks than NYSE stocks, despite the fact that nearly all quotations for Nasdaq stocks are automated. Moreover, the majority of trade-throughs that currently occur in NYSE stocks fall within gaps in the coverage of the existing ITS trade-through rules that would be closed by the Order Protection Rule. Consequently, we believe that the Order Protection Rule will materially reduce the trade-through rates in both the Nasdaq and the listed markets.
The Rule would implement the "top of book" or Market BBO Alternative described in the Reproposing Release by protecting the best bids and offers of the nine SROs and the Nasdaq Stock Market. We are not recommending adoption of the Voluntary Depth Alternative, which would have required quotes voluntarily displayed below the top of the book to be protected. Many commenters believed that enhanced depth of book interaction would likely result under the Market BBO Alternative, but with fewer of the costs and drawbacks associated with the Voluntary Depth Alternative. For example, many believed that the Voluntary Depth Alternative could be significantly more difficult and costly to implement, and that it put too much emphasis on competition among orders to the exclusion of competition among markets.
The Rule does not contain an opt-out exception. Rather, it contains a number of targeted exceptions to address concerns of commenters on the workability of the Rule. For example, the Rule eliminates any trade-through protection for manual quotations. There also are exceptions that accommodate orders intended to sweep the market, that address situations where quotes are rapidly-changing or "flickering," that allow for "self-help" when a market experiences a systems malfunction, and that accommodate benchmark trades such as those based on VWAP. There are a variety of other exceptions that were included in the reproposal, and also a new exception for certain "stopped" orders that was added in response to commenters' suggestions that it was needed to promote dealer liquidity. In addition, I should stress that the operative provision of the Rule requires trading centers to establish, maintain and enforce policies and procedures that are reasonably designed to prevent trade-throughs. It is not an absolute prohibition, and this acknowledges that even with well developed systems, a certain number of trade-throughs may individually occur in a fast moving market.
As to implementation, we believe that a phase-in process would be useful to gain experience with the Order Protection Rule before all stocks become subject to trade-through restrictions. We therefore recommend an initial phase that would begin on April 10, 2006 and end on June 9, 2006. During this initial phase, all trading centers would be required to begin trading 100 NYSE stocks, 100 Nasdaq stocks, and 50 Amex stocks, subject to the trade-through restrictions of the Order Protection Rule. These initial stocks would be chosen by the primary listing markets in consultation with Commission staff. The primary purpose of the initial phase would be to allow market participants to test the functionality of their systems and procedures and to provide the Commission with the ability to evaluate the effectiveness of the policies and procedures adopted by the various trading centers. To the extent that our analysis identifies particular problems, we would contact specific trading centers and communicate with general industry representatives. Our objective would be to have an ongoing dialogue with market participants during the initial phase in order to address any implementation issues as promptly as possible. Full implementation would begin on June 12, 2006, at which time the Access Rule would also be fully operational. We recommend that the Sub-Penny Rule go into effect on July 1, 2005 and that the Market Data Rule take effect on July 3, 2006.
Having explained what the Order Protection Rule provides, I would like to address a small fraction of the misinformation about the Rule perpetrated by its most vocal detractors.
The first is that the Order Protection Rule is anticompetitive. As the Release discusses in great detail, the Order Protection Rule is specifically designed to enhance one form of competition - that is, competition among orders to establish the best price. Congress specifically mandated that the Commission take two forms of competition into account in fashioning the rules for the national market system - competition among markets and competition among orders. I fail to see how a rule that strengthens a customer's ability to compete by setting the best price in a market is anticompetitive. Nor is it apparent how proposed Regulation NMS is a scheme to "manage competition" as some have alleged, by dictating how markets can compete. Markets can and will continue to compete to attract order flow by offering any number of services. And market participants will continue to program their systems to direct their orders primarily to the markets whose services they prefer. But ultimately the quality of the marketplace as a whole will be enhanced by rewarding those limit orders with an execution that have set the best price. At base, the Order Protection Rule is an investor protection rule that backstops a broker's duty of best execution by requiring the broker to get the best price for his customer that is immediately accessible on an order by order basis. This is an important enhancement of investor protections and is made possible by the vast advances in technology that we've seen over the past several years.
Some have suggested that the Order Protection Rule will require investors to direct orders to a market that may require them to wait minutes for a response and that they may miss the market during that period. Nothing could be further from the truth. The rule expressly applies only to quotes that are immediately accessible. If a market repeatedly does not respond within one second or less, market participants may exercise "self-help" and avoid that market for purposes of the Order Protection Rule.
Next, some critics argue that the economic data produced by the Office of Economic Analysis was flawed. Some asserted that the staff must not have controlled for certain conditions that would have led to distortive results. I can assure you that we took each comment very seriously and the OEA staff has responded specifically to each concern. It has checked its results very carefully and stands by its original assessments.
Some commenters asserted that, even if correct, the OEA data was not compelling enough to support the application of the Order Protection Rule to the marketplace, particularly the Nasdaq market. But OEA has confirmed its findings that the trade-through data for the Nasdaq market was quite similar to that in the NYSE market. And we stand by our view that, in the Nasdaq market, 1 in 40 trades (and 1 in 30 internalized trades) is an unacceptable rate of trade-throughs given the technological ability that the markets have today to avoid them.
We also firmly believe that a rule that protects the best-priced displayed orders will encourage more priced orders to be displayed, thus enhancing liquidity and price formation in the marketplace. Of course, no one can predict the extent to which this will occur with absolute certainty, but even an incremental increase could reap significant benefits to investors in terms of lower transaction costs. Our estimate is a minimum $320 million per year in benefits to investors and could rise much higher depending on the extent to which strengthened protection of limit orders enhances market depth and liquidity.
Finally, I'd like to address the criticism that the Commission should not act because there is not a consensus of views in the marketplace on a proper approach. It is unrealistic to expect all market participants, particularly those who profit in the current regime, to support reforms. The Commission has a long and noble history of acting in the face of strong opposition, whether it be issues such as the elimination of fixed commissions, the order handling rules, or the execution quality statistics. In each case dire consequences were predicted, yet each of these initiatives reconfirmed our status as the preeminent marketplace in the world. I urge the Commission to once again pursue what is right for investors and the marketplace in the face of opposition and approve the adoption of Regulation NMS.
There are a number of staff members, in addition to those you mentioned, who I would like to thank for their substantial efforts on Regulation NMS, including Yvonne Fraticelli, David Hsu, Molly Kim, David Liu, Ray Lombardo, and Mark McKayle. I would be happy to answer any questions you may have.