Regulation NMS: Have We Lost Sight of the Objective?

By Greg Pratnicki, product manager, SunGard Protegent

With the evolution of the Securities Exchange Commission (SEC) over the last four decades, a myriad of regulations have been mandated to enforce its role in structuring the market. But have these rules, in an attempt to create the National Market System, unduly burdened market participants? If the SEC were to allow market forces to drive the evolution of the market, would they avoid their continuous re-examination or rules, need for modification and the granting of exemptions in an attempt to address potential oversights?

In 1975, Amendments were made to the Securities Act of 1934 that were meant to further preserve the concept of self-regulation and protect competition.  At the same time, the Securities Exchange and Commission (the “Commission”) was strengthened in terms of market oversight, market enforcement, the rulemaking process and its role in structuring the market.  Net capital rules became the responsibility of the Commission, the antiquated clearing and transfer industry was failing, and Congress directed the Commission to create a “National Market System”.

Thirty years later, efforts to modernize and strengthen the outdated Intermarket Trading System (ITS) were undertaken and Regulation National Market System (Reg NMS) was unveiled as a conceptual release. A heated debate began.  Industry professionals and the Commission bearing the responsibility of protecting the investing public aired their opinions.  Along the way, did we somehow overlook the goal of the original concept?  Did the Commissions interpretation of the 1975 National Market System Amendments go beyond Congress’s intentions?    

 “… it is the intent of the House and Senate conferees that the national market system evolve through the interplay of competitive forces as unnecessary regulatory restrictions are removed.”[1] 

In the end, on April 6, 2005, Regulation NMS was passed by a narrow margin of 3-2.  So where are we today? Has Reg NMS brought the intended value to the U.S equities market, or has it brought additional burdens on the participants in our financial markets?  If we consider one of the main objectives of Reg NMS, the creation of a “uniform trade-through rule,” potential flaws in the ideology may exist. 

Consider that trade-through rates in the Commission’s studies were based on the size of the order, not the displayed size of the market.  In addition, is the objective of order protection met when a market participant has the ability to match a protected bid or offer, rather than routing the subject order to the venue for execution?  Take into consideration the growing list of exemptions to the Order Protection Rule, the exponential volumes of electronic messaging in the Reg NMS environment, and the resulting stresses on market data and infrastructure.  Unfortunately, this has led to increased spending by market participants on high performance hardware, support, trading and messaging infrastructures.  Costs that may potentially create barriers to entry have detrimental impact on innovation and possibly become a burden of the individual investor.     

While attempts at protecting the best markets have been costly and feeble, increasing market transparency has been making more productive strides.  Prior to adoption of Reg NMS, competition among the market participants for order flow was largely based on the merit of Best Execution under 11Ac1-5 (k/n/a Reg NMS 605), adopted in 2001.  Competition between broker-dealers, market makers, SRO’s and ECN’s was driven by technology and execution quality.  The result(s) of which were available for review in data disseminated to the public in monthly disclosures under 11Ac1-5.  Best Execution results combined with the Order Routing information under 11Ac1-6 (k/n/a Reg NMS 606) yielded transparency into a fragmenting market place.  The result? Competition was driven by innovation; the public investor was given an opportunity to comprehend exactly what happened to their order after submission for execution.   Moreover, the duty of Best Execution and the obligations on both the Buy and Sell Side created the exact type of innovation and competition that was sought more than 30 years ago when the idea of the National Market was introduced.  This concept is evident in the Commissions’ own Best Execution guidance:

“In deciding how to execute orders, your broker has a duty to seek the best execution that is reasonably available for its customers' orders. That means your broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or electronic communications networks (ECNs) offer the most favorable terms of execution.”[2]    

Although the concept of a trade-through rule codified by Reg NMS 611 protects the best markets at execution, it is the data produced under Reg NMS 605 that provides transparency on execution quality and aids in evaluating routing destinations as defined above by the Commission. 

The Congressional Amendments in 1975 granted the Commission the prudence to interpret the Congressional guidance in creating a National Marketing System.  In essence, the Commission was given the authority to enter into the business of managing market structure.  Have the plethora of rules crafted by the Commission, in an attempt to create the National Market System, created unduly burdens on market participants?  If the Commission were to allow market forces to drive the evolution of the market, would they avoid their continuous re-examination of rules, need for modifications, and the granting of exemptions in an attempt to address potential oversights?

Why not allow the market to evolve based on competition and innovation, rather than regulatory mandate?

[1] H.R. Rep. No. 94-229, 94^th Congress, (1975) Conference Report

[2] SEC.GOV/answers/bestex