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Reg NMS was just re-released last week and the document surprised everyone, notes Larry Tabb, CEO of the Tabb Group and Contributing Editor to WS&T. Tabb offers his perspective on the regulation, pointing out its winners and losers. "While this may sound tame, it has the teeth of a shark," he says, "and for better or worse it will shred many current market practices."

As events go this one is huge. It's really more than huge it's enormous, it's gigantic, and it's about the largest thing that has happened to the equity market structure since the Buttonwood Tree. For those that don't know, the SEC is in the process of determining just how the equity markets will operate. While many folks will write this off as regulatory minutia, it isn't. The proposal is far-reaching and will drastically change, not only how the markets work, but how we invest, trade and process securities transactions.

For the uninitiated, the SEC released a draft proposal for a new National Market Structure early in 2004. The SEC sponsored hearings on the proposal in the second and third quarters, and in December, it re-released its proposal for another 30-day comment period. The re-released proposal surprised virtually everyone.

The major impetus behind the SEC's action is to provide a more equitable and transparent market that attracts liquidity, provides open and honest price discovery, and does not disadvantage individual investors. To facilitate this, the SEC would like to encourage the use of limit orders, make those limit orders electronically/immediately accessible, and insure those orders are not ignored or bypassed.

To protect and encourage the use of limit orders, the SEC wants to expand the use of the Trade-Through Rule " an exchange rule mandating the price priority of limit orders even if that order is housed at another venue. While the Trade-Through Rule exists today for listed securities, block trades are exempt and it does not cover the Nasdaq marketplaces.

The SEC wants to not only close the block trade provision and extend the Trade-Through Rule to Nasdaq but it also wants to strengthen the rule to include all exchanges, electronic communications networks and alternative trading systems, as well as the full depth of book instead of just the top of book. The SEC by default is creating a virtual price-priority Central Limit Order Book (CLOB).

While this may sound tame, it has the teeth of a shark, and for better or worse it will shred many current market practices. The largest of which will be on the way that blocks are traded. The new proposal attempts to reduce reserve liquidity (orders hidden from the market) as hidden orders will be bypassed as orders sweep through displayed liquidity.

What is so bad about forcing out hidden liquidity?

The typical large institutional equity order is 150,000 shares. The average trade size across all U.S. equity markets is 400 shares. The huge imbalance between orders and trade size means that investors are splitting up large orders into much smaller pieces. But why?

With open order books and one cent spreads, it becomes easy to spot liquidity blocks and to insert an order one cent in front of the block, making it costly for large players. The larger the displayed liquidity, the easier it is for other players to butt in front and run the stock against the investor. This costs large investors billions in market impact expense. To counter act this phenomena large orders are typically either hidden (in reserve or with floor traders), crossed, or sold to brokers at the block level.

By creating and forcing firms to use a virtual CLOB, even for block trades, the SEC is telling investors that the only way that your order-flow will be price protected is if it is displayed. However, by displaying large order-flow, investors are inviting their flow to be picked off.

This dichotomy will have the opposite effect that the SEC desires. Instead of bringing more order-flow to light, it will force large order-flow to go underground.

This underground flow will be matched by crossing platforms such as Posit, Liquidnet, Harborside, or Pipeline which will need to stay in between the CLOB bid/offer but will be opaque. Order-flow that is not crossed will by-pass trading desks, floor traders, and traditional brokers, who would need to enter them as transparent limit orders. These orders will however be traded darkly through algorithmic models or anonymously through direct-access technologies.

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio

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