Is it Time to Tweak, Keep or Scrap Reg NMS?

In the ongoing debate over U.S. equity market structure, Regulation NMS has been blamed for driving the capital markets toward a complex, fragmented market structure where priority is given to speed over liquidity, small order sizes over large prints, and technology over human judgment.

It has also led to complex order types, the growth of dark pools and a technology arms race defined by colocation services, latency metrics, fights over cable lengths in exchange data centers and microwave delivery of market data.

In a report released earlier this week, Larry Tabb, founder of Tabb Group, analyzes the history and core principles of Reg NMS, including the Order Protection, Market Access, Sub-Penny Pricing and Market data rules. Tabb, who is a market structure expert, urged the industry to start a conversation about whether the rule set has been disastrous or helpful and worth keeping.

Noting that it’s been six years since Reg NMS, a collection of SEC rules was implemented in 2007, Tabb wrote there’s enough data to decide whether the rules have met their goals or whether the unintended consequences outweigh the positives. “It is time to rethink how our markets should operate; we need a healthy discussion about whether to keep tweak or even scrap Reg NMS, which so many in the industry have come to loathe,” wrote Tabb in the report titled “Regulation NMS Park I: Loved or Loathed and Why Many Want It to Die.”

It’s important to remember that Reg NMS was originally created in 2005 to insure that investors received a fair price and that markets were more competitive with their orders. Reg NMS was also a move to modernize the markets due to the increasing usage of trading technology – such as the FIX Protocol and other recent changes such as 2001’s shift to decimalization or penny pricing.

One of the main reasons that Reg NMS was implemented were complaints from institutional investors and brokers over the New York Stock exchange where specialists were slow to respond to orders. While Nasdaq stocks were executed in sub-second speeds, the NYSE average execution time was still in the low double digits seconds, according to Tabb’s report. In a 2004 Tabb study, 71 percent of 52 institutional asset managers felt that their most difficult challenge was working with the specialist and NYSE market structure, while fragmentation and liquidity aggregation was cited by 46 percent.

Prior to the implementation of Reg NMS, brokers had to meet best execution obligations so they were forced to route orders to the NYSE, which had approximately 90 percent market share. Even if an away market had a better price, the NYSE took longer to respond so it had time to outbid the faster electronic market.

Electronic execution networks (ECNs) were a way to trade electronically and were cheaper and faster than the exchanges, but the benefits of ECNs were mostly occurring in Nasdaq-listed stocks. Also, they weren't connected to the other markets. ECNs were giving buy side traders more control over their executions but traders needed new technology to protect their quotes from being picked off, noted the report.

After Reg NMS, brokers were required to route their orders to the market displaying the best price, and then allowed them to bypass slower markets. This also forced the NYSE to go electronic, and convert most of its market to a continuous matching system.

Reg NMS abolished the Intermarket Trading System, an antiquated network that linked the NYSE to regional exchanges. According to the report, ITS rules allowed specialists and market makers 30-120 seconds to price an order and to wait until the most opportune time to fill a client order. The architects of Reg NMS — which included brokers in the industry who attended the hearings —decided to scrap ITS and instead to use private high speed networks to link all the exchanges and ECNs.

According to Tabb, this started a speed race where today firms spend millions on high –speed connections in data centers to gain an advantage. While brokers are not forced to make this investment and can pick their own level of spend, speed improvements can improve their trading results.

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