After months of debate, the SEC was set to vote on a package of rule changes, known as Regulation NMS, on Wednesday.
The intent of Reg NMS, which is composed of a series of initiatives, is to modernize and strengthen the NMS (national market system) for equity securities. However, the new regulation highlight the differences between “digital” trading systems: hand-to-hand in the case of one exchange and computerized trading for another.
One of the more controversial provisions, which will have a significant IT effect on U.S. exchanges, is the trade-through rule, which is currently used at the NYSE (New York Stock Exchange).
The trade-through rule will be extended to all U.S. exchanges if Reg NMS passes in its current form.
Some say that the trade-through rule, which was first instituted in 1975, guarantees that investors will get the best price for their trade executions.
A market system would not allow one customer to “trade through” an existing order without first matching that order.
A customers order has to be routed to the destination with the best price at the moment the order is entered.
The problem with extending the trade-through rule from the NYSE to Nasdaq and other exchanges is that the NYSE is not an automated system.
The effect on the automated Nasdaq system, for example, would be to drastically slow it down, when one of the advantages of the system is the way it automatically matches buyers and sellers.
Though its moving in the direction of automation, the NYSE is still at heart a manual system, with trades handled by specialists in particular stocks.
Nasdaq, however, is fully automated, so while a quote on a Nasdaq stock is currently executable, a quote on a NYSE stock is considered an indication and not a firm quote.
A quote shown on the NYSE is not immediately executable, since specialists are allowed to hold an order for 30 seconds before either executing it or handing it off to another specialist.
During that time, the price may change. A quote on the Nasdaq, however, is executable.
Executives at the NYSE have defended the trade-through rule, saying its good for small investors.
But Nasdaq members often charge NYSE specialists with bait-and-switch pricing tactics so that orders are routed to the NYSE, then executed at a worse price than what was available at the time the order was entered.
According to the SEC (Securities and Exchange Commission) filing, the NMS promotes fair competition among markets, while at the same time assuring that all of these markets are linked together, through facilities and rules, in a unified system that promotes interaction among the orders of buyers and sellers in a particular NMS stock.
Intermarket “rules of the road” establish a framework within which competition among individual markets can flourish on terms that ultimately benefit investors.
The reproposed rules are, the SEC says, designed to strengthen and enhance the efficiency of linkages among the various competing markets, but without mandating any particular type of trading model.
Investor choice and competition will determine the relative success or failure of the various competing markets.
Brokers who make it possible for customers to direct their own orders, such as Schwab, Fidelity, TD Waterhouse and Ameritrade have strongly objected to the extension of the trade-through rule to the Nasdaq.
Robert Greifeld, CEO and president of the Nasdaq Stock Market Inc., said in his testimony before the SEC last year, “We have grave concerns about the impact this rule could have on our market, and the SEC has expressed no need for the rule on our market other than that it would promote uniformity of regulation.”
Greifeld concluded: “Critically, the SEC has not analyzed or assessed the impact of the rule to the Nasdaq market, yet it seems prepared to dramatically alter the way our market works.”
Other brokerages insist that if the trade-through rule is extended to all exchanges that the quotes displayed must be immediately executable, rather than subject to change depending on market conditions.
The SEC estimates that the change will cost $144 million to implement, a one-time charge, but will save investors $320 million to $755 million annually.
Observers of the SEC say that its rare that the commission splits its votes, but should that happen, they expect Congress to act, which may result in another stalemate.