What Does Reg NMS Mean for Stock Exchanges?

Opinion: A new set of rules passed by the Securities and Exchange Commission will influence IT investment for exchanges and for retail brokers for the next two years, if not longer.

A set of rules called the Regulation National Market System intends to modernize and strengthen the markets for equity securities. One of its 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 New York Stock Exchange.

With the passage of Reg NMS, the trade-through rule will be extended to all U.S. exchanges that trade equities—including the NYSE (New York Stock Exchange), Nasdaq and AMEX (the American Stock Exchange) —by April 2006.

"This is the most sweeping and controversial change to U.S. markets in 30 years," said Bill Cline, a senior analyst at Accenture.

Cline said he thinks the NYSE is clearly the big winner, as the extension of the trade-through rule to the Nasdaq will help it retain its dominant share in trading listed stocks, as well as helping it gain share in trading Nasdaq stocks.

/zimages/5/28571.gifClick here to read about the New York Stock Exchange eyeing a more automated future.

Some say 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 a fully 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.

Many online brokers have implemented "smart order routing" technology, which scans the markets and finds the best place to execute a customers order, based on price and liquidity. Extending the trade-through rule most likely will negate much of that innovative development.

"The passage of Reg NMS was expected, but in our view its not a good thing for our investors," said Vince Phillips, CEO of CyberTrader, an online brokerage that caters to very active traders. Phillips said he thinks their smart order routing technology will be made ineffective next April.

"One of the major drivers of price reductions in our industry has been the automation of order entry and execution," Phillips said. "Reg NMS is a blip on that ongoing evolutionary process."

The majority of retail brokers came out against Reg NMS because routing orders to the Nasdaq has given them lower costs as well as faster transaction processing. "Brokers will have to spend money to accommodate the rule, and those costs will be passed on to customers," Phillips said.

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