It's time for the SEC to take a hard look at this stock market rule
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President Trump has repeatedly pledged to dismantle outdated or ineffective regulations during his first year in office. As it relates to financial markets, much of the talk has centered around what to do with the Dodd-Frank Wall Street Reform and Consumer Protection Act, the 2010 law that came in the wake of the financial crisis. However, there is another regulation that needs serious review: the Securities and Exchange Commission’s (SEC) Regulation National Market System (NMS).

In 2005, the SEC fundamentally shifted the way equity markets operate by passing Regulation NMS. The goal, which came as adoption of electronic markets was growing, was to “modernize and strengthen” the way that markets operate. But markets have drastically changed over the past decade, and Regulation NMS has turned out to spur complexity, not efficiency.

When Regulation NMS was promulgated, for instance, the New York Stock Exchange (NYSE) traded mostly via open outcry on the floor. It wasn’t until January 2007 that the NYSE introduced a hybrid market combined floor and electronic trading. Since then, electronic trading has dismantled floor trading across every major exchange.


Simultaneously, major changes occurred on the retail investment front, largely the result of a dramatic shift towards investments in passive exchange-traded funds (ETFs) and mutual funds. According to Morningstar, assets in passive mutual funds grew 230 percent since 2007, while assets in active funds have grown just 54 percent. This shift to passive management means that retail investors are increasingly investing through big institutional trading funds.


Yet, parts of Regulation NMS make it harder for institutions like pension funds and mutual funds to execute their trades, increasing costs and dragging down returns. Case in point: a provision of Regulation NMS called the “order protection rule” and put into place to ensure that investors receive the best available price for their stock orders. The order protection rule created the National Best Bid and Offer (NBBO), which requires a broker to route an order to the venue with the best displayed price.

This makes perfect sense — in theory. Customers naturally want orders filled at the best price. At the same time, the rule was thought to encourage more displayed orders from market makers, who should be rewarded with orders when those markets are at the best price. But it’s not that simple.                                                

Instead of best price per share, investors, particularly those pensions and mutual funds investing in small- and mid-cap equities, are actually looking for the best execution — a distinction that matters as it relates to behavior. Institutions don’t worry about what price they can fill 100, 200 or even 1,000 shares of stock. They worry about whether they can place those trades without tipping off the rest of the market.

For instance, say that a pension fund was looking to buy 10,000 shares of stock XYZ, 1,000 shares of which was available at Exchange A for $100.01 and 10,000 shares of which were listed at Exchange B for $100.02. In this example, the pension would first have to buy those 1,000 shares at $100.01, at which point, they would still have 9,000 shares outstanding.

If they could buy the 9,000 shares on Exchange B at $100.02, all would be good and the order protection rule would have worked in their favor. However, markets are efficiently priced, so the purchase on Exchange A would have an immediate impact on the listed price on Exchange B. The whole Exchange B order may be pulled, or the price may tick higher to $100.03, $100.04 or more.

In that scenario, the fund ends up worse off for having to go to Exchange A first. Those higher costs are then passed down in the form of worse returns for the pension fund and its retirees.

Anyone would agree that the common-sense solution in this simplistic example would be to go straight to Exchange B first, paying the higher nominal price for assurances that the entire trade is executed at the known price. But that is not technically allowed under the order protection rule.

To work around that technicality, the market has attempted to innovate a solution, but it involves finely tuned technology and complicated order types that come with intense regulatory scrutiny. And these “innovations” are not a perfect fix. They complicate the market, instead of modernizing it.

Put simply, Regulation NMS no longer reflects the way that the modern market operates. It leaves market participants and long term investors handicapped by too stringent rules, which ironically benefit short term traders.

With Washington’s eyes now focused on outdated or ineffective regulations, it’s time regulators adapt to the different landscape, and either significantly revise Regulation NMS or eliminate it altogether.

Donald Ross III is chief executive officer of PDQ Enterprises, the parent company of U.S. equity trading platform CODA Markets.

The views expressed by contributors are their own and are not the views of The Hill.