Introduction[1]
On February 26, 2004, the United States Securities & Exchange Commission published for comment Release No 34-49325,[2]“Regulation NMS” which, in addition to routine matters:
“…would incorporate four substantive proposals that are designed to enhance and modernize the regulatory structure of the U.S. equity markets. First, the Commission is proposing a uniform rule for all NMS market centers that, subject to certain exceptions, would require a market center to establish, maintain, and enforce policies and procedures reasonably designed to prevent “trade-throughs”—the execution of an order in its market at a price that is inferior to a price displayed in another market. [3] [Emphasis added.]
This article deals with the Release’s first proposal, and as a public policy objective, recommends that a properly-modified trade-through rule would be appropriate. It argues against the opt-out provisions proposed because a properly designed and operated national market system could guarantee “best execution” for each transaction within an order.
A trade-through is the execution of an order in a market at a price that is inferior to a price displayed in another market.
The proposed “opt-out” provision in Regulation NMS would permit informed investors to elect to “opt-out” of the trade-through rule on an order-by-order basis. Depending on the price of the stock, the opt-out provision would allow trades to be made from one cent to five cents worse than the best displayed bid or offer.
The “trade-through rule,” and its proposed “opt-out” exceptions, is by far the most controversial piece of proposed Regulation NMS.
The Commission noted that it “… believes that these changes (opt-out exceptions to the trade-through rule) require it to revisit the issue of trading at inferior prices across markets.Clearly, in a fully efficient market with frictionless access and instantaneous executions, trading through a better-displayed bid or offer should not occur.” [4] [Emphasis added.]
The decision to be made by the Commission between maintaining or modifying the trade-through rule or introducing the opt-out exception will have a defining effect on the structure of U.S. equity markets.
The New York Stock Exchange, which has been the principal beneficiary of the trade-through rule, is fighting tooth and nail to maintain the status quo. Its competitors (and would-be competitors, such as ECNs), believe the present iteration of the trade-through rule to be old fashioned because it frequently requires manual intervention before an order can be executed, and gives an unfair advantage to NYSE specialists, who have time to make up their minds whether or not to participate in a trade.
The Intermarket Trading System, (“ITS”) is also a major part of the problem in enabling “best execution.” ITS is a system linking certain market centers that slows down executions. A quarter of a century ago, the then President of Merrill Lynch, William A. Schreyer, derided ITS in sworn testimony before two congressional subcommittees as follows: “It is as far from the concept of an automated, efficient marketplace as a tom-tom is from a communications satellite.”[5] ITS has not changed very much since then, except cosmetically.
Transactions, Executions and Orders
This article discusses the implications of the differences among the terms “Transactions,” “Executions” and “Orders,” and how the appropriate use of the terms will affect the decisions made by the Commission with regard to proposed Regulation NMS, and whether the Nation will finally achieve the national market system the Congress ordered the Commission to “facilitate” in 1975. (Note: “Facilitate” is defined as “to make easy.”)
In the 1963 Special Study of the Securities Industry, the Securities & Exchange Commission wrote:
“The Report concludes that the factors contributing to or detracting from the public's ready access to all markets and its assurance of obtaining the best execution of requires the continuous attention of the Commission and the Policy and Planning Unit.”[6] [Emphasis added.]
41 years later, in 2004, the Commission wrote in Proposed Regulation NMS:
“c. Opt-Out - Provision of National Best Bid or Offer
“The Commission also is proposing to require a broker-dealer to disclose to its customers that have opted-out the national best bid or offer, as applicable, at the time of execution for each execution for which a customer opted out.”[7] [Emphasis added.]
Notice the proposed regulation uses the term “execution,” rather than “order,” even though the proposed opt-out exemption is required for each “order.” In reality, however, the exemption is required for each execution within an order, since the proposed regulation requires the broker-dealer choosing the opt-out provision to certify to the investor the NBBO at the time each execution occurs, and report back to the investor the amount of any possible loss that might have occurred.
Section 11A of the Securities Exchange Act also contains these words:
“…it is in the public interest and appropriate for the protection of investors and the maintenance of a fair and orderly market to assure:
- the economically efficient execution of securities transactions” [Emphasis added.]
It is interesting to note the words chosen: “execution” and “transactions.” More recently the Commission has defined the word “order” as a synonym for “transaction” or “execution.” That is often incomplete, because every order which is filled (in whole or in part) must have at least one execution or transaction. Many orders, however, have multiple executions or transactions.
In 1968, the Commission directly addressed the definition of the term “transaction”:
“One of the basic duties of a fiduciary is the duty to execute securities transactions for clients in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances…”[8] [Emphasis added.]
The reality is that investors and other traders want only one thing: buyers want to pay the smallest total amount for each execution; sellers want to receive the greatest total proceeds for each execution. When an order requires execution by more than a single transaction, the investor would like to receive the highest aggregated proceeds for each sale transaction and the total lowest cost for each purchase transaction. The Commission has the ability precisely to define the term “best execution” for each transaction in a national market system, but it is impossible precisely to define “best execution” for any specific order requiring multiple transactionsto fulfill[9]
In 1996, Jonathan R. Macey and Maureen O’Hara of Cornell University, wrote “The Law and Economics of Best Execution,” in which they stated:
“Despite the seeming simplicity of this concept, few issues in today’s securities markets are more contentious than the debate surrounding best execution. Does clearing a trade in one market at the best available current quote constitute best execution if trades frequently clear between the quotes in another market?
Does the mechanism that provides best execution change when trade size is considered?
Can investment professionals comply with their legal best execution obligation if their trade price implicitly provides a rebate to the broker rather than a better price to the trader?
How can exchanges, investment professionals, and regulators guarantee the provision of best execution? Is best execution an achievable (or even definable) goal, or is it a more amorphous concept akin to market efficiency?
These questions represent just a part of what is becoming an issue of increasing complexity”.
Clearly, proposed Regulation NMS’s ability to describe “Best Execution” today is even more complicated than it was in 1996.
Orders requiring more than a single transaction to complete have but one thing in common: They need the professional skill and judgment of the person or persons responsible for fulfilling the order. There is no single way to assure best execution of a complex and large order, any more than there is for a competent and skilled attorney to have only one way to try a case.
Many orders—especially large orders for hundreds of thousands or millions of shares entered by institutional investors—require multiple trade executions, sometimes taking one or more days. This may be required to achieve what is believed to be the lowest overall cost or the highest proceeds. But if each and every trade execution at the time it is made is made at the highest bid (for a purchase) or the lowest offer (for a sale), the total cost or proceeds of the entire order will assure "best execution," provided reasonable judgment and care is taken with the order.
The Commission defines “best bid” and “best offer,” as follows: “The terms best bid and best offer shall mean the highest priced bid and the lowest price offer.”[10]
If there is any spread at all between best bid and best offer, there cannot be an execution. At the moment of execution, the spread must always be zero. There can be no “price improvement,” since the bid must be hit or the offer taken. The true issue is: Who gets to see and trade with the best bid or offer? “Price improvement” is only possible if the market system hides either bid or offer (or both) from some market participants. “Price improvement" is an oxymoron if the market system is properly designed and implemented.
The Commission is seeking to facilitate a national market system. There are multiple market centers in which the same securities are being traded at the same time, and in which various “pools” of liquidity (bids and offers) are collected and shown. There is no capability for any investor to be able to see and access the entire “ocean” of liquidity which would result by integrating all the pools of liquidity.
The reasons for this inability are many, but start by a failure of the present market structure to aggregate all bids and offers for each security into a single, instantly-accessible whole. However, if all market centers operated at the same speed, making instantly accessible all separate “pools” of liquidity, this would create an “ocean” of liquidity.
The Commission earlier wrote:
“The Commission anticipates that the proposed rule (11Ac1-5) will help broker-dealers fulfill their duty of best execution. That duty requires a broker-dealer to seek the most favorable terms reasonably available under the circumstances for a customer's order. Routing orders to a market center that merely guarantees an execution at the best published quote does not necessarily satisfy that duty…”[11] [Emphasis added.]
The definition of best execution goes on to state:
“A broker-dealer must consider several other factors [besides best price] affecting the quality of execution, including, for example, the opportunity for price improvement[12], the likelihood of execution (which is particularly important for customer limit orders), the speed of execution, the trading characteristics of the security, and any guaranteed minimum size of execution.”
In a properly-designed national market system, routing orders to an integrated set of market centers operating at the same speed would satisfy the duty of best execution, and a modified trade-through rule could be maintained. Under such a system, there would be no difference in “execution quality.” In the proposed Regulation NMS Release the Commission makes this point:
“In short, Section 11A of the Exchange Act envisions a market structure characterized by full transparency where competing markets are linked together to provide the ability to effectively and efficiently execute customer orders in the best available market. It is these core principles that have shaped the Commission’s actions to foster the development of a true NMS”.[13]
The problem with the Commission’s approach is that “the best bid and offer” is seldom, if ever, made up of all the bids and offers available at a moment in time. There are often better undisclosed bids and offers (which could have been and should have been published), but there is no practical or economical way for all orders to interact with them, since they are not known to exist. In addition, even under Regulation NMS’s proposed rules, locked and crossed markets would still be possible. Any trading system that permits locked and/or crossed markets should not be allowed to exist as a part of a national market system.
The only way for “best execution” of each transaction to be guaranteed is for all bids and offers in any particular security to be able to interact, preferably on a price-time priority basis. “Best execution” of a multiple transaction order will still require skill and judgment, as it should. But the cost of such a system would probably be at least one order of magnitude less than the present multiple, cobbled-together systems that are the result of the Commission’s actions since 1975.
Let me postulate the execution of a large order as follows under the “opt-out” proposal: An order is entered under the proposed opt-out provision to buy 100,000 shares. The NBBO in hypothetical stock XYZ is 20.15 bid for 15,000 shares, 10,000 shares offered at 20.23. The last sale was 20.20.
The buyer bids 20.25 for 50,000 shares, and buys the 50,000 shares at that price, bypassing the 10,000 shares at 20.23. There are now 110,000 shares remaining to be bought, which are may be completed in several transactions with or without employing the opt-out provision.
In this scenario, the presumptive reason the buyer is willing to buy above the best offer price is because of foreknowledge there is a specific quantity of stock available to be bought at that price, and the seller does not want to have to deal with 10,000 shares being bought away. That information is concealed from the rest of the market.
In addition, the buyer does not wish to allow a “slow” market center to be able to delay execution for some period of time.
This would appear to fly in the face of the congressional edict that:
“It is in the public interest and appropriate for the protection of investors and the maintenance of fair and orderly markets to assure--
the availability to brokers, dealers, and investors of information with respect to quotations for and transactions in securities”[14]
The law certainly suggests that the same information about bids, offers and executions of securities transactions, as well as executions (“transactions”) be made available to all brokers, dealers and investors at the same time, and not just to a subset.
The “Market” Order
Another defect of the present market structure is the ability to enter “market orders.” A market order is defined as an unpriced buy or sell order delivered to the trading arena. It is never included as part of the NBBO[15], since it contains no bid or offer price.
The "market order” was needed only when order entry personnel could not know what was going on in the trading arena. That was true in the 1950s, when I arrived on Wall Street, and earlier, but today, market orders are no longer needed, because in an electronic market system all participants should be able to see and interact with the very best prices at all times. Market orders increase volatility, since they must be executed immediately, regardless of prices available.
A true national market system would require that all orders be entered into the trading arena with a mathematically-calculable price or algorithm for execution at the time it is entered. In other words, no "market" orders are needed, which is the way specialists get their 30-second, free, unpriced valuable options.
Not only traditional limit orders could be entered. Orders to trade at the opening price, at the closing price, at the volume weighted average price (“VWAP”), the median price of the day, Immediate or Cancel (“IOC”), Fill or Kill (“FOK”), best bid or offer when received at the trading arena, or similar type orders, would also be able to be entered. Short sale execution restrictions could still be met, and other regulatory restrictions, such as buy “minus” or sell “plus” could also be continued, with the present “market order” condition replaced with either highest bid or lowest offer.
But all orders should contain a predeterminable, mathematically calculable price or algorithm at the time of entry. Unexecuted orders or portions of orders should be cancelable either by direction or by the previously entered algorithm. Execution should occur on a strict price-time priority basis. First, disclosed bids or offers would trade, and next, reserve orders (undisclosed, but entered orders) at the same prices as disclosed executed orders.
Bids and offers entered into the market should be able, if designated to do so, to “walk up or down” the “books” of displayed bids or offers that have been sent to the market through various market centers. Merely permitting immediate electronic executions only at the best bid or offer price would be anticompetitive and unnecessary.
Price Continuity
In the year 2004, information technology advances allow disclosed supply and demand to be made instantly available in the electronic trading arena. There is no longer any need to pay a monopolist for "price continuity." If the best bid is lower than the best offer by any amount, no trading can occur. As noted above, only when bid and offer are equal can there be a trade. If there is a spread, and no trading occurs, there is no need for a mandated "circuit breaker" when there is an order imbalance, and as a result, each stock would have its own natural circuit breaker.
Once again, the issue is whether any market participant has immediate and full access to all bids and offers when they are entered. If so, price continuity will become irrelevant, since whenever there is a spread, no executions could occur.
Market makers would be free to enter any bids or offers they wished to narrow spreads. There would be no need for “affirmative” or “negative” trading obligations. Regulatory halts would, of course, also be able to continue.
The idea of maintaining subsidized "price continuity" in an electronic age is unnecessary and anticompetitive. If market conditions create an imbalance between bids and offers, and there is a spread between the highest bid and the lowest offer, there should be no forced trading. Traders should only trade at the price at which buyers and sellers voluntarily agree (other than for a regulatory trading halt, which is very different from a market imbalance halt). If no trading takes place, it is solely because no buyer is willing to meet the seller’s offer and vice-versa.
If news occurs that should result in a significant price change, it should move to the new equilibrium price as quickly as possible. To move a stock slowly up or down to the new equilibrium price is a fraud on the market.
Professor Hans Stoll noted the lack of need for specialists’ affirmative obligations as long ago as 1997, as follows:
“It is time to reconsider the affirmative obligation, certainly as a regulatory obligation. It is not evident that an affirmative obligation reduces volatility or makes markets more efficient. The cost to the public of the privileges granted to market makers—such as a quasi monopoly position and access to trading information—are likely to outweigh any benefits. Finally the cross subsidization between easy trades and hard trades implicit in the affirmative obligation is increasingly impractical in today’s more competitive markets.”
[16]Conclusion
In 2004 there is no reason a properly-modified trade-through rule should not be promulgated. If that were to happen, would be no need for any opt-out provisions.
A good vision of what the national market system should become was attributed to Professor Charles Jones of Columbia University in an article in a recent newspaper column, as follows:
"Nobody would complain about the trade-through rule if all the markets got back to one another instantly and everyone was guaranteed that so-called best price when an order was sent someplace else," Jones said.[17]
It is long past the time the Commission should have enabled a market structure which met Professor Jones’ wish. We are nearly halfway through 2004, and the Commission has had nearly three decades to get it right. Now is its best chance, and the Commission should finally get it right.
It will be more than a bit interesting to see the result of the Commission’s deliberations, and how the politics of economics plays out. The stakes for the market centers are huge; the biggest risk is to the New York Stock Exchange, since their market structure is old, cumbersome, and people-intensive.
[1] Portions of this article incorporate ideas from several previous writings by the author.
[2] The Release, No. 34-49325, is 247 pages in length, has 105,804 words and contains 377 footnotes.
[3] Ibid., Summary,
[4] Ibid., p.16
[5] “Progress Toward the Development of a National Market System,” Joint hearings before the Subcommittee on Oversight and Investigations and the Subcommittee on Consumer Protection and Finance, 96th Congress, Serial 96-89, U.S. Government Printing Office, Washington DC, p.70.
[6]Special Market Study, Release No. 32, July 17, 1963
[7] Release No. 34-49325, p.36.
[8] Investor Advisors Act of 1940, Release No. 232; Securities Exchange Act of 19344, Release No. 8426, October 16, 1968.
[10] Rule 11Ac1-1 Dissemination of Quotations (Definitions). (Securities Exchange Act of 1934 as amended.)
[11]Release No. 34-43084; File No. S7-16-00 Disclosure of Order Routing and Execution Practices
[12] See discussion of “price improvement” above.
[13] Regulation NMS, Page 19.
[14] Securities Exchange Act of 1934, § 11A (1) C iii.
[15] The “NBBO,” is the “National Best Bid and Offer, a term applying to the SEC requirement that brokers must guarantee customers the best available ask price when they buy securities and the best available bid price when they sell securities. NBBO is the bid and ask the average person will see. The NBBO is updated throughout the day to show the highest and lowest offers for a security amount at all market centers.
[16] Hans Stoll, 1997, “Affirmative Obligation of Market Makers: An Idea Whose Time Has Passed?”, Financial Markets Research Center, Owen Graduate School of Management, Vanderbilt University, Working Paper 97-14. p. 17.
[17] Newark Star Ledger April 18, 2004, “Test by SEC supports 'trade-through' critics”
