New Electronic Trading Rules Are in Effect
Donna Block
The Deal
March 7, 2007
As stock exchanges and electronic trading platforms prepared for another potentially bumpy day of trading, they were also contending with a new regime of trading regulations, known as Regulation NMS.
The trading phase of Reg NMS is aimed at increasing the efficiency and transparency of the stock trading venues and went into effect live on Monday.
The rules require exchanges and electronic networks to implement procedures designed to prevent so-called trade-throughs -- where a trade is executed at a price lower than a protected quote displayed by another market.
Trades must now be routed to the exchange that offers the best price for the investor making the trade. Smaller regional players and electronic communication networks are expected to benefit from getting an equal crack at the business.
Reg NMS, short for National Market System, has four components. The others include a ban on price quotes containing figures below 1 cent for all but penny stocks; new rules on market center access fees; and a revised formula for parsing out revenues generated by market data fees to self-regulatory organizations, or SROs, that produce the data for investors. The new formula would allocate revenues to markets based on the value of their quotes and trades.
The market has been preparing for the rules, which have been delayed once to allow participants more time to adjust, for over two years.
Reg NMS will no doubt shake up the trading environment, and most stock exchanges and trading platforms in the U.S. have had to build new electronic trading systems or revamp their existing ones to meet Monday's deadline.
The new trading regime is bound to test the technological capabilities of the stock markets. This became evident when a surge in electronic trading volumes led to server failures at both the New York Stock Exchange and Dow Jones, which calculates the trading averages. As share prices plummeted last Tuesday, Dow Jones noticed in midafternoon that its system had fallen behind. It was forced to switch to a backup server, sending the Dow Jones Industrial Average down 200 points in an instant as it caught up with trading. The precipitous instantaneous decline caused widespread confusion.
But the Securities and Exchange Commission says it will closely monitor the operation of the equity markets to assess whether any systems or other trading problems develop following the introduction of Reg NMS and says "exceptions may be granted if trouble erupts." This may include a marketwide suspension of the rules should serious disruptions or system malfunctions occur.
And, there are concerns that the rapid development of electronic trading in the run-up to the new requirement means the systems might not have been sufficiently tested and that the spike in volumes that is widely predicted after a selloff in overseas markets overnight could expose cracks in the system.
In a statement, Erik Sirri, director of the SEC's division of market regulation, acknowledged that the rollout of new trading systems "inevitably presents challenges for the market and its participants."
Sirri also stated that the "exceptional trading volume and price volatility of the equity markets over the last few days raise the potential of even greater challenges." Meanwhile, NYSE Group Inc., parent of the NYSE, asked the SEC Friday for a partial delay, until April 5, in adopting one part of Reg NMS. This is the second time the NYSE has requested a delay, and the SEC has yet to respond to its request publicly.
The NYSE said that while it was ready for the official adoption of the rules and is ready to operate under the Reg NMS environment, it needed more time to link with platforms operated by the International Securities Exchange Inc. and the alternative trading platforms regulated by the NASD.
To comply with Reg NMS, and become more competitive, the NYSE has created a hybrid trading system, which uses electronic trading as well as human interaction that operates alongside its online exchange, NYSE Arca, to complete transactions.
The Nasdaq Stock Market Inc., which has been using electronic trading since it began trading in the 1970s, has been leeching market share away from the NYSE because of its ability to route trades quicker.
The new regulation gives smaller players more of an opportunity. Systems expected to benefit include the Boston Equities Exchange, an electronic market launched last year through a venture of large brokers, and the Boston Stock Exchange and BATS Trading, an electronic system, that offers fast trades at prices that have been consistently undercutting those of its competitors.
Regional exchanges also stand to benefit. Previously, markets like the Philadelphia Stock Exchange did not have enough trading volume to make sure there was a buyer for every seller. An increase in volume will help reverse this.
Nevertheless, NYSE and Nasdaq are expected to remain the biggest competitors in the business. While the Nasdaq may have the faster technology, NYSE has the larger liquidity pool and the larger footprint as it expands into Europe and Asia.
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