May 24, 2004

Regulation NMS; Proposed Rule

Key materials
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Stated Purpose:

The SEC is proposing four rules under NMS to enhance and modernize the national market system.

Summary of RSP Comment:

The SEC proposes four components in its Regulation NMS: (1) uniform trade-through rules that would affirm the fundamental principle of price priority, (2) establishing a de minimis standard for intermarket linkages, (3) a sub-penny quoting rule establishing the penny as the minimum quoting increment for a security, and (4) changes to the rule governing market information.

This comment focuses on the first and third elements of the SEC’s Regulation NMS. In contrast to the SEC’s stated objective, both the trade-through and sub-penny proposals may stifle technological innovation in the marketplace. The trade-through proposal will force markets to adapt to antiquated market linkages, which could increase investors’ order execution costs. The sub-penny quoting proposal has the potential to keep bid-ask spreads in certain securities artificially high, which could cost investors millions of dollars. It could also give market centers disincentives to invest in upgrades to the way quotes are publicly displayed.

Prohibiting trade throughs and enforcing market integration and linkages by regulation is rational if market linkages perform well, are well monitored, and if price is the most important attribute desired by market participants. Recent research suggests, however, that "downstairs" linkages such as ITS, have a number of problems, including that requiring markets to link directly reduces competition among market centers. A second concern is that since no market center has ownership of the system there is little incentive to invest in its improvement. By refraining from specifying the linkages, investors get to choose a trading venue based on many factors including price, certainty of execution, liquidity and speed--rather than just price alone.

Currently, no major market center permits quoting in sub-pennies in shares priced above $5.00. Although, importantly, some ECNs do permit exceptions in price quotes for the Qubes (QQQ), which mimic the Nasdaq-100 Index. In these cases, the average spread in Qubes is approximately three tenths of a penny, and the quotes are not clustered around $0.001 and $0.009, implying that investors are not "stepping ahead." It is estimated that mandating a penny increment in the Qubes case could cost investors as much as $150 million per year, as spreads remain artificially high. While the Commission’s concerns have some validity, market participants have already recognized the problems with sub-penny quoting and are moving away from the practice where it makes sense to do so.