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From Securities Regulation Daily, February 28, 2014

House panel conducts hearing on Regulation NMS ahead of SEC review of market structure

By Jim Hamilton, J.D., LL.M.

As SEC Commissioners call for a broad review of the structure of the financial markets, a House panel held a hearing focused on the continued efficacy of Regulation NMS. The hearing of the Capital Markets Subcommittee was conducted by the Subcommittee’s Vice Chair, Robert Hurt (R-Va). Congress is very interested in the SEC’s review of market structure, but there are concerns about the right way to do it and whether the SEC has the proper data to conduct such a review.

Vice Chair Hurt asked former SEC Commissioner Roel Campos about the best way to navigate through a review of market structure and about what data the SEC needs to conduct a review that will ultimately strengthen the equity markets. Mr. Campos said that the SEC has a great deal of data with which to conduct such a study. The study should determine whether investors are getting best execution and pricing, noted the former Commissioner, and the data is available to do such a study. Order routing data is also available. The study should also determine if liquidity is being held back and what is going on with internalization models. Enforcement mechanisms and examinations have been robust, he added, but these areas could be examined as well.

Regulation NMS. The Securities Acts Amendments of 1975 added Section 11A to the Securities Exchange Act, which mandated that the SEC facilitate the establishment of a national market system linking together the multiple individual markets that trade securities. The SEC adopted Regulation NMS, which includes four main provisions designed to strengthen and modernize the regulatory structure governing the equity markets.

The Order Protection Rule, or Trade-Through Rule, requires trading centers to establish policies and procedures reasonably designed to ensure that investors’ trades are not executed at prices inferior to protected quotations being displayed by other trading centers. The Access Rule is designed to ensure that trading facilities operated by SROs provide fair and non-discriminatory order execution to both members and non-members. The Sub-Penny Rule prohibits market participants from displaying, ranking, or accepting a bid or offer, or an order in an NMS stock, that is priced in an increment less than a penny ($0.01), unless the price of the stock is lower than $1.00, in which case the minimum allowable increment is $0.0001. The Market Data Rules provide a new formula for allocating revenues to SROs for disseminating market information, based on trades and quotations, rather than solely on trades.

Former Trading and Markets Director. Eric Sirri, former Director of the SEC Division of Trading and Markets, testified that SEC Chair White has announced plans for a review of equity market structure, has instructed the staff to develop the necessary empirical evidence to accurately assess the current market structure and instructed them to consider a range of possible changes. He believes that a thorough study, such as the one the Commission is contemplating, is an important step to complete before implementing any substantive change to market structure regulation.

But he also said that it is important to examine the need for improvements in the structure of the fixed income markets, which are larger than the equity markets. Bond investors trade using an opaque OTC network of dealers, in which retail investors may pay spreads of up to five percent as bonds move from sellers to buyers. In contrast, the same investors trade equity markets in millisecond turnaround times and stocks may trade in spreads less than one-tenth of a percent. He urged the SEC to increase its focus on the trading structure of these vital markets.

The former Director also noted that any review of equity market structure should focus on the responsibilities of brokers handling customer orders and their best execution duties. Although market structures have an ephemeral quality, the principal underlying the common law duty of best execution associated with broker-dealers who handle customer orders is a constant. Existing interpretations of the duties of best execution, however, have not have kept pace with the changes in market structure and with automated trading.

Thus, he urged the Commission, as part of its review of market structure, to revisit its guidance on best execution and consider whether another approach, such as one based on policies and procedures, would be useful in augmenting any change to market structure under consideration.

Former Chief Economist. While Regulation NMS has had some profound impacts on the structure of equity trading, testified former SEC Chief Economist Chester Spatt, there are a number of concerns around NMS. For one thing, he said, at its core NMS is highly prescriptive, which implies that aspects of its mandate can become entrenched and needlessly protect against potential market competition. To some extent, he continued, Regulation NMS imposes a degree of price fixing, treating the pricing from different platforms equivalently and regarding price outcomes as the product that various platforms provide. This limits the extent to which platforms can consider differentiating themselves, instead imposing a one size fits all structure. Meanwhile some platforms are performing SRO services, he added, while others are providing more modest compliance services. This raises the question as to whether price is all that matters from an investor’s perspective.

Also problematic is the structure of the order protection rule component of Regulation NMS. While orders at the top of the book from each platform are protected, orders below are not. At one point, Chester Spatt urged the SEC to step back and formulate the broad goals and objectives necessary for a revamping of market structures.

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