Rethinking Trade-Through Prohibitions: Beware of the Market Structure Octopus

Market structure is complicated and interconnected. If you change one rule you have to address multiple other rules. That's the important message coming out of last week's SEC Roundtable on the Trade Through Rule.

The U.S. Securities and Exchange Commission (SEC) recently hosted a roundtable at which SIFMA participated to discuss trade-through prohibitions applicable to trading in National Market System (NMS) stocks and listed options. In this blog, we share some of our thoughts and interpretations from the roundtable.

What Is A Trade-Through?

Rule 611 in equities, also known as the Order Protection Rule, was adopted by the SEC in 2005 under Regulation NMS. It requires trading centers - including exchanges, ATSs, and wholesalers - to establish policies to prevent trade-throughs, or executing a trade at prices inferior to protected quotes displayed on an exchange during regular trading hours. Rule 611 does not require routing to the best price, rather it only prohibits executions at worse prices than those protected quotes. Only marketable limit order quotes that are automated, displayed publicly at the National Best Bid or Offer (NBBO), immediately and automatically executable, and disseminated via consolidated market data feeds are considered protected quotes (though there are exemptions, such as Intermarket Sweep Orders or ISOs). A main objective of Rule 611 was to ensure investors receive the best available price for their equity trades.

The equivalent rule for listed options - those with equity or equity index underlying securities - is included in the Options Order Protection and Locked/Crossed Market Plan, often called the Options Linkage Plan. It prohibits trade-throughs of better-priced quotes displayed on other options exchanges.

The Market Structure Octopus

Market structure can be thought of as an octopus, with its many tentacles or arms. Its arms can move in multiple directions, all by changing shape in a variety of ways. Its arms are incredibly flexible, enabling infinite and complex - yet precise - movements. Its arms can move independently yet are interconnected. In fact, an octopus's nerves do not just run the length of a single arm but can also connect to another arm two arms away. Its arms can even continue to move after death.

Like the octopus, market structure involves many moving, interconnected pieces, and Rule 611 represents the head of this octopus. If you move or change one piece, other parts could move as well.

The Transformation of Markets Since Pre-Reg NMS

One of the original objectives for Reg NMS was to correct market inefficiencies from the ITS system. It intended to eliminate the disconnect between automated and manual - or floor-based - markets; improve price transparency; and reduce market fragmentation. In other words, Reg NMS aimed to create a national, automated, connected market system.

Twenty years later, markets are certainly automated and connected and the landscape has changed dramatically. While it is difficult to identify one piece of market structure as the sole driver of any change - or changes - over the last 20 years, it is always good to evaluate the evolution of markets. Below we portray a by-the-numbers view of the transformation of equity markets:

With significant changes in the equity market over the past two decades, order routing complexity has increased, as have costs. Brokers potentially must connect to up to 16 exchanges, as well as other trading venues offering liquidity, thereby incurring substantial connectivity, market data, and compliance costs.

Questions Before Moving Forward

As such, before making any changes, it is important to identify and analyze interconnected market structure pieces and study what corresponding changes could stem from any intentional change, as well as the cumulative net effect of changes. After all, unlike in economic studies, all else is not equal. One change will most likely lead to other changes.

When assessing changes, it is important to ask, "What is our intent? What harm - or harms - are we trying to eliminate? What benefit - or benefits - do we expect to stem from the change? And what could be the unintended consequences of the change?"

What other areas of our rules for equity market structure will need to be reviewed and potentially revised if any changes are made to Rule 611, or it is eliminated entirely? Areas and rules that were discussed at the roundtable include (not in any priority order or an exhaustive list): NBBO calculation, Rule 610 - access fees, Rule 603 - market data, Rule 612 - minimum pricing increments (tick sizes), Rule 605 - order execution disclosure, and Regulation SHO - short sale regulation. It was also discussed that, in order to stem the continuing growth in compliance costs, there should be a review of Securities Information Processor (SIP) revenue and the way it is allocated among SROs.

Specific to options, panelists stressed that options are very different from equities. For example, options are quote-driven versus order-driven in equities, there is no off-exchange trading in options, and options have around two million strikes versus around eight thousand stocks/ETPs. As such, panelists indicated that the markets should be analyzed separately and the locked/crossed market ban in options should be considered separately from Rule 611.

Additionally, any rule review should include FINRA's best execution rule, Rule 5310.¹ Best execution underpins the investor experience, and best execution is scrutinized by not just regulators but also a brokers' customers. These customers - both retail and institutional - have best execution review committees which rigorously scrutinize execution quality of brokers and direct flow accordingly. What does best execution mean without 611?

It is critical to ask these probing questions - and perform rigorous analyses - before making changes, particularly to the head of the octopus, prohibitions on trade throughs. The U.S. capital markets are the envy of the world - not only the largest but also the deepest, most liquid, and most efficient. Investors - both retail and institutional - enjoy narrow spreads, low transaction costs, fast execution speeds, high levels of pre- and post-trade transparency, and strong investor protections.

Moving forward, it remains important to continue to ask these questions and analyze what changes could mean for all investors. This is particularly true today, as the landscape for modern securities markets is under consideration in conjunction with incorporating emerging technology platforms. After all, in 2005, one of the objectives of Reg NMS was to modernize markets, and its unintended consequences are still the subject of discussion in 2025.

Author

Katie Kolchin, CFA is Managing Director, Head of Equity and Options Market Structure at SIFMA.

Footnote

1. Rule 5310 codifies the obligation for broker-dealers to use reasonable diligence to ensure that customer orders are executed at the most favorable terms reasonably available under prevailing market conditions.[↩]

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