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If it’s not broken, don’t try to fix it. Chances are, it will end up broken, and we all know it’s not the same after it’s been glued back together. With luck, whatever plans the Securities and Exchange Commission has in its pocket for the implementation of Regulation National Market System, better known as Reg NMS, market participants will not feel left in the lurch. More than that, we hope the plan will not fail so miserably or be subject to so much opposition that the SEC will have to return to the drawing board.

A proposed plan that has received as much public outcry as Reg NMS should be given serious consideration and its intentions thoroughly examined. That the SEC attempted to pass a revised version under the nose of the public is reason enough to make one ask probing questions to elucidate the deeper nature of the proposal. For all intents and purposes, Reg NMS appears benign – until you reach the trade-through phase, and then it all goes to hell in a hand basket.

The reform, composed of four proposals, seeks to put in place an access rule, a sub-penny rule, make amendments to the market data rules and establish the trade-through rule. The concern of market participants is that with the implementation of Reg NMS, market competition among the exchanges will be decreased if not eliminated, and the hidden price advantages currently available to those who use electronic trading tools will be unhinged. All told, market participants are worried about the drastic changes the proposed reform will cause to their business models.

Clearly worth examining are the potential impacts the passage of the revised trade-through rule will have on the various constituents of the marketplace. One effect expected under Reg NMS is that the volume of listed securities traded electronically will rapidly increase. Electronic trading tools currently allow traders to view the exchanges as one entity as an electronic trade order searches for the best price.

The passage of Reg NMS would eliminate this advantage, presently implemented by the electronic trading community, and would result in new order types being created in attempts to exploit the new trade order rules. “There are electronic trading tools that take the different pools of liquidity and connect them so even today we don’t have fragmented markets as long as there are electronic trading tools on the trader’s desk allowing him to glue those markets back together as one large pool,” says Jim Kwiatkowski, executive vice president at FutureTrade. “Reg NMS is actually saying that’s an obligation as opposed to a feature.”

There is something to be said for leveling the playing field, but if the proposed Reg NMS becomes a rule, brokers will be forced to invest more of their resources into technology in order to handle the increase in order volume that will accompany the upsurge in electronic trading. There also will be a rise in the number of brokers forming alliances with trading vendors to provide new and enhanced services to the buy-side community in attempts to remain competitive.

Competition is a primary concern of the SEC and market participants alike when considering the passage of Reg NMS. There are two essential levels of competition that will need to be maintained in order for the passage of the rule to ensure the markets remain effectively competitive. One level of competition being examined is that of the markets, the other is competition among orders. Reg NMS must not bring the markets too close together, as the competition that currently exists will only continue if the markets can interact with one another as separate entities. It is this interaction that allows and essentially forces the creation of new order types and promotes an innovative environment. Competition among orders must be maintained due to its importance in helping to achieve best price.

With much of the debate around Reg NMS having to do with best execution, it is important and difficult to formulate a rigid definition of best execution. It is important because it will help shape the ultimate form taken by Reg NMS. It is difficult because best execution is really a term best defined and understood between a trader and its client. A trade executed for best price available is treated differently than a trade order with a time constraint as its driver of execution. “Best price sometimes is obtained by reducing market impact,” comments Kwiatkowski. “Sometimes staying anonymous is enough to reduce market impact.” The ability to remain anonymous, however, may also be challenged by the passing of Reg NMS. 

Ultimately, “what NMS will do and how it will change the marketplace is something we’ll have to wait for and see how it will play out,” says Michael Boyd, head of institutional sales and trading at CJM Securities. If for naught else, the electronic marketplace will experience a boost in activity thanks to Reg NMS, and we may see how far we can push the limitations of our electronic trading methods yet. Hopefully the vendors will be able to keep up.