On Tuesday, September 29, 2015, the Securities and Exchange Commission (“SEC”) announced that the SEC Equity Market Structure Advisory Committee (“Committee”) will hold its second meeting on Tuesday, October 27, 2015, beginning at 9:30am (EDT). The meeting is open to the public, will be held at the SEC’s headquarters at 100 F Street, N.E., Washington, D.C., and will be webcast live on the SEC’s website.  According to the SEC’s press release, the meeting will focus on Rule 610 of SEC Regulation NMS and the regulatory structure of trading venues. In particular, the Committee will address three key market structure related topics: (i) the impact of the access fees and rebates that are widely used by exchanges and other trading venues, (ii) the current regulatory model for exchanges and other trading venues, including the different regulatory frameworks applicable to exchanges and other trading venues, and (iii) recent market volatility and any market structure issues it may have revealed.

The SEC announced the establishment of the Committee on January 13, 2015, to provide a formal mechanism for the SEC to receive advice and recommendations on equity market structure issues.  The Committee held its first meeting on Wednesday, May 13, 2015, to discuss Rule 611 of SEC Regulation NMS, also known as “Order Protection Rule” or “Trade-through Rule.”

On April 30, 2015, in anticipation of the Committee’s first meeting, the SEC Division of Trading and Markets prepared and made publicly available a Memorandum on Rule 611 of Regulation NMS (“Rule 611 Memorandum”).  In Rule 611 Memorandum, the SEC Division of Trading and Markets discusses the role of Rule 611 in the context of the U.S. regulatory framework for equity market structure, then summarizes Rule 611 requirements and exceptions, and further analyzes the SEC’s objectives for Rule 611 when adopted. Next, the SEC Division of Trading and Markets examines empirical data, broken out between NASDAQ and NYSE stocks, highlighting three major changes that have occurred in the equity market structure since the adoption of Rule 611, as follows:

1) Trading venue market share and market fragmentation, both visible and dark (Tables 1-4)

  • NASDAQ stocks
    • Market Share
      • February 2005 = Inet ECN was the largest lit trading venue (25.3% market share).
      • February 2014 = NASDAQ was the largest lit trading venue (26.2% market share).
    • Market Fragmentation:
      • Visible Fragmentation (as measured by the HH index for lit venues) = marginal increase from 0.72 in February 2005 to 0.76 in February 2014. (+0.04)
      • Dark Fragmentation (% volume executed in NASDAQ stocks by dark ATSs and broker-dealers) = significant increase from 29.4% in February 2005 to 38.6% in February 2014. (+9.2%)
  • NYSE stocks
    • Market Share:
      • February 2005 = NYSE was the largest lit trading venue (78.9% market share).
      • February 2014 = NYSE was the largest lit trading venue (20.1% market share).
    • Market Fragmentation:
      • Visible Fragmentation (as measured by the HH index for lit venues) = substantial increase from 0.18 in February 2005 to 0.82 in February 2014. (+0.64)
      • Dark Fragmentation (% volume executed in NYSE stocks by dark ATSs and broker-dealers) = significant increase from 13.0% in February 2005 to 34.6% in February 2014. (+21.6%)

These figures highlight a remarkable change in the market share and visible fragmentation metrics for NYSE stocks from 2005 to 2014. Data also shows a significant increase in dark fragmentation for both NASDAQ stocks and NYSE stocks from 2005 to 2014, with a resulting level of dark fragmentation similar for both NASDAQ and NYSE stocks. As noted by the SEC Division of Trading and Markets, the substantial increase in trading by dark venues may suggest that Rule 611 has not achieved the objective of rewarding the display of limit orders by increasing their likelihood of execution.

2) Trading volume and average trade size (Tables 5-6):

  • NASDAQ stocks
    • Average Daily Share Volume (+7%):
      • February 2005 = 1.97 billion shares.
      • February 2014 = 2.11 billion shares.
    • Average Trade Size (-53%):
      • February 2005: 434 shares.
      • February 2014: 204 shares.
  • NYSE stocks
    • Average Daily Share Volume (+87%):
      • February 2005 = 1.96 billion shares.
      • February 2014 = 3.67 billion shares.
    • Average Trade Size (-75%):
      • February 2005: 777 shares.
      • February 2014: 195 shares.

The foregoing data shows a significant increase in trading volume for NYSE stocks compared to a marginal growth in the average daily share volume for NASDAQ stocks during the period from 2005 to 2014.  In contrast to trading volume, average trade size fell substantially for both NASDAQ and NYSE stocks from 2005 to 2014. As noted by the SEC Division of Trading and Markets, the average trade sizes for both NYSE and NASDAQ stocks had been steadily declining for several year prior to Rule 611’s adoption in 2005. Given the clear trend of smaller trade sizes prior to 2005, it is likely that algorithms and factors other than Rule 611 have contributed to the continuing decline in average trade size after 2005.

3)  Trade-Through Rates (Tables 7-8)(*):

  • NASDAQ stocks
    • Trade-Through Rates – Trades:
      • 2003 = 2.3%.
      • February 2014 = 0.11%.
    • Trade-Through Rates – Shares:
      • 2003: 7.7%.
      • February 2014: 0.16%.
  • NYSE stocks
    • Trade-Through Rates – Trades:
      • 2003 = 2.5%.
      • February 2014 = 0.13%.
    • Trade-Through Rates – Shares:
      • 2003: 7.2%.
      • February 2014: 0.18%.

(*)Note: trade-through rates for 2003 are calculated with a three-second quotation window; trade-through rates for February 2014 are calculated with a one-second quotation window consistent with the exception in Rule 611(b)(8).

The above data shows a remarkable decline (more than 95%) in trade-through rates for both NASDAQ stocks and NYSE stocks. As indicated by the SEC Division of Trading and Markets, Rule 611 appears to have helped reduce trade-through rates, although additional factors may also have contributed to the lower trade-through rates.

Based on the foregoing, the SEC Division of Trading and Markets concludes its analysis by discussing four major critiques of Rule 611:

CRITIQUE 1: Rule 611 has contributed to excessive fragmentation among trading venues, thereby increasing market complexity and connectivity costs of market participants.

When addressing this critique, the SEC Division of Trading and Markets notes that:

Visible Fragmentation

  • There is a direct link between trade-through restrictions and potentially greater visible fragmentation among lit venues. First, trade-through restrictions can require market participants to route orders to certain trading venues that they otherwise might not choose to do business with. Thus, if Rule 611 enables more lit venues to stay in business that would otherwise be the case, then visible fragmentation will increase. In addition, Rule 611 may have helped new exchanges enter the market by lowering barriers to entry (e.g., by giving all exchanges, irrespective of their size, an opportunity to display a protected quotation). Lower barriers to entry may have promoted competition among lit trading venues thus further increasing visible fragmentation.
  • Consequences of increased visible fragmentation include higher connectivity costs, and greater complexity of monitoring quotes and routing orders.

Dark Fragmentation

  • There is no direct link between trade-through restrictions and greater dark fragmentation. In particular, Rule 611 does not require orders to be routed to dark venues in any context.
  • There might be an indirect causal connection between trade-through restrictions and greater dark fragmentation. For instance, Rule 611 may have created an indirect incentive for market participants to trade in dark venues by causing them to avoid lit venues.

CRITIQUE 2: Rule 611 indirectly led to more dark trading by constraining the nature of competition on lit venues to factors such as speed, fees, and exotic order types, in contrast to factors that are more appealing to investors, such as liquidity and stability.

In response to this critique, the SEC Division of Trading and Markets notes that:

Displaying Protected Quotations

  • Rule 611 does not require exchanges or other lit venues to display protected quotations. If a venue decides to display protected quotations, then Rule 611 imposes specific requirements to assure that protected quotations are automatically and immediately accessible by anyone who wishes to access the liquidity.
  • In practice, all exchanges have chosen to operate as automated trading centers that continuously display protected quotations. This may suggest two things: first, exchanges consider the ability to display protected quotations as a valuable means that helps them attract order flow; second, exchanges believe that the viability of alternative trading models is compromised by Rule 611’s restriction on trading through the protected quotations of other exchanges.

Speed & Orders

  • Rule 611 does not require automated trading centers to adopt price-time priority.
  • In practice, nearly every equity exchange has adopted price-time as a primary priority rule (exception: NASDAQ OMX PSX). This seems to suggest that competitive forces reward exchanges that offer speed advantages, even in a context without any regulatory mandate for speed.

Speed & Identification of Protected Quotations

  • Rule 611 provides a “one-second window” exception that allows trading centers to disregard newly displayed protected quotations at another trading center.
  • In practice, no exchange has adopted a rule that would allow it to utilize this exception. This may suggest that various competitive forces adverse to the use of the “one-second window” exception have influenced the exchanges, including concerns about “latency arbitrage.”

High-Speed Trading

  • Proprietary firms increasingly trade in a variety of financial products across multiple venues, most of which are not subject to Rule 611 (e.g., E-Mini markets, Virtu Financial, Inc.).
  • Rule 611 does not appear to be essential elements for the prevalence of high-speed proprietary trading strategies, rather other factors, including competitive and technologies forces, may play a more relevant role.

CRITIQUE 3: Rule 611 has harmed institutional investors that need to trade in large size by forcing them to access small-sized quotations and thereby signal their trading intentions to short-term proprietary traders.

The SEC Division of Trading and Markets notes that this critique is fundamentally based on a misunderstanding of Rule 611. In particular, Rule 611 provides a number of alternatives for institutional investors that help them prevent the risk of signaling their trading intentions by executing first against small-sized quotations (e.g., the ISO exception). In addition, institutional investors can use brokers with the technological sophistication to access displayed liquidity across multiple exchanges simultaneously.

CRITIQUE 4: Rule 611 has not succeeded in achieving the SEC’s stated objective of enhancing the reward for the display of limit orders.

In response to this critique, the SEC Division of Trading and Markets notes that:

  • The great majority of dark volume is executed at prices that are not substantially better than those offered by displayed limit orders.
  • The declining percentage of total trading volume that interacts with displayed limit orders may suggest that Rule 611 has not achieved the objective of enhancing rewards for the display of limit orders. However, data also shows that quoted spreads have narrowed and the level of displayed liquidity at lit venues has increased significantly in the years following the adoption of since Rule 611, thus suggesting that the incentives to display limit orders, at least for some types of market participants, remain strong.