The following is an excerpt from Chapter 4 of our book “Broken Markets” (FT Press, 2012):

In February 2004, the SEC published for comment its most devastating regulation yet – Regulation NMS. Reg NMS was billed as a way to modernize and strengthen the existing national market system (NMS). Due to changes in technology and regulations over the previous decade, the SEC thought it was time for sweeping reform.

After proposing the 500-page Reg NMS, the SEC was inundated with comments from the industry. The SEC received 1,691 letters. Many saw the rule as damaging to their business and were trying to protect themselves, but many saw it as a golden opportunity and they were staking out their position.

The original Reg NMS proposal in February 2004 had four parts:[1]

-Trade Through Proposal:  Market centers would be required to prevent trade-throughs, which are the execution of an order in its market at a price that is inferior to a price displayed in another market.

-Market Access Proposal: The goal here was to modernize the terms of access to quotations and execution of orders in the NMS. The SEC wanted market centers to provide non-discriminatory access to their quotes.

-Sub-Penny Proposal: Market participants would be prevented from accepting, ranking, or displaying orders, quotes, or indications of interest in a pricing increment finer than a penny, except for securities with a share price of below $1.00.

-Market Data Proposal: Market data revenue rules would be modified to reward market centers for trades and quotes.  The formula for the splitting of the estimated $500 million/year market data pot would now be based on 50% trades and 50% quotes at the national best bid and offer.

The most disruptive piece of Reg NMS was the Trade Through proposal.  The rule was intended to make sure that smaller orders that were priced better did not get bypassed when a block trade occurred.  This rule was already in place for NYSE listed stocks, but Reg NMS would extend it to all market centers, including NASDAQ.  In its original version, the Trade Through proposal had an exception which would have allowed a “fast” automated market to trade through a “slow” non-automated market like the NYSE up to a certain level.  The NYSE wouldn’t have to convert to a “fast” market since the trade through exception allowed investors to trade through “slow” markets.  The power of “being downstairs” and “in the crowd” was left intact.  The power of Dick Grasso was evident in the writing of this exception.  But now that Dick Grasso had left the NYSE, the trade through exception faced an assault from automated traders that wanted full access to an all-electronic book.  These high frequency traders were dominating NASDAQ and now they wanted access to NYSE.  But if a non-automated, slow market center were still allowed to quote, then the HFTs would not be able to play their arbitrage games.  They needed full access to a book of orders that all had to respond instantly.

On April 21, 2004, the SEC held a public hearing on Reg NMS.  The attack on the trade through exception was about to begin. The automated trading community wanted this exception removed.  The witness list read like a who’s who of Wall Street and included exchange executives, brokerage executives, specialists and academics. Without Grasso to organize a coordinated defense, the NYSE auction market was under assault.  Tower Research, an automated trading firm, complained about the trade through proposal by saying it “creates an unfair advantage for slower market centers.” [2]  Madoff Securities, a “third” market maker demanded full automation of quotes.  Bernie Madoff stated at the hearing that the SEC should “require all ‘quoting’ market centers to employ an automated order execution facility for inter-market orders.”[3] Professor Daniel Weaver of Rutgers demanded that “price priority should be established in all markets.”[4]

In December 2004, the SEC relented to the pressure from the high frequency trading community and submitted a new Reg NMS proposal that significantly altered the Trade Through proposal, which was renamed the Order Protection Rule.  The Order Protection Rule would now protect only quotations that were on top of the book and electronically accessible.  If the NYSE wanted to be part of the NBBO, then it would have to change from a “slow” market to a “fast” market.  Reg NMS was approved in June 2005.  The Order Protection Rule, also known as Rule 611, basically was the death of the “slow” market.

Even though Reg NMS was approved, it was far from a unanimous approval.  It passed by a vote of 3 to 2 with commissioners Paul Atkins and Cynthia Glassman dissenting.  Atkins and Glassman claimed that the SEC cherry picked statistics to substantiate their proposals.  They claimed the trade through rate in the market was much less than what the SEC had said it was and therefore was not a problem.   In their dissent, Atkins and Glassman wrote[5]:

“…Regulation NMS is at odds with Congress’ goal, expressed in the Securities Acts Amendments of 1975 (“1975 Act Amendments”), of protecting competition within the national market system. We believe that Regulation NMS turns back Commission policy regarding competition and innovation and sets up roadblocks for our markets.  The majority’s statutory interpretations and policy changes are arbitrary, unreasonable and anticompetitive…Regulation NMS saddles the marketplace with anachronistic regulation that reduces investor choice and raises investor costs.  Far from enhancing competition, we believe that Regulation NMS will have anticompetitive effects.”

In July 2007, Reg NMS was fully implemented.  The war was over.  From 1997 to 2007, the SEC had fully changed how the equity market functioned.  Volumes in listed stocks exploded as competing market centers began fragmenting liquidity.  Since the NYSE was becoming obsolete, so was the block trade.  Average trade sizes plummeted, as orders began to get chopped up, as institutional traders sought to cloak their larger orders from fast HFT traders.  Spreads did shrink, but so did the amount of displayed liquidity in the best bid and offer.

The new equity market had arrived and it was about to wreak havoc on every investor.