Reg NMS Enforcement Demanded

Terry Flanagan

The advent of high-frequency trading and its attendant mushrooming volume of quotes is triggering calls for the SEC to enforce regulations for ensuring that orders get routed to the venue with the best price.

In particular, Regulation NMS contains an Order Protection Rule which requires trading centers to prevent “trade-throughs,” or trade executions at prices inferior to the national best bid and offer (NBBO), which is defined as the price sent by a market center to a Security Information Processor or SIP for that exchange; for example, Consolidated Quotation System (CQS) is the SIP for stocks listed on NYSE, AMEX, and NYSE Arca.

The NBBO lies at the heart of Reg NMS,” Eric Scott Hunsader, CEO of Nanex, told Markets Media. “However, due to the recent industry trend that emphasizes speed at all costs, the NBBO, in practical terms, no longer exists.”

Nanex provides a real-time data feed comprising trade and quote data for U.S. equity, option, and futures exchanges.

Because of the need to process millions of quotes per second emanating from HFTs exchanges can’t rely on the SIP to provide the NBBO, which has led to exchanges using their own internal calculation of the best bid or offer as a substitute for the real NBBO for order routing and trade through protection.

“Each exchange computes the NBBO internally from direct connections to other exchanges,” said Hunsader. “As the speed of trading increases, the likelihood of any two exchanges having the same NBBO decreases.”

In a world where HFT systems can send and cancel a quote in one millisecond, many quotes will expire before leaving exchange networks.

“Today we frequently see qpss [quotes per second per stock] rates of 2,000, with peaks in the 5,000 to 30,000 range,” Hunsader said. “These numbers are growing at alarming rates, and within a year, if left unchecked, recipients of CQS will need to upgrade their telco to 10 gigabit.”

The SEC could address the situation by enforcing Reg NMS by clearly documenting how an investor’s order is routed through the system at each step in the process, in detail, with particular attention paid to the step when the NBBO is taken into account.

“If we are going to allow machines to trade faster and faster, then at the very minimum, there must be audit trail data that includes each exchange’s view of top-of-book quotes for every linked exchange trading that stock,” said Hunsader. “In other words, what now only exists in an exchange routing computer’s RAM, needs to be captured and made available.”

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