By
Dan Mathisson; Sang Lee; Joe Gawronski;
Wall Street & Technology
January 30, 2006 Best Execution Confusion
As with most major market changes, Reg NMS undoubtedly will bring unintended results - some good, some bad - in addition to its planned benefits. For instance, it's not hard to imagine Reg NMS leading to consolidation in the brokerage industry, particularly of smaller firms, which will face the twin burdens of greater compliance costs and investments in systems to prevent trade-throughs, and higher costs passed on by vendors that must overhaul their systems to comply with Reg NMS. Even without looking into a crystal ball, we already are seeing one of Reg NMS' unintended consequences - the possibility of more-vigorous competition. Renewed interest in moribund regional exchanges (e.g., Philadelphia and Boston), as well as new entrants in the ECN game, such as BATS and Knight (through the Attain acquisition), are trends I expect to continue and even accelerate with more new entrants and interesting partnerships announced over the coming months.
That said, there is one unintended consequence that I have yet to hear voiced - confusion about best execution responsibilities under Reg NMS. On the surface, Reg NMS' National Best Bid or Offer (NBBO) trade-through protection for immediately accessible quotes, along with the mandate that market centers route out to the NBBO if they can't compete, should make things pretty simple on the best execution front. Right? However, much like the NASD's pronouncements around the time of the launch of the NYSE's first auto-ex product, Direct +, the picture isn't so clear. At the time, to discourage wide-scale internalization at the NBBO, the NASD announced that "executing small orders on an automated basis at the NBBO may not satisfy a member's duty of best execution ... [because] prices better than the NBBO may be readily accessible to the member." The same issue will exist in a post-Reg NMS world. For instance, if price or size improvement is routinely offered by a market center, whether that be an ECN's reserve and discretionary features or the Hybrid's broker interest file and specialist algorithms, choosing to route first to another market center with the same or an even better advertised quote presumably would violate a broker's best execution duties. Similarly, in a stock experiencing unusual volatility, a market center that stops offering immediately accessible quotes to balance supply and demand may in fact be the right choice for best execution even if automated quotes are available elsewhere.
The waters get muddied even further when rebates enter the picture (e.g., Nasdaq's recent announcement of a 5-cent-per-hundred-share rebate for posting listed stocks). A broker's duty of best execution can get confused, and ultimately compromised, if it factors that rebate into its routing decision. It is my belief that the SEC should address these issues of best execution (and the role rebates can play in it) before going live with Reg NMS to avoid any unnecessary confusion.
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