As regulators focus on the practices of
high-frequency trading (HFT) in Europe and the US, the rule
which led to the creation of the industry continues to be
Regulation National Market System (Reg NMS), that gave traders insight into other
investors’ trading strategies, was originally
intended to correct problems raised in the 1987 crash when brokers refused to answer phones
to avoid placing orders to sell.
When the rule was passed in 2005 in a three to two vote, the
dissenting Securities and Exchange Commission (SEC)
commissioners expressed concerns that it could create
anti-competitive behaviour. They drew particular attention to
the trade-through aspect of the law, which requires orders to
be executed at the best price regardless of what exchange the
securities are listed on.
Trade-through has been accused of allowing HFT to
front run, by giving high-speed traders a chance to see larger
investors’ orders on one market and then race
ahead to other exchange to purchase shares of the same stock
and sell them back to that investor at a high price.
Opposition to the rule lingers today.
"It’s not fundamentally necessary to have a rule
that people trade on any exchange," said Steven Lofchie,
partner at Cadwalader Wickersham and Taft.
"One alternative possibility is simply requiring
broker-dealers be responsible to provide best execution and
letting broker-dealers decide the mechanisms around how they do
Concerns that Regulation NMS would
encourage anti-competitive behaviour were raised in the dissent
when the rule was passed in 2005;
The regulation has increased high
frequency traders’ ability to arbitrage using
fragmentations in the market created by the increased number of
Reg NMS effectively opened the US exchanges to
greater competition, spawning the creation of new trading
Many in the industry defend the rule, arguing that
it achieved its intention: to create competition between the
exchanges. "We had a Duopoly between NYSE and NSDAQ. Reg NMS
was a conscious decision by the regulators to break that
duopoly," said John Adam, global head of product development at
Portware, a trading technology provider.
This fragmented market made latency arbitrage
possible, giving traders the ability to profit from a
difference in price between exchanges for only milliseconds. It
has become a standard tool for high-frequency traders.
"Reg NMS did
exactly what it was intended to do, create competition
between the exchanges"
While computerised trading was already an element
of the market when the rule was created, trading speeds were
not as fast or a much of a concern.
HFT has become the focus of public scrutiny following release of the book "Flash Boys" by Michael Lewis. Regulators have
been looking into issues created by Reg NMS and HFT, but are
now facing greater outside pressure to act.
"My concern is if this becomes a political problem
that Congress attempts to solve, it’s hard to see
how it will be beneficial for the market," said Keith Ross, CEO
at PDQ Enterprises, LLC, an equities market venue.
So far the current SEC commissioners, none of who
voted on Reg NMS, have taken a less reactionary approach, but
it is yet unclear if any new regulation will consider the
information that was overlooked in 2005.