Next week, the Securities and Exchange Commission plans to consider changing its proposed rule that would govern how stocks trade. The changes would give investors marketwide price protection for quotes, among other benefits. But whether corporate issuers will gain or lose from an overhaul has become a matter of debate.
Basic details of the revised rule, known as Regulation NMS (National Market Structure), have already been leaked to the press and widely debated. For starters, it would expand to the Nasdaq Stock Market the so-called “trade-through rule,” which limits orders from being traded at anything but the best displayed price quote. The floor-based specialist trading systems of the American Stock Exchange and the New York Stock Exchange (NYSE) already adhere to the trade-through rule.
The most progressive element of the SEC’s revision is that it would apply to the “full depth of book,” as well as the top or best price. That new provision would require every market to display all available orders so that participants can choose to execute trades faster, minimizing the price-movement risk associated with having to rely solely on a floor-based trade. The revision would also allow orders to “sweep” the markets, which is done when investors value timely execution over price.
The SEC is set to consider the changes on December 15, followed by a public comment period before a final ruling early next year. Michael Panzner, head of sales trading at Rabo Securities USA, believes that securities regulatory reform of the markets generally work in the issuer’s favor. “Anything that makes the marketplace more efficient will tend to be to the benefit of issuers,” he says. “Efficient markets tend to reduce costs.”
But don’t expect such market efficiency anytime soon. Panzner notes that while the rules’ sweeping of the market sounds great in theory, an electronic linking of various markets is contingent on the participants agreeing and getting the technology in place first. “Both, in my view, will take an extraordinary amount of time,” he says.
Panzner compares the challenge to the number-portability rule associated with cell phones, which he says gave competing phone companies no incentive to work together to allow consumers to switch carriers without changing their mobile phone numbers. For Regulation NMS, the competitive divide, he says, “becomes a hidden stumbling block to the efficiency being discussed.”
Rick Roberts, a former SEC commissioner, believes that such a “sea change” in market structure — while positive over the long run — also bears significant risk. “From an issuer standpoint, liquidity should be unchanged — probably enhanced — by the electronic model. But volatility will be increased,” says Roberts, now a partner at law firm Thelen Reid & Priest. CFOs are typically wary of higher volatility because it translates to higher cost of capital.
Roberts explains that increased volatility can be a natural byproduct of faster price execution that results from increased electronic trading. Liquidity, however, might improve if, under the new structure, the markets are able to handle more buyers and sellers at any one time.
Panzner, for his part, downplays the effect of faster price execution on volatility. “There are moments where electronic markets can be more volatile,” he says. “But in aggregate, I think they are less volatile.” He notes that lower volatility tends to lead to more aggressive pricing by investors, helping issuers. The more information that is available to investors, the more comfortable they become. In turn, the market becomes more liquid, and trading less volatile, he explains.
Regulators, however, face an uphill battle to get competing markets to work in concert. Roberts notes that the proposal requires an order to be displayed on a securities information processor (SIP), a type of electronic posting system. “The rub is that there are two: one controlled by the NYSE and the other by the Nasdaq,” he says.
“Will the SIPs operate in a manner that advances the interests of just the NYSE or Nasdaq?” Roberts asks. Or will the exchanges “jack their costs up to the extent that they are basically holding other market participants hostage?”
The proposal would worsen the concerns about the posting system, adds Roberts. The SEC “will need to ride herd over these SIPs very carefully,” he says.
Over the last year, the NYSE and Nasdaq have tried to head off Regulation NMS with their own market-reform proposals and initiatives. But observers note that the SEC’s proposed changes indicate that the commission feels neither the NYSE’s proposed hybrid specialist-electronic market structure, nor a recent Nasdaq initiative, go far enough. (The Nasdaq’s “open-cross” system aims to acheve the best price at the start of trading on the Nasdaq).
If the SEC adopts its proposal in its current form, Roberts says, the NYSE will heavily campaign against the depth-of-book aspect because it would require NYSE specialists to change their business model. Says Roberts, “They would focus more on illiquid securities where there aren’t a lot of buyers and sellers and focus on areas where an immense amount of capital is required.”
Steve Braverman, managing director at Tahoe Advisors, a consulting firm, believes that the NYSE will have a tricky balancing act as it makes a transition to a more hybrid electronic and floor-trading specialist execution model as prescribed by the SEC.
By his lights, if more orders begin to flow through NYSE’s electronic system — and specialists are restricted in how much they can trade for their own accounts — there’s a greater chance specialists could become disengaged.
That could be risky for issuers and investors in the near term. Braverman explains that if the specialists’ earnings decrease as a result of market structural changes, they may lose the incentive to invest capital as often, thereby leaving the market forces of supply and demand more open to drive stock prices. “That will lead to more volatility,” he says, and potentially cause major investors to balk at taking positions for fear of moving the market too much without specialist support in times of market stress.
“A major battle looms ahead on this proposal,” says William Uchimoto, partner with law firm Saul Ewing LLP and a former attorney with the SEC division of market regulation. “I think the toughest hurdle for the SEC is to figure out all the changes or unintended consequences that will occur if, by government fiat, all orders from all markets must be publicly displayed with a rule that brokers must go after the best price orders regardless of where they reside.”
Roberts, who was a SEC commissioner from 1990 to 1995, admits that there are no simple solutions or shortcuts when it comes to Reg NMS. “If these issues were easy, the commission would have solved them years ago,” he says.