Order Protection Rule Tug-of-War

There is still uncertainty around the fate of the Order Protection Rule, a key rule governing U.S. stock trading that has led to more complexity, speed and order types, but also protects retail investors from receiving inferior prices on their orders.

Also known as the trade-through rule, Rule 611 has been and still is a central tenet of Regulation National Market Structure (Reg NMS), which requires brokers to route orders to the venue displaying the best price.  It ensures that investors receive an execution price that is equivalent to what is being quoted on other exchanges.

On April 5, the Securities and Exchange Commission’s Equity Market Structure Advisory Committee (EMSAC) held an open meeting to hear findings from its subcommittee on Regulation NMS.

Rather than recommend a clear direction on whether to keep or remove the trade-through rule, representatives of buy- and sell-side firms indicated they had “struggled to come to produce conclusive evidence that would drive a clear or compelling future direction.”

“We are not at the stage of making any recommendations,” said Kevin Cronin, head of global trading at Invesco, who noted there were strong arguments on both sides of the issue.

“As it pertains to 611, I think it’s less clear that people conclude something needs to be done. Even for the crowd that believes something needs to be done, it’s much less clear ‘what’ is the something that needs to be done,” added Cronin.

Instead, the subcommittee provided a framework for conducting a potential pilot on the order protection rule, should the SEC prioritize the initiative, which would help the agency gather data for a quantitative assessment of the impact and effectiveness of Reg NMS.

“The no. 1 issue we struggled with was it’s difficult to resolve the 611 question in a data driven capacity,” said Joseph Mecane, Managing Director in the Electronic Equities and Credit Product Business at Barclay’s. “It wasn’t necessarily clear whether 611 had a meaningful impact on displayed limit orders or whether the burdens of compliance with 611 would outweigh those benefits,” said Mecane at the meeting.

One of the key arguments for keeping the trade-through rule is that it has served as a “back-stop” protection for displayed limit orders particularly from retail investors.  A second argument is fear of a new compliance burden that would fall on brokers if the rule were scrapped. If 611 were eliminated, firms would need to prove that limit orders posted on a trading venue were not getting traded through, noted Mecane.

Retail brokerages have come to rely on rule 611 to ensure they are providing individual investors with the best price available across all exchanges and off-exchange trading venues.

“Arguably the purpose of 611 was to ensure that investors don’t get inferior prices in a complex, fragmented market. Essentially it’s a principles-based rule that sets forth a floor that investors get best execution,” stated SEC Commissioner Kara Stein during opening remarks. However, the rule has led to market complexity, shrinking order sizes, and internalization of retail orders, noted Stein.

Critics of Reg NMS’ trade-through and locked and crossed market rules point to growth in market complexity, fragmentation and the proliferation in order types to remain in compliance with the rules, noted the EMSAC memorandum.

Whether the SEC decides to abolish the OPR or keep it, there are a series of trade-offs and unintended consequences of taking either action. One issue to consider is that if the OPR were removed, could this hurt or help investor confidence, noted Jim Toes, president of the Security Traders Association on an open call after the SEC meeting.

The challenge of dealing with the OPR is that it must be looked at with a host other interrelated aspects of the market structure, such as interconnectivity to every venue and high-speed market data feeds that are costing firms significant sums.

Known and Unknown Trade-Offs

Unlike the pilot that it recommended for access fees, the EMSAC suggested that a pilot for OPR would need to be market-wide and apply to all NMS stocks. This is in contrast to other pilots such as the proposed access-fee pilot, which recommends security-specific pilot groups and a control group.

“If you do a pilot on OPR, you are taking away a protection that is afforded to investors today,” said Toes. At the end of the day, the pilot will take something away from the retail investor, he noted.

Conducting a pilot that removes OPR could open up a Pandora’s box of issues. “Do the retail orders get traded through?” asked Shane Swanson, director of Citadel Securities who spoke on the STA call.  “That question is really difficult to answer,” said Swanson.

“The debate then goes to, do you remove enough operational risk to balance out what arguably would be the harm to the retail investor,” said Swanson.  “Or, the burden [of best execution] then shifts to the [brokerage] firms that are handling their order flow when they get traded through,” said Swanson.

Removing the trade-through rule raises other issues about operational risk. “If you take out something like OPR, can you then reduce the operational overhead, and that operational overhead is risk in the system. There’s no question about that,” said Swanson.

Citing steps taken by the industry to improve market structure and market infrastructure, Swanson pointed to market-access controls and limit up/limit down as measures that have eliminated risk in the system. But, each time you do that, there is a cost to the industry, he warned. “We need to know if we remove OPR, how much risk are we taking out,” said Swanson. If exchanges are no longer required to connect with everyone, is there is less risk of a system error?  On the other hand, less connectivity could be against the commercial interests of exchanges and brokers. “Clearly, brokers are still going to connect everywhere because they need to provide the best solution to the client,” said Swanson.

Even if there is no OPR, brokers are still bound by best execution, so they will still need to be connected to venues and ATSs.  Are exchanges not going to connect to each other? That is unlikely since brokers want the exchanges to check everybody else from the time they are sent an order.

Simplicity?

Getting rid of OPR doesn’t necessarily mean that all complexity will go away. Exchanges will still maintain their connectivity to each other and some of their order types.  While a fair number of the order types, such as the infamous hide-not- slide will disappear, that will depend on the adjustments made to OPR. “It’s not a magic bullet,” said Swanson. Some of the complexity might go away, but not all of it, he predicted.

If the trade-through protection is taken away from retail investors, then the brokerage industry can expect some type of best execution requirement to replace it. The concern is what will the SEC require brokers to do to determine best execution.

“Every thread pulled on OPR could lead to an enhanced best execution obligation, which is one of the concerns that retail brokers face,” said Swanson.  “Who bares that burden?” he asks.

Enhanced Best Execution?

Historically, the term ‘best execution’ has been loosely defined and open to interpretation. “It’s been a set of best practices,” said Swanson. There are other variables to consider, but the trade-through rule tells brokers to care about best price. If the OPR goes away, “what is going to be the metric” asks Swanson. “Or is it going to be many metrics,” asked Swanson. “ Or will it be in the eye of the beholder in a MiFID II world, when as long as you said what you would do, you’ve met your best ex obligation.”

Under MiFID II, European regulators have instructed firms to consider a number of factors in their assessment of best executing, including price, cost, speed, likelihood of execution, and likelihood of settlement. Firms must have an investment policy and consistently follow it.

But there is concern about the amount of effort it will take the brokers to monitor order routing activity with a less clear-cut best execution rule. Many buy-side participants advocate it will be difficult to monitor order routing behavior without the removal of the conflict of rebates.

“I doubt that the US market goes that way, but I guess it’s a possibility,” said Swanson. It remains to be seen whether the US wants to follow the direction of EU regulators.

In the end, it will be up to the SEC to conduct a pilot on the Order Protection Rule so as to gather data before making any market structure decision.  EMSAC has recommended that a Rule 611 pilot should be sequenced after the current tick pilot and a potential access fee pilot and not run concurrently.  This will give the SEC more time to review all three pilots, perhaps leading to that holistic review of Reg NMS.