Addressing complexity from the trade-through rule

30 April 2015

The Securities and Exchange Commission (SEC) recently announced the first meeting of the Equity Market Structure Advisory Committee on May 13.  The first topic of discussion will be the trade-through rule outlined in Rule 611 of Reg NMS. 

What is a trade-through?  The SEC explained it in their final rule on Reg NMS:  “A trade-through occurs when one trading center executes an order at a price that is inferior to the price of a protected quotation, often representing an investor limit order, displayed by another trading center.”

The idea behind the trade-through rule was that it would “promote fairer and more vigorous competition among orders seeking to supply liquidity.”  Essentially, it was meant to help ensure investors received the best price for their orders.  Broker best-execution requirements already did most of this, but Rule 611 was intended to serve as a back-stop to these requirements on an order-by-order basis.

Instead, it has dramatically increased fragmentation and complexity in equity markets.  The trade-through rule effectively requires all market participants to do business with all trading venues that display orders. 

This has two problematic consequences: first, it acts as a subsidy to trading venues that otherwise do not add substantial value to the marketplace.  The cost of this subsidy is borne by market participants, who are essentially required to connect with, send orders to, and process market data from all trading venues.  These costs are, of course, passed on to market end-users. This has contributed to a significant growth in the number of exchanges in the market, which increases complexity.

Second, the trade-through rule requires trading venues to implement procedures to prevent trades at prices worse than the best-priced quotes displayed by other venues.  This means that venues must collect and process data from other venues and must be able to handle a variety of instructions about how to handle orders that appear to “trade through.”  The result is complex and elaborate routing mechanisms and hundreds of intricate “order types.”

Excessive complexity is detrimental to our markets: it drives up costs, obscures risk, hampers surveillance efforts, and damages investor confidence.  The complexity created by the trade-through rule has increased complexity without delivering sufficient benefits. 

What’s the solution?  FIA PTG recommends eliminating the trade-through rule.  This reform, along with the elimination of the requirement to avoid displaying locked and crossed markets (Rule 610.d) would go a long way toward simplifying market structure.

We believe that these reforms, in conjunction with modernization of best execution requirements and improved market quality reporting, would reduce transaction costs, raise investor confidence, improve transparency, and help make markets more resilient.

To learn more about how we can address complexity by eliminating the trade-through rule and the ban on locked and crossed markets, read our full paper here.

We look forward to discussing these ideas with policy makers and other market participants. 

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