Regulation NMS

In 2005, the SEC got the National Market Systems (NMS) regulations, designed to modernize the US equity markets. There are a number of key rules that are part of it.

Disclosure of order execution information (SEC Rule 605)

Requires market centers to publish monthly reports detailing order execution quality for NMS stocks. Execution quality includes things like price improvements (do orders get executed at better than displayed prices?), execution speed, and order sizes (how different-sized orders are handled). These reports are only required on NMS covered securities, that being any NMS security, along with any security for which translation reports, quote information, or last sale information is disseminated through an automated quotation system.

Market centers: would be national exchanges, broker-dealers, OTC market maker, and similar.

Disclosure of order routing information (SEC Rule 606)

There are 2 primary reports this rule is concerned about.

• Rule 606(a) is a quarterly report broker-dealers are required to publish, detailing their order routing for non-directed equity and option orders, describing top execution venues and the relationship. These quarterly reports are broken down by calendar month and must be posted on a free website, accessible for at least 3 years following posting. The report must break apart options from NMS stocks, and then further separate NMS stocks into those that are included in the S&P 500 and those that aren’t. Each of these sections must report the percentage of total orders for the section that were non-directed orders, the percentage of total non-directed orders for the section that were market orders, marketable limit orders, non-marketable limit orders, and other orders.
• Rule 606(b) is a customer-specific disclosure that can be requested by customers and contains detailed information on where their specific non-directed or directed orders were routed in the past 6 months.

Customers can direct orders themselves, where the customer states the location at which the order will be executed. Non-directed orders are where the broker-dealer can choose. There can be some conflicts, which is the purpose of this rule, as the broker-dealer may be directing to a place that compensates them somehow. All that needs to be disclosed, as certain soft-dollar (non-direct cash compensation), is perfectly allowed. Things like providing research reports, access to software, but not physical computers.

Customer account statements (SEC Rule 607)

Broker-dealers acting as agents for a customer cannot effect transactions or do business with that customer unless they disclose certain potential conflicts of interest to the customer first.

• The broker-dealer’s policies on payment for order flow. Payment for order flow is defined as any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration to a broker or dealer from a broker-dealer, exchange, or association.
• The broker-dealer’s policies for determining where to route customer orders that are subject to payment for order flow, without specific instructions from the customers. They must include a description of the extent to which orders can be executed at prices better than the national best bid and offer prices.

Access to quotations (SEC Rule 610)

This is sometimes simply called “the access rule”.

An exchange or association shall not impose unfair discriminatory terms that prevent/inhibit any person from obtaining efficient access through a member of the exchange or association to the quotes of an NMS stock displayed through its SRO trading facility (for us, FINRA, and the TRFs).

Any trading center displaying quotes of an NMS stock through an SRO display-only facility must provide a level and cost of access to the quotes that is substantially equivalent to the level and cost of access to quotes displayed by SRO trading facilities in that stock. Additionally, any trading center that displays quotations in an NMS stock through an SRO display-only facility shall not impose unfairly discriminatory terms that prevent/inhibit any person from obtaining efficient access to the quotes through a member, subscriber, or customer of the trading center.

A trading center shall not impose, or permit to be imposed, any fee or fees for the execution of an order against a protected quote of the trading center or against any other quote of the center that is the best bid/offer of a national securities exchange or the best bid/offer ot a national securities association in an NMS stock

• If the price of a protected quote or other quote is $1.00 or more, the fee/fees cannot exceed or accumulate to more than $0.001 per share, or
• If the price of a protected quote or other quote is less than $1.00, the fee/fees cannot exceed or accumulate to more than 0.1% of the quoted price per share.

Order protection rule (SEC Rule 611)

The order protection rule was designed to prevent “trade-throughs”, and therefore, is sometimes called the trade-through rule. A trade-through means the purchase or sale of an NMS stock during regular hours, either as a principal or agent, at a price lower than the protected bid, or higher than the protected offer/ask. To be protected, a quote must be immediately and automatically accessible, and represent the best bid and the best offer prices.

Minimum pricing increment (SEC Rule 612)

If the stock is priced at least $1.00, the increment in bid or offers is $0.01, or 1 penny. If the stock is priced less than $1, it usually is an increment of $0.005, or half a penny, unless the average quoted spread during the evaluation period (a 3 month period), is greater than $0.015, then the increment is a full penny.