My first post refuting Nanex’s HFT Study was read by over twelve hundred people in the first day, and covered by numerous columnists including Matt Levine on Bloomberg View. I was shocked at the overwhelming support I received and by how many people had similar concerns about Nanex’s analysis. Thank you!
In the days following my first post Nanex has earnestly and repeatedly cited § 242.600(b)(42) as proof that the use of anything other than the SIP for purposes of identifying protected quotes in order to comply with Reg NMS constitutes a violation of the Order Protection Rule of Reg NMS. This claim conflicted with my own understanding; however, I couldn’t reference any sources to support my understanding. One reason I decided to write this blog entry was to confirm (or correct) what Nanex was claiming. In this post I am exploring Reg NMS and its application within the market. I have inserted portions of the regulation below.
§ 242.600 NMS security designation and definitions.
(b) For purposes of Regulation NMS (§§ 242.600 through 242.612), the following definitions shall apply:
(42) National best bid and national best offer means, with respect to quotations for an NMS security, the best bid and best offer for such security that are calculated and disseminated on a current and continuing basis by a plan processor pursuant to an effective national market system plan; …
Frankly, looking only at that clause without the benefit of any context or history of Reg NMS, I can sort of see where he’s coming from; however, after reading the adopting release of Reg NMS and the FAQs, I think I understand why there is a disconnect between Nanex and the rest of the industry.
The rest of the industry, it seems, reads the reference to a “plan processor” as a way to clarify that a quote that is not submitted to the SIP at any time, (e.g., a quote submitted to a dark pool or some other alternative venue which will not, at any point in time, display the quote) will not qualify as the NBBO (and won’t be protected).
Of course, the actual text of the Order Protection Rule in Reg NMS (Rule 611 on page 518 of the Adopting Release, pasted below) is what determines what orders are protected. Notice that the SEC uses the term “Protected Quotation” and NOT “National best bid and national best offer”. This is significant because it allows us to focus on understanding what the “Protected Quotation” is and move beyond any fixation on the purpose of the reference to the “plan processor” in the NBBO definition.
§ 242.611 Order protection rule.
(a) Reasonable policies and procedures.
(1) A trading center shall establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs on that trading center of protected quotations in NMS stocks that do not fall within an exception set forth in paragraph (b) of this section and, if relying on such an exception, that are reasonably designed to assure compliance with the terms of the exception.
(2) A trading center shall regularly surveil to ascertain the effectiveness of the policies and procedures required by paragraph (a)(1) of this section and shall take prompt action to remedy deficiencies in such policies and procedures.
The terms trade-through and protected quotation are defined here:
§ 242.600 NMS security designation and definitions.
(b) For purposes of Regulation NMS (§§ 242.600 through 242.612), the following definitions shall apply:
(58) Protected quotation means a protected bid or a protected offer.
(77) Trade-through means the purchase or sale of an NMS stock during regular trading hours, either as principal or agent, at a price that is lower than a protected bid or higher than a protected offer.
And protected bid and protected offer are defined here (read carefully):
§ 242.600 NMS security designation and definitions.
(b) For purposes of Regulation NMS (§§ 242.600 through 242.612), the following definitions shall apply:
(57) Protected bid or protected offer means a quotation in an NMS stock that:
(i) Is displayed by an automated trading center;
(ii) Is disseminated pursuant to an effective national market system plan; and
(iii) Is an automated quotation that is the best bid or best offer of a national securities exchange, the best bid or best offer of The Nasdaq Stock Market, Inc., or the best bid or best offer of a national securities association other than the best bid or best offer of The Nasdaq Stock Market, Inc.
And an automated trading center is defined here:
§ 242.600 NMS security designation and definitions.
(b) For purposes of Regulation NMS (§§ 242.600 through 242.612), the following definitions shall apply:
(4) Automated trading center means a trading center that:
(i) Has implemented such systems, procedures, and rules as are necessary to render it capable of displaying quotations that meet the requirements for an automated quotation set forth in paragraph (b)(3) of this section;
(ii) Identifies all quotations other than automated quotations as manual quotations;
(iii) Immediately identifies its quotations as manual quotations whenever it has reason to believe that it is not capable of displaying automated quotations; and
(iv) Has adopted reasonable standards limiting when its quotations change from automated quotations to manual quotations, and vice versa, to specifically defined circumstances that promote fair and efficient access to its automated quotations and are consistent with the maintenance of fair and orderly markets.
Using the Substitution Principle, we can summarize the Order Protection Rule (Rule 611) as:
A trading center shall establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent (the purchase or sale of an NMS stock during regular trading hours, either as principal or agent, at a price that is lower than a protected bid or higher than a protected offer) on that trading center of (a quotation in an NMS stock that):
(i) Is displayed by an ((4) Automated trading center means a trading center that: (i) Has implemented such systems, procedures, and rules as are necessary to render it capable of displaying quotations that meet the requirements for an automated quotation);
(ii) Is disseminated pursuant to an effective national market system plan; and
(iii) Is an automated quotation that is the best bid or best offer of a national securities exchange, the best bid or best offer of The Nasdaq Stock Market, Inc., or the best bid or best offer of a national securities association other than the best bid or best offer of The Nasdaq Stock Market, Inc.)
in NMS stocks.
I could go on, but I think it would be annoying and I expect that most of you now see what the rest of the world sees: the Protected Quotation is what’s actually protected — regardless of how it’s received (SIP or Direct Feed), as long as the quote is (i) displayed by an automated quotation center, (ii) disseminated to the public in a consolidated stream of data (SIP); and (iii) the best bid or offer on a qualifying national securities exchange.
For those of you still doubting this interpretation: don’t worry — it didn’t click for me the first time either. Thankfully, it seems that the SEC was asked this question enough times that the SEC included it in the Reg NMS FAQ and the Rule 611 FAQ that it published. For convenience I’ve pasted and highlighted 3 Q&A’s that I felt helped me understand that, assuming reasonable data handling policies and procedures, while the SIP’s view of the NBBO would be a useful tool for market participants in gauging their compliance generally, utilizing direct feeds for purposes of identifying protected quotations and complying with the Order Protection Rule is permitted.
Section 6: Data Policies and Procedures
Question 6.01: Rule 611 Compliance/Data Latency
In the national market system, trading centers across the U.S. simultaneously display quotations and execute trades in the same NMS stocks. Given the latencies in transmitting data among these trading centers, as well as among broker-dealers that route ISOs to execute against the protected quotations displayed by trading centers, how will regulators assess the compliance of trading centers and broker-dealers with Rule 611?
Answer: In the NMS Release, the Commission stated that, assuming a trading center has implemented reasonable policies and procedures for handling data (see FAQ 6.02 below), a trading center’s compliance with Rule 611 “will be assessed based on the time that orders and quotations are received, and trades are executed, at that trading center.” The same standard will be used to assess the compliance of broker-dealers in routing ISOs under Rule 611(c).
The data that bears on Rule 611 compliance can be divided into three categories: (1) the order and trade data of each trading center or broker-dealer (“Firm”), with internal time stamps reflecting when it was processed by each Firm (“Firm-Specific Order and Trade Data”); (2) the protected quotation data received by each Firm, with internal time stamps reflecting when it was received by the Firm (“Firm-Specific Quotation Data”); and (3) the protected quotation and trade data of the Network processors, with time stamps assigned by such processors (“Network Data”). Assuming reasonable data handling policies and procedures, compliance by individual Firms with Rule 611 will be assessed based on Firm-Specific Order and Trade Data and Firm-Specific Quotation Data, and not on Network Data (the relevance of Network Data to Rule 611 is discussed in FAQ 6.04 below).
Question 6.02: Data Handling Policies and Procedures
What are examples of matters that need to be addressed in a Firm’s data handling policies and procedures?
Answer: As noted in FAQ 6.01 above, compliance by individual Firms with Rule 611 will be based on that Firm’s own data, assuming that the Firm has implemented reasonable data handling policies and procedures. Such policies and procedures should address latencies in obtaining protected quotation data from the sources of such data. The Firm should implement reasonable steps to monitor such latencies on a continuing basis and take appropriate steps to address a problem immediately should one develop.
…
Question 6.04: Rule 611 Compliance/Relevance of Network Data
What is the relevance of Network Data for assessing compliance with Rule 611?
Answer: As noted in FAQ 6.01 above, the Network processors disseminate to the public a stream of trade and quotation data, with time-stamps, for each NMS stock. In this respect, Network Data is unlike Firm-Specific Order and Trade Data and Firm-Specific Quotation Data, which will have time stamps that vary to some extent from Firm to Firm. As a result, Network Data constitutes a common reference point for quotations and trades in NMS stocks that will be readily available to the public, Firms, and regulatory authorities.
As discussed in FAQs 6.01 and 6.02 above, the compliance of an individual Firm will be assessed based on the data it sees at the time it trades and routes orders, assuming it has implemented reasonable data handling policies and procedures. As a practical matter, however, Firms should be aware that Network Data, as the single available common reference point for quotations and trades in NMS stocks, may be used by regulatory authorities, as an initial matter, to gauge their compliance with Rule 611 generally.
For example, regulatory authorities may examine the Network data for comparable Firms to assess whether any Firm has an exceptionally high trade-through rate. If so, the relevant regulatory authority is likely to contact such Firm and ask for an explanation. At this point, the focus will shift from Network Data to (1) the reasonableness of the Firm’s policies and procedures, particularly for handling data and reviewing for compliance with Rule 611, and (2) the Firm-Specific Order and Trade Data and the Firm-Specific Quotation Data that support the results of the Firm’s compliance reviews. The Firm will want to be in a position to demonstrate that its policies and procedures are reasonable. For example, it could present Firm-specific data from its periodic compliance reviews showing that trades that might appear to be trade-throughs in the Network data are in fact “false positives” that were not trade-throughs at the Firm.
Firms also should recognize that the widely available Network Data could be a valuable external tool for assessing the effectiveness of their internal policies and procedures. For example, an examination of the Network Data might reveal particular types of stocks, times of day, or types of trading conditions in which the Firm appears to generate a high rate of trade-throughs. The Firm could use this information to fashion its compliance reviews to assess these specific potential problem areas. Such compliance reviews could reveal that the trade-throughs in the Network Data are false positives, as well as the explanation for why they appear to be trade-throughs in the Network Data. Conversely, compliance reviews targeted on the problem areas may reveal weaknesses in the Firm’s policies and procedures that the Firm could correct with timely action. In either case, policies and procedures that include the use of Network Data may enable the Firm to provide a more effective response to regulatory inquiries.
As I stated in the beginning, my goal of this blog was to better understand the nuances of the Order Protection Rule in order to determine the validity of the viewpoint that Reg NMS compliance is assessed exclusively on the SIP. I’m not an attorney but I follow the industry generally, I’ve read the rules and the adopting release, and the FAQs. After this review, my conclusion is that this SIP-only viewpoint is not supported by the published material. I’ve also never read about or heard of any HFT, broker-dealers, exchange, or dark pools being investigated or sanctioned for failure to comply with this SIP-only viewpoint of protecting quotes. Especially in the current environment and with today’s 24 hour news coverage, I have to assume that if the SEC/FINRA did not agree with this interpretation, we would have heard about it.
To those who find this analysis compelling, especially those with a greater voice than my own, I hope that you will join me in attempting to educate others on this important issue. To those who advocate a different interpretation, I would invite you to share your support for your interpretation using the rules, adopting release, FAQs, and any other materials published by the SEC. For those advocating a different interpretation but unwilling/unable to clearly identify SEC-published materials in support of your position, I can only conclude that your goal is something other than improving investor confidence and market integrity.
