The response to the first two articles in this series, pointing out that the “Air Raid” of the NYSE’s monopoly power is long gone, meaning that eliminating the Order Protection Rule (OPR) makes sense, has been outstanding. Predictably, some exchanges are not fans of the approach, as the OPR provides them economic advantages, and ATSs / HFT firms / Institutional brokers mostly support it. The retail brokers, however, are against the idea, as they see the OPR as providing comfort to their clients and eliminating headaches for them. Cynically, as I listened to some of their complaints, I was reminded of an old, somewhat inappropriate joke:
Q: How many retired old men does it take to change a light bulb?
A: “CHANGE???” “What needs to be changed?” “We don’t want change.” “Change, that’s all you young people think about…”
I recently had the opportunity to discuss the idea of repealing the OPR with senior executives at some of the nation’s largest retail firms. They don’t want change, for valid reasons, since their clients are happy and get demonstrably great execution quality today. Their opinion is that, while they are not fans of the complexity and message traffic caused by the Inter-market Sweep Orders (ISOs) required by the OPR, they already experience trade-thrus on their client quotes at depth. They believe that this proves that repealing the OPR will, therefore, increase them substantially. The result will be a lot of work for them to explain to clients why trade-thrus occurred.
This, from their perspective, is a very valid concern. It will cause problems to have trade thrus increase. The issue, however, is that the OPR actually increases some trade-thrus (since 611 compliance is cited by some firms as “proof” of best execution) and is a particularly bad way to solve for top-of-book trade-thrus. A far better approach to both trade-thrus and the issue of investor protection in general, is to enforce best execution obligations, improve disclosures, and let the free market operate to solve trade-thru and other issues.
Enforcement of best execution rules should mean that routing brokers and market centers are forced to defend any process that ignores displayed liquidity in the National Market System, including displayed quotes that are not top-of-book. While there are some valid reasons for ignoring displayed liquidity, it should be incumbent upon the routing broker (including exchange routing brokers) to document their analysis that explains those reasons. Valid reasons could include:
- Quantitative analysis indicating that, in a specific situation, there is a low probability of the quote being accessible or that accessing the quote would be sub-optimal due to delays incurred or increased risk of market impact.
- Multilateral or bilateral negotiated block crosses or auctions where the liquidity demanded significantly outstrips the publicly displayed quantity.
- Market-Making systems where the market-makers are willing to provide excess liquidity instantly, in some part based on their subsequent ability to access those displayed quotes.
⇒ In the two later examples, it is assumed that where institutions are seeking liquidity well beyond what is displayed, they understand and are willing to pay the higher cost for certainty and immediacy of execution.
⇒ It is also quite likely that, in most situations, the market will act to fill the quotes that were traded-thru during the auction, block cross, or market maker provided liquidity.
In these cases, I believe that it is better market structure to be able to trade-thru some quotes, as each example represent brokers attempting to fulfill their best execution obligations on behalf of their clients. (While brokers that posted orders that get traded thru, should choose venues in order to minimize the occurrence to fulfill their best execution obligations). In addition to the academic arguments on behalf of auction market structure, the fact is that the OPR stops trading where both sides of the trade understand and agree to the same terms. It suppresses innovation at the same time as it enforces the oligopolistic power of exchanges.
That said, I do not believe that, in the long run, these exceptions will have any significant impact on retail investors. Well-constructed routers will almost never ignore fully accessible, non-delayed quotes, whether at top of book or at secondary levels, and retail brokers can ensure that they only use such venues. Even if this proves to be incorrect, however, the problem would be short lived due to competition. Wholesale market-makers and market centers will offer execution guarantees for the right to display those orders. Participants desire to interact with retail orders, since they are generally placed for longer periods of time, and far less likely to correlated with subsequent orders than other market participants. Both exchanges and market makers, therefore, have profit motives to compete for the right to display retail orders. As a result, I would expect that retail orders will tend to get filled in most (if not all) of the situations where trade- thrus occur. Of course, there will be some exceptions, such as when a routing broker or over aggressive trader pushes the price too far via a poorly designed sweep. Those sweeps, however, likely violate best execution obligations, meaning that with consistent regulatory enforcement, they should ultimately become an extremely rare occurrence.
Considering the importance of best execution in a “post OPR” world, it would, therefore, be intelligent to enhance the disclosure regime to improve best execution compliance. Specifically, this means that Rules 605 and 606 should be improved and modernized. For rule 605, this means several key enhancements:
- Make the rule universal by requiring all sizes to be reported
- This would eliminate major gaps in coverage, particularly for lower priced stocks
- Create statistically valid categories, by segregating IOC from Day orders, dark from displayed orders, and reporting on orders with special conditions separately.
- This will allow direct comparisons of market centers execution quality instead of having to guess at the business mix of each. Each of these order categories have different fill rates, execution qualities and costs and combining them makes analysis impossible.
- Add metrics for limit orders that measure fill rates vs “traded at” and “traded thru” shares. This is a direct way to measure the impact of trade-thrus as well as to provide statistical evidence of the likelihood of execution on various venues. It is also worth noting that these metrics, combined with the segregation of displayed from dark orders, will provide insights into the trade-offs between those types of orders.
- Modernize the time categories and time-frames for realized spreads to be in milliseconds rather than seconds.
Rule 606, needs much more of a change, since it should provide an aggregated view of broker’s routing behavior and quality, while the current rule has no any execution quality statistics. It also provides no insight into how firms route, in whole or in part, on behalf of “Not Held” institutional orders as opposed to “Held” retail or directed orders. The most important change, therefore, is to measure execution quality from the perspective of the routing broker, including all the statistics currently in Rule 605 plus those suggested above. It is also important, to categorize routing on behalf of different types of orders received, since they denote very different levels of discretion at the routing broker. As a result, as I have written previously, reporting for orders that were originally “Held” should be segregated from “Not Held” and within the “Not Held” category, those orders which are directed, should be separately reported from those where the broker has discretion. These changes would allow clients to compare routing brokers based on effective spreads and fill rates. It is also easy to imagine that enhanced firm reporting will ultimately include statistics on how often their routers, auction, or block trading facility trade thru quotes.
In conclusion, the OPR was originally needed to overcome the monopolistic power of the NYSE. Today, however, it has become a classic example of a prescriptive government regulation that, while solving some problems, creates new ones and suppresses innovation. It would be much better for the future of the equity market to allow free-market competition with best execution obligations to solve the trade-thru problem. It would certainly make sense to augment the disclosure regime of Rules 605 and 606 alongside this deregulation, which has the additional benefit of fitting well within the current administration’s policy of packaging de-regulation with intelligent, less prescriptive rules.
 One of the key flaws in the OPR is that it only protects top-of-book quotes, meaning that retail orders, placed as the second or third price level at an exchange are unprotected in the event that a routing firm sweeps through multiple price levels to access liquidity.