This looks to be an obvious attempt on the part of the exchanges to promote their own interests. Using the SEC’s language, broker-sponsored dark pools can avoid the routing obligations of trade-at by posting displayed quotations of any size at the NBBO. Just 100 shares would do it. With the 10 words added by the exchanges and FINRA, they can’t.
If the pilot is implemented as now proposed, Test Group 3 would deliver new flows and additional revenues to the leading quoting venues. Broker-sponsored ATSs, on the other hand, would receive a heavy blow if they don’t change their model, with trading effectively limited to mid-point executions. It would severely handicap wholesale market-makers, a long-time exchange nemesis, diminishing their ability to provide retail clients with size improvement at the NBBO. By turning a significant portion of what is now a profitable principal trade into a costly agency route, it would saddle wholesale market-makers with expenses that would inevitably be passed through to the retail customer.
The implications extend beyond the market-share battle between exchanges and non-exchanges. To provide themselves with this gift, the exchanges have ratcheted up the scope and impact of Reg NMS to mind-boggling levels. Under this proposal, an NBBO quote is not protected until it is 1 second old, so fleeting quotes can be ignored. And block trades are exempt from the obligation. But beyond those and a handful of other exceptions, the proposal effectively extends the obligations of Reg NMS to the NBBO. A lot more trading happens at the NBBO than outside it. That’s why those 10 words have turned Test Group 3 into Reg NMS on steroids.
And that’s assuming the market structure landscape remains unaltered. Consider that broker-sponsored dark pools would be able to mitigate some of the effects of this proposal by displaying quotations at the NBBO. With a public quotation of, say, 200 shares, a broker could print an ATS trade at the NBBO up to 200 shares. Without the ability to post quotes, they would have to route and pay another venue’s access fees. With an incentive like that, expect broker-sponsored dark pools to start posting their own quotations in small quantities. As an added benefit, nobody could call them dark pools anymore.
That seems likely to happen under the SEC’s definition of trade-at. And what a feather in the regulator’s cap: increased transparency, and no more dark pools!
But with the exchange/FINRA proposal, those new quoting venues also become protected venues too. Imagine the level of complexity of Reg NMS compliance when there are 40 or 50 venues to be protected.
To be sure, some of this effect may be softened by the impact of nickel increments. More size may congregate at the NBBO, creating a high lower-bound where venues can print without routing, and not a lot of distance to the exemption for block size at the upper-bound. Even so, to ensure that you don’t violate trade-at, each quoting venue would have to monitor the quotes (and the ages of those quotes) and be ready to route to every other trading venue. All 50 of them.
The typical pattern in our industry is for participants who are unhappy with the status quo to lobby Capitol Hill and the regulatory bodies for change, and then later to blame the regulators for all the unintended consequences that inevitably come with change imposed by regulation. It is amazing how many anti-government free-marketers in our industry turn to government as their first choice solution to their problems. You can’t at the same time blame Reg NMS for today’s market structure problems – as Michael Lewis and others do – and lend support for this proposal, even if it is just a pilot.
Commenters, start your engines.
[Related: “Is Test Group 3 of the Tick Size Pilot Program Being Set Up To Fail?”]