In the best possible marketplace, all buyers see the prices asked by all sellers and all sellers see the prices offered by all buyers — and little guys are treated the same as big ones. The result: competition that insures the most efficient interplay of supply and demand.

In theory, it sounds great. And indeed, this is the idea behind the Security and Exchange Commission’s push for an integrated stock market called the National Market System, or NMS. It is meant to assure that every trader gets the best price available at any moment on any exchange in the country.

But could those best intentions backfire? In a new paper, Wharton finance professor Marshall E. Blume warns that they could. The regulation, approved by the SEC in 2005 and scheduled to take full effect this fall, amounts to micromanagement that will stifle market innovation, Blume argues, adding that in the end it may give the New York Stock Exchange and Nasdaq virtual monopolies, allowing them to inflate fees paid by investors.

“The whole idea of Regulation NMS is that everybody will be better off if you have absolute sunshine everywhere,” he says. But the national market system is like a poker game: “If everyone has their hands exposed when you play, the system is not going to work very well.”

Misplaced Emphasis?

NMS is controversial. The New York Stock Exchange supported it while the Nasdaq did not, and institutional traders split over the issue. It was approved in June 2005 on a 3-2 vote, with two Democratic SEC commissioners and chairman William Donaldson supporting it, while the two Republican commissioners voted no.

While NMS is meant to protect small investors trading stocks for themselves, it could hurt them by increasing costs for institutional investors that serve individual investors, such as mutual fund companies, Blume suggests. Another “alleged advantage of an NMS is that all investors are treated equally,” Blume writes in his paper, “Competition and Fragmentation in the Equity Markets: The Effect of Regulation NMS.” “A small retail investor receives the same treatment as a large institutional investor. On the surface, this equal treatment seems eminently fair, but on closer analysis, it represents a naïve view of how trading takes place among different types of investors.”

In passing NMS, the SEC was attempting to complete a goal set in 1975. But implementation has been delayed by technical snags and other obstacles. In January, the SEC said the effective date for some key rules was being pushed back from early February to early March. After a phase-in period, the entire industry is to be operating under NMS by October 8.

NMS requires that all exchanges, as well as the Nasdaq marketplace, provide individuals with the same access to quotes that is offered to institutional traders. It requires that prices for most stocks be displayed in increments no smaller than a penny — permitting, for example, a price of $10.01 a share, but not $10.015. Most importantly, it contains a “trade-through rule,” also known as an “order protection rule,” meant to assure the best prices. A purchase order entered at the New York Stock Exchange might be executed on the Nasdaq if a seller there offers the stock at the lowest price, for example.

This emphasis on best prices is the regulation’s chief flaw, Blume argues. “There’s been a feeling among regulators that a fair market is one where every investor is assured of getting the best and fairest price,” he says. “We don’t have that kind of market for automobiles, but they think we have to have it here.”

According to Blume, getting the best price in each individual trade is not necessarily every trader’s top priority. Often, an institutional trader’s effort to accumulate a large block of a particular stock must be broken into numerous trades. The buyer may be satisfied if some trades are not at the best price so long as the entire block can be bought quickly at a low average price. By emphasizing speed over minor price variations, the trader reduces the risk some event will drive the price up before the block of shares is assembled. “An institution that is trading a large order is concerned with the ultimate average price, not with the price of each transaction,” Blume notes.

For technical reasons, the price quotation systems developed under NMS allow a trader looking at a specific stock to see only the best price available on each exchange — the “top of the book.” It is as if all the offers to buy or sell were people standing in a line so straight that, from the front, only the first person could be seen.

This can work to the trader’s detriment, Blume states. For example, the top of the book in a Chicago exchange might list an offer to sell 100 shares of XYZ Corp. for $20 a share, while the next best price offered there might be 100 shares for $20.01. At the same time, a New York exchange might list a top-of-the-book offer of 100 shares for $20.02. Because of NMS, Blume says, a buyer who wanted 200 shares would end up with 100 from Chicago at $20 and 100 from New York at $20.02, since those would be the two best top-of-the-book prices. In fact, the buyer would have been better off getting all the shares in Chicago, but the $20.01 offer there would not be visible. 

Because NMS requires that bids and offers be visible to all buyers and sellers, it makes it difficult for institutions to execute big trades discretely, Blume says. Even if the specific identity of the trader is not known, the fact that someone is trying to buy a large block of shares signals an up-tick in demand that will lead sellers to hold out for higher prices.

Concern about this has led big traders to use alternate trading systems rather than the traditional exchanges. So-called “crossing networks” or “dark pools” have sprung up to match buyers and sellers without revealing their intentions to the broad market.

The Straightjacket Effect

One alternative system, Liquidnet, was launched in 2002 to serve clients such as pensions and mutual funds. It limits trading to a group of approved participants and bars dealers who could leak secrets. And it permits trading at prices that include fractions of a penny, a significant benefit to anyone trading millions of shares. To operate, Liquidnet had to get the SEC to exempt it from some NMS rules.

While Blume applauds the SEC’s willingness to make exceptions, he says it would be better to allow this kind of innovation to sink or swim on its own merits without regulators’ involvement. “Now, to get anything changed, you have to get prior approval from the SEC. And the SEC is notoriously slow at approving things.”

NMS, he says, may lead to a concentration of trading at exchanges that can provide the high speed that institutional investors demand. That will likely benefit the New York Stock Exchange or Nasdaq, both of which are now publicly traded, for-profit companies with an incentive to drive fees up. “In short, Regulation NMS has placed innovation in a straightjacket and, as an unforeseen consequence, may lead to increased concentration in the trading of equities,” Blume writes. “If Regulation NMS causes the cost of trading to become onerous, institutions will find ways to evade its dictates… .

“They can always trade U.S. Securities offshore through offshore offices. They can turn to the growing number of crossing networks, or ‘dark pools’. … One should not underestimate the ability of financial engineering to circumvent regulation.”

The SEC, Blume says, “is venturing into uncharted seas.”

Competition and Fragmentation in the Equity Markets: The Effect of Regulation NMS