On June 16, the SEC proposed to rescind the Order Protection Rule (the Trade-Through Rule) and the prohibition on locked and crossed markets under Regulation NMS. If adopted, the changes could reduce the incentive for broker-dealers and other market participants to maintain connections to every exchange, particularly where the cost of market data and connectivity outweighs the available liquidity. At the same time, firms would gain greater flexibility in how they evaluate execution quality and satisfy their best execution obligations, moving away from a framework heavily focused on achieving the National Best Bid and Offer (NBBO) on every execution. In an interview with Traders Magazine, Wayne Aaron, Partner and Co-Chair, Broker-Dealer Regulation at Katten, discusses how market participants may adapt their connectivity strategies, whether the integrity of the NBBO could be affected, alternative approaches the SEC could have considered, and what the proposal could mean for routing decisions and best execution standards going forward.

Will market participants connect to fewer markets because they are not required to do so?

Market data and connectivity come are expensive and market participants will certainly welcome the opportunity to reduce expenses. The likely result is that market participants will evaluate the liquidity available from a particular market to assess whether it is advisable (and cost-efficient) to connect to the market. Market participants may also be more likely, over time, to rely upon the SIP than direct connections. All of this will further be balanced against best execution considerations, which will become less formulaic and focus more on the nuanced facts-and-circumstances of executions and the prevailing market.

Will quoting activity, and therefore the integrity of the NBBO, suffer, affecting best execution analyses?

Quoting habits are likely to change, but it is not clear that quoting activity will “suffer” – it is possible that market participants will aggregate their quoting activity on certain market centers rather than refrain from quoting at all. Similarly, best execution analyses are likely to evolve and be less formulaic. There will be more room for a best execution narrative, for market participants to explain why it was reasonable not to seek out or obtain small amounts of liquidity in disparate markets or how to evaluate best execution overall at the parent level rather than be focused on one or a small number of child executions. There will likely be more potential executions outside the NBBO, placing more of a burden on those reviewing exception reports to evaluate and reconcile individual executions.

Are there less restrictive alternatives – such as potential additional exemptions for less robust markets or for significantly sized institutional orders – that might be considered short of full rescission?

There are certainly less restrictive alternatives. The Commission could have considered exempting certain types of orders from trade-through protection and also could have considered raising thresholds for a market center to “earn” protected quote status. The counter-argument to this, however, is that these alternatives might add more complexity to equity market structure. Accordingly, it appears that the Commission, balanced the possibility of these less-restrictive alternatives against considerations of market fragmentation, complexity, and the desire for a market-based solution and evolution.

How could the proposal affect execution quality and the standards brokers use to satisfy their best execution obligations?

The proposal is not likely to affect execution quality per se, but may very well affect the manner in which Best Execution Committees consider how and where to route orders, and the factors they take into account. Best Execution Committees will still need to justify and document routing decisions, but they will have more latitude to consider the full range of factors from FINRA Rule 5310 and will not necessarily have to consider price (and minor variations in price) as the be-all-and-end-all. There will be a more holistic evaluation.