Our subscribers frequently ask us about the meaning behind the post-trade modifiers listed when a Luminex trade reports to the Consolidated Tape. As part of complying with Reg NMS and the Order Protection/Trade-through Rule (Rule 611), one of the trade qualifiers associated with a negotiated trade at Luminex is the Rule 611 exemption. In order to provide our subscribers with a better understanding of our execution process, below is an overview of the Rule 611 exception and its application to negotiated trades effected at Luminex.
The Luminex Negotiated Trade
The execution price1 of a negotiated trade at Luminex qualifies as one of the 9 exceptions listed in Paragraph (b) of Rule 611 under Regulation NMS, or the “Order Protection Rule” or “Trade-through Rule”. The execution price of a negotiated trade at Luminex is a derivatively priced trade, and thus, exempt from Rule 611. Therefore, the trade may execute at, within, or outside the NBBO, and in the case when the execution price falls outside of the U.S. NBBO, a “top-of-book sweep” is not required prior to reporting the trade to the Consolidated Tape.
For example, if the U.S. NBBO were $10.00 – $10.01, a Luminex negotiated trade with a final execution price of $10.02 would not be a violation of Rule 611 and would not require a top-of-book sweep prior to reporting the trade to the tape. (All Luminex trades reported to the Consolidated Tape include the applicable trade reporting modifiers as dictated by FINRA.)
How does the Rule 611 exemption impact trading?
Rapid and frequent quote movements are commonplace, and at times, impair traders’ ability to consummate trades. This might occur when parties negotiating a trade, agree on price and quantity, but are prevented from immediately reporting it to the Consolidated Tape because the agreed upon price is no longer at or within the NBBO – a potential violation of Reg NMS even though the previously agreed upon price was within the NBBO at the start of the negotiation. A common solution, mainly as a means to prevent a violation of Reg NMS, is to route orders to the market center(s) posting better prices in sufficient quantity to match the displayed top-of-book liquidity.
Speed coupled with information gathered from various market data feeds drive the trading ecosystem, so although satisfying displayed top-of-book liquidity is a perfectly viable and necessary solution, it generates a trading signal in the marketplace, which may be even more prevalent if followed by a large execution off-exchange. At Luminex, because a “top-of-book sweep” is not required as part of executing the trade, the amount of information signaling is significantly reduced because the behavior informing the broader market of a potentially large trade does not exist.
Overview of Rule 611
Rule 611, under Regulation NMS, or the “Order Protection Rule”, promotes intermarket price protection of orders and requires that brokers and venues ensure they do not “trade through” the U.S. National Best Bid or Offer, or NBBO. Without an applicable exemption set forth under the Rule, the execution of trades at prices inferior to protected quotations displayed by other trading centers, is prohibited.
Reg NMS and Rule 611 were conceived in 2005, well before the start of the intense technological “race to zero.” At the time, the regulation was forward thinking because the “one second window”, another important exception to Rule 611, accounted for the practical difficulties associated with fast moving markets and rapid quote changes. The idea was that frequent quote changes may create a false impression that a trade through occurred, when in fact, the trade was executed nearly simultaneously. (To put things in perspective, in 2005, the average speed of execution for a relatively small, marketable order on the New York Stock Exchange was approximately 10.1 seconds.)
For example, if the best bid price displayed by another trading center is flickering between $10.00 and $10.01 over a 1-second window, a trading center that executed a trade at $10.00 would not be in violation of Rule 611. When the SEC approved the exemption back in 2005, it noted that it “generally does not believe that the benefits would justify the costs imposed on trading centers of attempting to implement an intermarket price priority rule at the level of sub-second time increments.”2
During that time, few could have predicted the level of impact technology would have on trading, particularly that quote changes would take place at today’s blinding pace, but as time and trading grew inextricably linked, the rules that dictated trading remained largely intact. Therefore, as quote changes grow in frequency, the likelihood that previously agreed upon prices for negotiated trades fall outside of the NBBO increases dramatically.
Venues compete in today’s crowded marketplace through variations in execution logic to ultimately improve the overall quality of execution, and sometimes, to address an inherent structural problem unforeseen by regulators.
The controversy around the Order Protection Rule is not new as participants continue to debate its on-going benefits and logistical functionality in today’s trading ecosystem. At the May 2015 Equity Market Structure Advisory Committee Meeting, Rule 611 was a topic of discussion. Some industry participants recommended creating a block exemption to Rule 611. Another noted that markets do not uniformly address the various needs of all investors and “exchanges should be free to experiment and evolve to take into account issuer size and trading patterns.” The rules that govern all markets are complex and do not always keep pace with the markets’ infrastructure, yet must evolve to ensure they remain appropriately sound. Challenges in trading will continue to exist and grow in complexity and the reliance on private market solutions driven by innovation is necessary to enhance overall efficiency and improve the quality of our markets for all participants.
As always, if you have any questions, just let us know.
- For orders that execute following a negotiation, the Luminex execution price is a front-weighted average of a series of midpoint prices sampled once each second over the negotiation window, plus two additional seconds after the block size has been determined. The weighted execution price assigns lower weight to later prices in order to reduce the execution’s susceptibility to price manipulation.
- Regulation NMS Adopting Release, 70 FR at 37523