By the year 2000, SEC rulemaking had done much to create a truly national market system. There were multiple, competing, markets, with trading priority defined by common order handling rules. Yet limitations remained. As Annette Nazareth, who took over as director of Market Regulation in 1999 put it, “many of those rules that had been put in effect no longer made sense given advances in technology, so that the rules that were well-reasoned thirty years before now were actually having a distorting effect.” 44
With Rule 390 gone, the greatest remaining distorting factor was the Quote Rule, which mandated that orders be transmitted through ITS. Once a solution, ITS had now become a problem. Since it did not distinguish between electronic and manual quoting of listed securities, ITS formed a bottleneck that negated many of the advantages of computer technology. Therefore, said Commissioner Cynthia Glassman, investors did not get the best price—instead they got what Glassman called a “phantom price” not likely to be available after the floor markets caught up with the electronic ones. 45
Through it all, the public—and therefore Congress—remained concerned about market fragmentation. In 2000, Congressional hearings on fragmentation were scheduled while the SEC solicited views from the public summarized in a “Fragmentation Concept Release.” Following precedent, the SEC declined to issue a broad edict. Instead Nazareth considered this release the “beginning of a dialogue” intended to come up with a variety of ways to square the circle. 46 As the Fragmentation Concept Release put it, “although the objectives of vigorous competition on price and fair market center competition may not always be entirely congruous, they both serve to further the interests of investors and therefore must be reconciled in the structure of the national market system.” Nazareth later put it more succinctly: “is there a possibility that you can have greater competition [among markets] but also encourage greater order interaction?” 47
As a Wall Street veteran and former NYSE chairman, William Donaldson, who became SEC Chairman in 2003, was particularly well-suited to pursue market reform. “He knew it was extremely important,” recalled Nazareth. “And once he got comfortable—and that took really several months of work on his part—then he was ready to go.” 48
Between 2003 and 2005 the SEC held a number of public hearings and roundtables, convened an advisory committee, issued three concept releases, offered a number of temporary exemptions that it hoped would “generate useful data on policy alternatives,” and stayed in close touch with investors and industry leaders. “It was a very iterative process,” recalled Nazareth, “but as it should have been, since these were very, very complicated issues.” 49
The final result was Regulation National Market System (Reg NMS) effective August 29, 2005. This most comprehensive effort of the SEC to fulfill its 1975 mandate to create a national market system comprised four different solutions to four separate problems. Larry Harris, who served as the Commission’s chief economist at the time, acknowledged that “it basically came together in the end that, look, we’re working on market structure, these are four issues that we have to work on, and let’s just lump them all together and call them Reg NMS.” 50
The first, and most contentious, provision was the “Order Protection Rule,” which required “trading centers” to protect their customers from executing trades in their market at prices inferior to the best available price on any other market (what was known as the national best bid or offer, or NBBO). “To be protected,” the rule stated, “a quotation must be immediately and automatically accessible.” Thus, the quotes of slower, floor-based markets would not be protected quotes under the rule, and faster, electronic markets could ignore their prices. The second provision of Reg NMS was designed to harmonize different practices among exchanges regarding access fees that made it difficult for investors to distinguish between prices on different markets. The “Access Rule” put limits on the fees that market centers could impose and also required them to take steps to prevent locked or crossed quotes. A third rule dealt with the form of front running that had become endemic in the markets as traders obtained price priority by bidding higher by fractions of a cent. The “Sub-Penny Rule” stipulated that price increments could only be smaller than a penny on shares trading at less than $1.00 per share. Finally, Reg NMS introduced new “Market Data Rules.” Exchanges had long profited from selling market information to banks, broker-dealers, investment companies, and others. The formulas for allocating revenues to the markets for their data had created financial incentives for SROs to capture market data revenue by maximizing reported trade volume by rewarding a larger allocation of revenues on the basis of trades rather than the number of shares executed on a particular market. As a result, said Nazareth, “it was encouraging bad activity like wash sales in order to create trades so that markets could get higher market data fees.” The new Market Data Rules resolved this problem and attempted to promote more efficient dissemination of market information. 51
Although Reg NMS was more a bundle of remedies than a grand design, it was probably the most ambitious plan that the Commission could have implemented, owing its success to firm backing by Nazareth (who became a Commissioner shortly after Reg NMS was adopted) and especially Chairman Donaldson. Indeed, the measure split the Commission, with two Republicans voting against adoption of Reg NMS and the third Republican, Donaldson, siding with the Democratic Commissioners. Somewhat ironically, the dissenters called out the SEC’s timidity as much as its overreach. “If the goal was to bring everything together, we should have had one market,” said Commissioner Cynthia Glassman. “But we didn’t do that. It’s sort of the worst of both worlds.” 52 Whether that was truly the case had yet to be seen.
(44) November 4, 2005 Interview with Annette Nazareth, 23.
(45) November 21, 2005 Interview with Cynthia Glassman, 42.
(46) November 4, 2005 Interview with Annette Nazareth, 26.
(47) Regulation and Market Structure from ATS to NMS, June 1, 2018, 13.
(48) November 4, 2005 Interview with Annette Nazareth, 36.
(49) November 4, 2005 Interview with Annette Nazareth, 26-28.
(50) September 6, 2017 Interview with Larry Harris, 29.
(51) See SEC Release: Regulation NMS, June 9, 2005.
(52) November 21, 2005 Interview with Cynthia Glassman, 43.
