In a recent Streetwise Professor blog post, University of Houston Finance Professor Craig Pirrong discussed the unintended consequences of Regulation NMS, applauded the SEC's new Special Study of the Securities Market, and questioned whether the SEC Order Protection Rule is necessary to sustain a competitive equity trading marketplace.
The Order Protection Rule (i.e., Rule 611 under Regulation NMS) protects the best-automated quotations of national securities exchanges by obligating other trading centers to honor those quotes by not executing trades at inferior prices. Professor Pirrong argued that the Order Protection Rule has (i) broken the liquidity network effect that resulted in NYSE dominance regarding its listed securities (i.e., the "socialization of flow" means that no one exchange is trading more than a quarter of the volume), and (ii) resulted in the "disintermediation of traditional intermediaries."
Professor Pirrong noted that the Order Protection Rule has led to a proliferation of order types, which increases complexity and forces traders to monitor quotes at all trading venues, regardless of the size of the trade. He said that the crucial question of the moment is whether the equity trading marketplace will be as competitive without the rule (if relaxed or eliminated) as it is today. He concluded that the answer is potentially complex:
"It is therefore not clear to me that elimination of the Order Handling Rule [i.e., the Order Protection Rule] will result in traders having their cake (intense inter-exchange competition) and eating it too (less complexity, lower connection cost). Given the substantial benefits of greater competition that have been realized in the past dozen years, changes to the cornerstone of Reg. NMS should not be taken lightly. The Special Study, and the SEC, should pay close attention to how competition will evolve if the Order Handling Rule is eliminated."
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