Reg NMS Research Articles

Refusing the best price?

The Regulation National Market System (Reg NMS) links fragmented stock exchanges by routing orders to the National Best Bid and Offer (NBBO). As the NBBO ignores exchange fees, 62% of routings lead to worse net prices. An increase in fee differences increases the market share captured by orders that refuse Reg NMS routings, particularly for stocks whose fees account for a large portion of transaction costs. Heterogeneous opportunity costs rationalize routing choices: non-routable orders entail lower non-execution costs than routable orders. Our results indicate that fees and clientele segmentation drive the proliferation of order types in the Reg NMS era.

Liquid speed: A micro-burst fee for low-latency exchanges

A micro-burst fee on liquidity-taking orders that surges during high-frequency races reduces costs associated with latency arbitrage. Moreover, micro-burst fees provide higher revenue for exchanges versus co-location subscriptions. Unlike co-location fees, micro-burst fees scale with trading activity and allow exchanges to extract higher revenues from HFTs. To ensure long-run adoption incentives for exchanges, a regulator should impose a cap on micro-burst fees; for example, a calibration suggests that liquidity improves with a micro-burst fee as low as 7.8 bps, while a Reg NMS cap on fees of 30 bps per share would improve liquidity by 75%.

The Joint Impact of Fragmentation into the Dark and Algorithmic Trading on Implicit Trading Costs and Market Manipulation

The authors investigate the effects of algorithmic trading and lit/dark fragmentation on US equity market quality. Market quality refers to the efficiency of lower implicit trading costs as well as market integrity, which are addressed here as reduced end-of-day (EOD) trade-based manipulation. A simultaneous equations model of effective spreads, a proxy for algorithmic trading, and EOD manipulation is carefully specified, and the instrumental variables are pretested to confirm exogeneity and strength. They estimate how fragmentation of the lit and dark order flow in NYSE-listed firms pre- and post-Regulation National Market System (Reg NMS) along with high-frequency algorithmic trading (HFT/AT) jointly determine round-trip implicit transaction costs and EOD manipulation. The authors find that lit (dark) market fragmentation lowers (raises) effective spreads, reduces (increases) EOD manipulation, and increases (decreases) HFT/AT once Reg NMS establishes quote discipline.

Intraday volatility smile: Effects of fragmentation and high frequency trading on price efficiency

In 2007, the European Markets in Financial Instruments Directive ended the national concentration rule. As a result, market fragmentation has accelerated across multiple trading venues. Spatial fragmentation might create opportunities and incentives for High Frequency arbitrageurs to fill the void left by the lack of Reg NMS type order routing requirements in Europe, without neglecting market integrity. This paper examines intra-day volatility and price efficiency through the metric of the normalized volatility ratio for the years 2006, 2012 and 2013 for Euronext Paris, BATS and Chi-X Europe. Our findings show that price determination remains inefficient at market opening due to the complexity of price discovery activity following a period of non-trading and heavy information releases. However, we demonstrate that an active participation of high-frequency traders significantly improves market efficiency at opening session.

Can Market Structure Impact Systemic Risk? Evidence from Trade-Through Prohibition

We examine changes in systemic liquidity risk brought about by the trade-through prohibition and the fragmentation of order flow caused by Reg NMS. A dynamic factor model allows us to decompose liquidity co-variances into “exchange-specific” and “market-wide” components. We document a decrease in liquidity measures driven by exchange-specific factors, and an increase in the variance explained by market-wide factors following the implementation of Reg NMS. Overall commonality decreases, with liquidity shocks smoothed across multiple trading venues. While liquidity shocks are shared among more exchanges (becoming more systemic), the impact of a single shock on any individual exchange actually declines.

Who Uses Which Order Type and Why?

Financial regulations and clientele segmentation explain the proliferation of order types on stock exchanges. Plain market and limit orders lose money, indicating that informed traders use complex orders. Fifty-seven percent of trading volume comes from non-routable orders, which are designed to bypass Reg NMS. Because Reg NMS routes orders based on the best gross prices, it often routes orders to worse net prices after adjusting for fees. Non-routable orders win speed races to capture short-term profits, but all order types containing long-term information are routable. An order type that complies with share repurchase regulations earns a 30-day return of 7%. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Reg NMS and Minimum-Tick Distort the Market in Opposing Directions: Theory and Market Experimental Evidence

We investigate the SEC Tick Size Pilot which mandated a 400% increase in minimum tick from 1 to 5 cents for small stocks. We predict and show that an increase in the minimum tick promotes venues operating inverted fee structures while Reg NMS promotes venues operating maker-taker fee structures. This is because the Reg NMS directs orders to the venue with the lowest displayed quotes – maker-taker venues with the highest make rebate to limit orders irrespective of take fees. By contrast, the minimum tick enforces uniformity in displayed quotes and thus directs orders to the inverted venue with the highest market order rebate. Both regulatory mechanisms are highly distortionary and cause the equivalent of water to flow uphill – the rise in the minimum tick results in a 60% relatively higher cost increase in inverted venues but, despite this, trading shifts from maker-taker to inverted venues.

Tick Size Is little more than an Impediment to Liquidity Trading: Theory and Market Experimental Evidence

We investigate the SEC Tick Size Pilot which mandated a 400% increase in minimum tick from 1 to 5 cents for small stocks. We predict and show that an increase in the minimum tick promotes venues operating inverted fee structures while Reg NMS promotes venues operating maker-taker fee structures. This is because the Reg NMS directs orders to the venue with the lowest displayed quotes – maker-taker venues with the highest make rebate to limit orders irrespective of take fees. By contrast, the minimum tick enforces uniformity in displayed quotes and thus directs orders to the inverted venue with the highest market order rebate. Both regulatory mechanisms are highly distortionary and cause the equivalent of water to flow uphill – the rise in the minimum tick results in a 60% relatively higher cost increase in inverted venues but, despite this, trading shifts from maker-taker to inverted venues.

Overview of Emerging Blockchain Architectures and Platforms for Electronic Trading Exchanges

Several international electronic primary financial exchanges have begun to announce they will explore the adoption of blockchain technology in their trade processing and reporting for execution and clearing. Therefore, in this work we will begin by providing an overview of the new exchange regulations appearing in different jurisdictions around the world, including EMIR, Dodd Frank, MiFID I/II, MiFIR, REMIT, Reg NMS and T2S. We will discuss some of their key features, specifically in regard to transparency reporting and trade/transaction reporting requirements.The current status of regulatory requirements for reporting and the massive data sets such regulation will generate as well as the significant challenges faced by firms and market participants in meeting such requirements in an automated manner, is a key to the discussion in this paper. We explain different blockchain solutions based on blockchain architectures being currently developed in the market place to handle key aspects of transparency and pre and post trade reporting requirements that will be universal in applicability in both UK, Europe and U.S. regulations.In the process of this commentary we will discuss the different emerging architectures and features that are being developed in a range of different blockchain technologies. This will include details on different forms of blockchain technology including : permissionless blockchains, where anyone can participate in the veri cation process, i.e. no prior authorisation is required and a user can contribute his/her computational power, usually in return for a monetary reward. Permissioned blockchains, where verification nodes are preselected by a central authority or consortium. Public blockchains, where anyone can read and submit transactions to the blockchain and Private blockchains, where this permission is restricted to users within an organisation or group of organisations. We detail which market participants and which blockchain architectures are emerging as possible solutions for addressing pre and post trade reporting requirements in modern electronic exchanges.

Blockchain Architectures for Electronic Exchange Reporting Requirements: EMIR, Dodd Frank, MiFID I/II, MiFIR, REMIT, Reg NMS and T2S.

Several international electronic financial exchanges have begun to announce they will explore the adoption of blockchain technology in their trade processing and reporting for execution and clearing. Therefore, in this work we will begin by providing a detailed discussion and overview of the new exchange regulations appearing in different jurisdictions around the world, including EMIR, Dodd Frank, MiFID I/II, MiFIR, REMIT, Reg NMS and T2S. We will discuss their key features, specifically in regard to transparency reporting and trade/transaction reporting requirements under these regulations. We then demonstrate how these reporting requirements can be addressed through development of a blockchain solution.

Commonality in Liquidity: The Impact of Financial Crisis and Regulation NMS

Following the liquidity dry-ups witnessed during the 2007-09 financial crisis, many studies highlighted the relation between market downturns and increased co-movements in liquidity. This study examines whether the mid-2007 implementation of Regulation National Market System (Reg NMS) played a contributing role in driving equity liquidity co-movements, and whether its impact has been confounded with that of the recent crisis. Results from a dynamic factor model approach confirm the recent crisis's impact on increasing co-movements within bid-ask spreads, and additionally demonstrate that Reg NMS contributed to structural changes in commonality within dollar volumes even prior to the crisis.

A Decade in the Life of a Market: Visible Market Fragmentation, Quality and Efficiency

In contrast to the Reg NMS regime in the US, the European Markets in Financial Instruments Directive (MiFID) does not impose a formal exchange trading linkage or guarantee the best execution price. This raises concerns about consolidated market quality in an increasingly fragmented European trading environment. We investigate the impact of visible trading fragmentation on equity market quality on FTSE 100 stocks over the period 2004 to 2014. We find a U-shape relationship between fragmentation and adverse selection costs. At lower levels of fragmentation, order flow competition reduces adverse selection costs and improves market transparency. However, there is a fragmentation threshold where implied adverse selection costs could increase with visible fragmentation. Visible fragmentation also stimulates market efficiency by reducing arbitrage opportunities.

Understanding the Stakes of High-Frequency Trading

Recent regulatory changes, known as Reg NMS in the United States or MiFID in Europe, together with the effects of the financial crisis (mainly its impact on liquidity), induced major changes on market microstructure in two main aspects: • the fragmentation of the liquidity around several trading venues, with the appearance of newcomers in Europe like Chi-X, BATS Europe, or Turquoise, some of them being not regulated or “dark; • the rise of a new type of agents, the high frequency traders, liable for 40% to 70% of the transactions. These two effects are linked since the high frequency traders, being the main clients of the trading venues, have an implicit impact on the products offered by these venues. Combining a survey of recent academic findings and empirical evidences, this paper presents what we consider to be the key elements to understand the stakes of these changes, and also provides potential clues to mitigate some of them. A first section is dedicated to exposes the recent modifications in market microstructure. The second one explains the role of the price formation process and how, interacting with liquidity supply and demand, high frequency traders can reshape it. The next section discloses the various strategies used by these new market participants and their profitability. A final section discusses recent tools designed in order to assess and control the high frequency trading activity.

Fragmentation and Price Discovery: A Comparison of Reg NMS and MiFID1

We study NYSE, NASDAQ, and ARCA prices for DJIA stocks and LSE, Xetra, and Chi-X prices for five leading British equities. MiFID1 hastened fragmentation but accomplished the intended cointegration of European equity markets that had previously been segmented. Initially, price discovery in London was largely unaffected; permanent quote innovations remained more than 90% attributable to the LSE. However, clearing and settlement fee reductions by Chi-X five months later did result in a substantial reduction in the information impounding and price discovery efficiency of London Stock Exchange trades. The contemporaneous situation in the United States with the implementation of Reg NMS was quite different. During its staggered rollout in 2007, NYSE’s price discovery declined steadily from 74% to 41%, with much of that role migrating to ARCA. In this case, the price discovery efficiency of NASDAQ substantially improved.

Fragmentation and Price Discovery: A Comparison of Reg NMS and MIFID1

Fragmentation and Price Discovery: A Comparison of Reg NMS and MIFID1

Implementation Details for Frequent Batch Auctions: Slowing Down Markets to the Blink of an Eye

Our recent research (Budish, Cramton, and Shim 2013) proposes frequent batch auctions - uniform-price sealed-bid double auctions conducted at frequent but discrete time intervals - as a market design alternative to continuous-time trading in financial markets. This short paper discusses the implementation details of frequent batch auctions. We outline the process flow for frequent batch auctions, discuss a modification to the market design that accommodates market fragmentation and Reg NMS, and discuss the engineering and economic considerations relevant for determining the batch interval. Open questions are discussed throughout.

The Impacts of Automation and High Frequency Trading on Market Quality

In recent decades, US equity markets have changed from predominantly manual markets with limited competition to highly automated and competitive markets. These changes occurred earlier for NASDAQ stocks (primarily between 1994 and 2004) and later for NYSE-listed stocks (mostly following Reg NMS and the 2006 introduction of the NYSE hybrid market). This paper surveys the evidence of how these changes impacted market quality and shows that overall market quality has improved significantly, including bid-ask spreads, liquidity, and transitory price impacts (measured by short-term variance ratios). The greater improvement in market quality for NYSE-listed stocks relative to NASDAQ stocks beginning in 2006 suggests causal links between the staggered market structure changes and market quality. Using proprietary data sets, provided by two exchanges, that identify the activity of high frequency trading firms, studies show these firms contributed directly to narrowing bid-ask spreads, increasing liquidity, and reducing intraday transitory pricing errors and intraday volatility.

Market Quality Breakdowns in Equities

A breakdown in market quality occurs when an order book thins to the point where extreme price movements are observed. These are frequently reversed as the market learns that nothing fundamental has occurred. The daily average breakdown frequency from 1993-2011 is 0.64%, with averages in 2010-11 below this amount. Controlling for microstructure effects, breakdowns have fallen significantly since Reg NMS. Spikes in market correlation and high frequency trading surges make breakdowns more likely. ETFs break down more often than non-ETFs. Both ETFs and high frequency trading Granger cause market correlation. Breakdowns are predictable for up to two days.

MiFID, Reg NMS and competition across trading venues in Europe and the USA

PurposeThe purpose of this paper is to evaluate how markets in financial instruments directive (MiFID) and regulation national market system (Reg NMS) affect the competition for order flow among trading venues in, respectively, Europe and the USA.Design/methodology/approachThe paper examines the differences between MiFID and Reg NMS and provides, based on market microstructure principles, insights as to their likely impact on European and the US securities markets.FindingsAlthough MiFID and Reg NMS share the common objective of enhancing competition in securities markets, they adopt different provisions with respect to three issues that strongly influence the competition for order flow among trading venues. Specifically, some of the provisions set forth by the US regulation with respect to the best execution duty, the consolidation of market data and the disclosure of execution quality information appear to be more effective, compared to the European Union ones, in strengthening competition for order flow among trading venues.Research limitations/implicationsRegulatory factors can only partly explain the current structure of the European and US securities markets. Technology and heterogeneity in traders' demand are other important factors that concur in shaping the European and US markets.Practical implicationsThe degree of competition for order flow among trading venues depends on how regulations define the best execution duty, the availability of updated and consolidated pre‐trade (i.e. quotations) and post‐trade (i.e. transactions) information and the efficiency of post‐trading infrastructures.Originality/valueThe paper addresses issues not yet investigated and provides valuable insights for financial intermediaries, incumbent and prospective exchanges as to the competition in the securities industry, and to regulators as to the likely impact of the new regulations.

Is High-Frequency Trading Inducing Changes in Market Microstructure and Dynamics?

Using high-frequency time series of stock prices and share volumes sizes from January 2002-May 2009, this paper investigates whether the effects of the onset of high-frequency trading, most prominent since 2005, are apparent in the dynamics of the dollar traded volume. Indeed it is found in almost all of 14 heavily traded stocks, that there has been an increase in the Hurst exponent of dollar traded volume from Gaussian noise in the earlier years to more self-similar dynamics in later years. This shift is linked both temporally to the Reg NMS reforms allowing high-frequency trading to flourish as well as to the declining average size of trades with smaller trades showing markedly higher degrees of self-similarity.