National Market System (NMS) in USA
The National Market System (NMS) was created by the Securities Acts Amendments of 1975. It was created to promote market transparency by regulating how all major exchanges disclose and execute trades. It is applicable for equity securities trading.
There are four major rules under the NMS regulations, they are as follows:
- The "Order Protection Rule" which requires trading centers to establish, maintain and enforce written polices and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible.
- The "Access Rule" requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations across different trading centers, and requires each national securities exchanges and national securities associations to adopt, maintain, and enforce written rules that prohibit their members from engaging ina pattern or practice of displaying quotations that lock or cross automated quotations.
- The "Sub-Penny Rule" prohibits market participants from accepting, ranking, or displaying orders, quotations, or indications or interest in a pricing increment smaller than a penny, except for orders, quotations, or indications of interest that are priced at less than $1 per share.
- The "Market Data Rules" that update the requirements for consolidating, distributing, and displaying market information, as well as amendments to the joint industry plans for disseminating market information that modifies the formulas for allocating plan revenues ("Allocation Amendments") and broaden participation in plan governance ("Governace Amendment").
The NMS works by linking together the multiple individual markets that trade securities. These include national securities exchanges, alternative trading systems (ATS) and market-making securities dealers.
Before the implementation of NMS rules, various empirical studies of trading data found, among other things, that an estimated 1 out of 40 trades for both NYSE and NASDAQ were executed at prices inferior to the best displayed quotations, or approximately 98,000 trades per day in NASDAQ alone.
The following are some of the reasons for the implementation of the above rules.
Ordern Protection Rule
Various experts in equity market trading were of the opinion that if orders are fulfilled at the best prices then investors, particularly retail investors, will have greater confidence in participating in the equity markets. Maintaining investor confidence is an essential element of well-functioning equity markets. Also, the protection of the best displayed and accesible prices will promote deep and stable markets that minimise investor transaction costs. More than 84 million individuals participate, directly or indirectly, in the US equity markets. The transaction costs associated with the prices at which their orders are executed represent a continual drain on their long-term savings. Although these costs are difficult to calculate precisely, they are very real and very substantial, ranging from $30 billion to more than $100 billion per year.
Principles and Objectives of NMS
The following are the principles of NMS.
- Competition among markets and competition among orders
The NMS is premised on promoting fair competition among individual markets, while at the same time assuring that all of these markets are linked together, through facilities and rules, in a unified system that promotes interaction among the orders of buyers and sellers in a particular NMS stock. The NMS thereby incorporates two distinct types of competition - competition among individual markets and competition among individual orders - that together contribute to efficient markets. Vigorous competition among markets promotes more efficient and innovative trading services, while integrated competition among orders promotes more efficient pricing of individual stocks for all types of orders, large and small. Together, they produce markets that offer the greatest benefits for investors and listed companies. The NMS has been designed to create and maintain an appropriate balance between these two vital forms of competition, while avoiding things such as market fragmentation and centralization.
The equity markets in US can be divided into five categories:
- Traditional Exchanges with active floor and electronic trading which offer both automated and manual trading
- Alternative Trading Venues which offer both standard limit orders and conditional orders that are designed to facilitate complex trading strategies.
- Market-making securities dealers which offer both automated execution of smaller orders and the commitment of capital to facilitate the execution of larger institutional orders
- Regional Exchanges many of which have automated systems for executing small orders
- Automated matching systems that permit investors, particularly large institutions, to seek counterparties to their trades anonymously and with minimal price impact.
Note: Unlike US markets, in many other countries, the equity markets typically have a single, overwhelmingly dominant public market.
- Serving the interests of long-term investors and listed companies
One of the important requirements for proper functioning of a market is to minimise the transaction costs, particularly for long-term investors. It is believed that the transactions costs in secondary market and cost of capital for listed companies are inherently related, in the sense that the cost of capital of the listed companies is influenced by the transaction costs of whose who are willing to accept the risk of holding corporate equity for an extended period.
While designing the NMS, the issue is "Should the overall efficiency of the NMS defer to the needs of professional traders, many of whom rarely intend to hold a position overnight? Or should the NMS serve the needs of longer-term investors, both large and small, that will benefit substantially from intermarket price protection?". The SEC, while designing the NMS, have favoured the long-term investors over the short-term as they felt that the NMS must meet the needs of the long-term investors, nothing that any other outcome would be contrary to the Exchange Act and its objectives of promoting fair and efficient markets that serve the public interest.
Long term investors depend on the performance of their equity investments for such vital needs as retirement security and their children's college education. Their investments are reduced by transaction costs of all types, including the explicit costs of commissions and mutual fund fees. But the largely hidden costs associated with the prices at which trades are executed often can dwarf the explicit costs of trading. For example, the implicit transaction costs associated with the price impacts of trades and liquidity search costs of mutual funds and other institutional investors is estimated at more than $30 billion per year. Such hidden costs eat away at the long-term returns of millions of individual mutual fund shareholders and pension plan participants. One of the primary objectives of NMS is to help reduce such costs by improving market liquidity and depth. The best way to promote market depth and liquidity is to encourage vigorous competition amount orders.
Overview of the NMS Rules
Order Protection Rule
The "Order Protection Rule" establishes intermarket protection against trade-throughs for all NMS stocks. A trade-through occurs when one trading center executes at a price that is inferior to the price of a protection quotation, often representing an investor limit order, displayed by another trading center. Limit orders are the building blocks of public price discovery and efficient markets. A uniform rule for all NMS stocks, by enhancing protection of displayed prices, would encourage greater use of limit orders and contribute to increased market liquidity and depth.
Under this rule, a trading center is required to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs or, if relying on one of the rule's exceptions, that are reasonably designed to assure compliance with the exception. To assure effective compliance, such policies and procedures will need to incorporate objective standards that are coded into a trading center's automated systems. The trading center is also required to regularly surveil to ascertain the effectiveness of its policies and procedures and to take prompt action to remedy deficiencies.
The Access Rule governs access to quotations in NMS stocks. The Order Protection Rule (mentioned above) would be futile if broker-dealers and trading centers are unable to access those prices fairly and efficiently. The Access Rules are designed to promote access to quotations in three ways:
- It enables the use of private linkages offered by variety of connectivity providers, rather than mandating a collective linkage facility such as ITS, to facilitate the necessary access to quotations.
- The rule, generally, limits the fees that any trading center can charge (or allow to be charged) for accessing its protected quotations to no more than $0.003 per share. The purpose of the fee limitation is to ensure the fairness and accuracy of displayed quotations by establishing an outer limit on the cost of accessing such quotations. For example, if the price of a protected offer to sell an NMS stock is displayed at $10.00, the total cost to access the offer and buy the stock will be $10.00, plus a fee of no more than $0.003. If the price of a protected quotation is less than $1.00, the fee cannot exceed 0.3% of the quotation price. The adopted rule thereby assures order routers that displayed prices are, within a limited range, true prices.
- The rule requires SROs to establish, maintain and enforce written rules that, among other things, prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross the protected quotations of other trading centers. Trading centers are allowed, however, to display automated quotations that lock or cross the manual quotations of other trading centers. The Access Rule thereby reflects the disparity in speed of response between automated and manual quotatons, while also promoting fair and orderly markets by establishing that the first protection quotation at a price, where it be a bid or an offer, is entitled to an execution at that price instead of being locked or crossed by a quotation on the otherside of the market.
The Sub-Penny rule prohibits market participants from displaying, ranking, or accepting quotations in NMS stocks that are priced in an increment of less than $0.01, unless the price of the quotation is less than $1.00. If the price of the quotation is less than $1.00, the minimum increment is $0.0001. This rule addresses the practice of "stepping ahead" of displayed orders by trivial amounts.
Market Data Rules and Plans
The Market Data Rules and Plans are designed to promote the wide availability of market data and to allocate revenues to SROs that produce the most useful data for investors. These rules strengthen the existing market data system, which provides investors in the U.S. equity markets with real-time access to the best quotations and most recent trades in the thousands of NMS stocks throughout the trading day. For each stock, quotations and trades are continuously collected from many different trading centers and then disseminated to the public in a consolidated stream of data. As a result, investors of all types have access to a reliable source of information for the best prices in NMS stocks.
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