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Nazareth Reviews Possible Reg. NMS Guidance

Annette Nazareth, director of the SEC's Division of Market Regulation, acknowledged the delay in the release of Regulation NMS, which was adopted April 6, but said that it contains no surprises. The few changes that will be included in the release, which largely reflects the reproposal of December 2004, were made to accommodate requests for additional flexibility or to make the meanings more clear, according to Nazareth . In the prepared text of her May 20 speech before the SIA market structure conference, Nazareth reviewed the areas in which the SEC is likely to issue additional guidance on the implementation of Regulation NMS.

Regulation NMS was subject to vigorous disagreement and debate, Nazareth noted, but given its complexity and the various interests affected by the reform measures, a consensus was not expected. Some urged the SEC to repropose the rules a second time before adoption, but the Commission concluded that five years of debate was long enough. The Commission adopted Regulation NMS to provide regulatory certainty in the equity markets. Nazareth said the recently announced market consolidations reflect the need to maximize economies of scale, reduce excess capacity and respond to the demand for more automated trading at the NYSE.

The application of the order protection rule across all markets gained a great deal of attention, according to Nazareth . She said the market consolidations demonstrate the rationale underlying Regulation NMS. By leveling the playing field across markets, they now compete directly under rules requiring best price, open access and transparency.

Nazareth denied rumors that the delay in the release of Regulation NMS was based on the intention, through rule text or staff action, to limit or discourage the number of new electronic communications networks or alternative trading system entrants into the marketplace. She said the rumor was preposterous. She also quashed rumors that certain ATSs, such as Liquidnet, were exempted from the order protection rule in the final release. Liquidnet requested an exemption from the 5% fair access standard since it does not publish quotations, she explained. The SEC recognizes the logic of the request and will consider the exemption request during the implementation period for any entity that operates as an electronic block trading desk and does not disseminate public quotations, she advised.

Nazareth also has gotten calls from those who believed that the final order protection rule was revised to require the protection of reserve size. Imagine mandating the protection of an order you cannot see, she said, in denying that rumor as well.

The implementation of Regulation NMS will require securities industry input, Nazareth said. She anticipates working closely with industry participants and groups during the implementation process. As key issues surface during this process, Nazareth said the SEC will provide interpretive guidance, as warranted, on issues that are likely to arise, such as questions concerning automated markets and automated quotations. For instance, the staff may issue guidance to the industry that a trading center does not qualify as automated, she explained, which would provide other trading centers with the ability to bypass the nonautomated trading center for purposes of the order protection rule.

Nazareth also expects questions to arise with respect to the policies and procedures necessary to comply with the order protection rule. The SEC will likely provide industry-wide guidance, she said, but all trading centers will not be expected to have identical policies and procedures. Another area that may require guidance relates to surveillance procedures. She said the input of industry participants will be beneficial in determining the frequency and scope of the required surveillance procedures.

The policies and procedures for block positioners, as well as hybrid markets, will have to address the standards for manual executions as well as fully automated trading, according to Nazareth . She explained that, to take advantage of the intermarket sweep exception to the order protection rule, trading centers will have to automate their execution process so that at the time the order is executed, the systems evaluate the existing protected quotations and route the orders accordingly. The time of execution should be recorded separately from the trade reporting time, if they differ, she said.

The staff also is likely to provide guidance to trading centers as they develop standards for implementing the self-help exception, according to Nazareth . Prior to providing the guidance, however, she said it would be helpful to discuss with the industry the problems they currently experience and how they are resolved. Nazareth also predicted that there will be questions about the scope of the benchmark exception to the order protection rule and advised that industry input will be essential before granting exceptions.

The overarching duty of best execution will continue, Nazareth advised. She expects the release to state that, when trading in a stock is largely automated, a broker can reasonably determine to bypass manual quotes of a nonprimary market if its experience has demonstrated that an attempt to access the market would not be in its customers' best interests. There is much to do, she observed, and only a year to get it all done before the implementation date.