SEC’s Bid to End Order Protection Rule Stirs Industry Debate

The SEC proposal to rescind Rule 611 in Reg NMS and related rules on locked-and-crossed markets is sparking debate on how fundamental changes to US equity market structure could impact the future of electronic trading.

The proposal would dismantle Rule 611, known as the Order Protection Rule, or trade-through rule, which requires brokers to avoid trading at an inferior price on one exchange, if a better price exists on other exchanges.

Many market participants who submitted comment letters agree with the SEC’s view that Rule 611 has not lived up to its potential, and that instead of incentivizing lit liquidity, it has caused venue proliferation, fragmentation of liquidity across exchange order books, and high connectivity and market data costs.

But critics have raised concerns about the effects it could have on displayed liquidity, competition between venues, order routing, and best execution. Individual investors have objected to removing guardrails guaranteeing them the best available price, suggesting that brokers would rely on their own internal routing preferences.

Wayne M. Aaron, partner at Katten, who is Co-Chair Broker-Dealer Regulation, said the proposal reflects the SEC’s broader goal of seeking to simplify regulatory complexity and allowing market forces to determine how liquidity is displayed and accessed.

“It’s very balanced, letting market forces work it out and on reducing complexity and fragmentation,” Aaron said.

According to Aaron, the 267-page proposal is notable for asking participants numerous questions about the rules rather than prescribing a detailed alternative framework. “It’s a whole lot of ‘proposing,’ asking commenters what they think about ‘this facet’ or ‘that facet’ of the rule.” It is not clear whether the proposal will go forward, as some commenters question whether there is a need to repeal the rule.

Potential Consolidation of Trading Venues

One of the big questions is whether removal of the trade-through rule could accelerate consolidation of exchanges. Today, Rule 611 practically guarantees that brokers and routing systems must consider the protected quotes of smaller exchanges. This has led to high connectivity costs since brokers had to connect, either directly or indirectly, to every startup exchange that displayed protected quotes.

Without order protection, some market participants could choose not to connect with venues with limited volume or liquidity, he said.

“I think the overriding theme of the proposal is that – if it is adopted, there will be a little bit of growing pains,” Aaron said. “We’re not entirely sure what we’re going to see, because no one has seen a market structure without a trade-through rule for some time. If the rule is repealed, I think the market structure eventually will reach some equilibrium, but it will take a little bit of time.”

While some observers suggest that repealing the rule will negatively affect venues with minimal liquidity, Aaron believes that liquidity is more likely to migrate to other venues rather than fully disappear.

“There may be a concentration on Market Center C, instead of Market Center A. Does that mean that A may not survive or be consolidated? Potentially, said Aaron, “but it still means that the liquidity, quote, or interest now represented on Market Center C will still be displayed.” There could potentially be a consolidation of venues, he said.

If liquidity is concentrating on fewer venues, then it’s a lot easier to check or be connected to (for example) 5 prominent venues, rather than 17, said Aaron. This also could make it more efficient for institutional traders to execute large orders or block-size trades. “If this were to happen, this would result in reduced connectivity fees and reduced fragmentation, all the changes that the Commission is exploring and might want to happen.”

What Happens to the NBBO?

Another consideration is whether eliminating protected quotes could weaken the national best bid and offer (NBBO), which consolidates all the best prices across exchanges and serves as the benchmark for execution quality and best execution.

Critics argue that if brokers are no longer required to interact with displayed quotations, traders may have less incentive to post lit liquidity, which could affect quoting quality and deter firms from posting better priced limit orders.

Aaron recognizes the concern but said the outcome is uncertain.

“There are two arguments. One is: ‘Why bother displaying,’ and if that occurs that might result in widened quotes,” he said. The other is that “people will continue to display; they just display on more concentrated markets and maybe that will help fragmentation.”

Aaron thinks the NBBO can remain as strong, but again, it could be consolidated from fewer venues. “If the proposal goes forward, it will take a little bit of time for everybody to figure out where the markets of interest really are and where pools of displayed liquidity should aggregate,” he said.

But some market participants caution that rescinding the trade-through rule could weaken the National Best Bid and Offer (NBBO), which has served as a backstop for best execution.

In a comment letter, Jeff Martinez, a founder and financial advisor at Treveri Capital LLC, who is a former electronic floor broker on the Pacific Exchange, writes that the SEC’s diagnosis of Rule 611 is correct, but the remedy is wrong.

“Rule 611 is the single mechanism that ties execution prices across venues to the best displayed quotation. Remove it, and investor protection rests entirely on the duty of best execution.”  In the comment letter, Martinez, who worked previously for a wire house and now serves retail investors, maintains that the duty of best execution, which is independent of Rule 611, is not a sufficient substitute.

Similarly, 24X National Exchange writes that the NBBO has provided retail investors with a single, transparent benchmark for evaluating market prices. “Retail investors benefit from the confidence that the NBBO represents the best protected quotations across the national market system, regardless of which brokerage platform they use.”

If Rule 611 is eliminated, 24X suggests that brokers will have leeway to select which quotations are considered by their order routing strategies.

“Without a regulatory requirement in place to protect the best displayed quotations, broker-dealers would have greater discretion in determining which quotations to incorporate into their routing and pricing methodologies.”

Best Execution Becomes More Subjective

Under the current framework, compliance officials tend to rely on NBBO-based metrics to evaluate best execution, notes Aaron. Since executions come from the displayed quotes, evaluating executions has become highly mechanical.

That could change if Rule 611 is repealed.

“Everyone knows what EQ and what the NBBO is, and the current process has largely become formulaic because all the data are there and comes together,” said Aaron.

Without the trade-through rule, firms will have to go back to trade-by-trade analysis, resembling the way it was in the 1990s. For example, if there were a 200-share quote on a market, they would look at the overall size of the potential execution and decide if it was reasonable to access the small size.

“I think it will remain a process, but will become a little bit more subjective,” he said.

They may need to look holistically at the entire execution to determine how best execution should be evaluated. He also predicts a shift toward best-execution analysis at the parent order level, rather than at the child slice level, he said.

Compliance Savings: Intermarket Sweep Order

If the order protection rule is dismantled, traders could see the end of the intermarket sweep order or ISO, an order type which enables traders to stay in compliance with the trade-through rule.

By labeling an order as an ISO, the trader takes full responsibility for routing simultaneous orders to any other displayed markets that have better-priced quotes.

“It’s the way you effectively satisfy obligations,” explains Aaron. “If you know you will be trading through a certain number of [protected] quotes, you can execute at a price that would constitute a trade through but satisfy the trade-through obligations.” 

For example, if a broker is crossing 300,000 shares of a particular stock, and another market center is offering 300 shares at a better price, it currently must justify not going to that other market. A broker will most likely take that 300 shares into its principal trading account and sell [it]out at some small loss as an expense of doing business, said Aaron.

If the trade-through rule goes away, then ISO will disappear, said Aaron. But a broker will still need to go through the overall argument of best execution on crossing a large order, explaining they would have incurred an extra cost. If the rule is rescinded, it will make it easier for broker dealers to handle those orders, he said.

Locked and Crossed Markets Remain Uncertain

 The SEC is also proposing to remove the condition in Reg NMS that basically tells that market centers to adopt rules prohibiting locking or crossing markets.

“By removing that condition, it’s now left to each market center to determine whether they want to remove their rules or modify their rules. Part of the Commission’s analysis was to let market centers compete on that as well,” said Aaron.

The provision on locked and crossed markets relates to addressing access fees. In the 1990s, some traders did not want to pay an access fee to trade against another venue’s quote. When they saw an offer, they bid at the same level. “It became a standoff,” said Aaron.

“That resulted in a locked or a crossed market, driven solely by access fees.”

At the SEC roundtables, there was a lot of discussion on locked and crossed and it was intertwined with access fees. “The Commission has made proposals on just a small bit of it, rescinding 611 and opening the door a little wider for locked and crossed markets,” he said. But the SEC delayed the implementation of the tick size and access fee amendments until November 2027.

What’s Next?

Market participants have until August 17 to submit their comments on the proposal, which is going through the full rule making and commenting period. After that, the SEC is expected to deliberate.

While this is just a proposal, Aaron notes that it has the unanimous support of the Commission and certainly has legs. That said, Aaron noted that there is some opposition to changing the status quo, so that adoption is uncertain.

There could be a little more work to do on the proposal.

“It took time for this market to coalesce in a post-Reg NMS environment,” Aaron said. “If the proposal comes to fruition, we’ll have to see how it works in a post-NMS environment.”

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