Why would anyone criticize the order protection rule that means well?
What is the order protection rule?
The NMS or the Regulation National Market System has four main provisions. One of them includes the order protection rule. It ensures that the investors get an execution price equal to the quoted price on any other exchanges where a specific security is traded. This avoids a trade-through of orders. What is a trade-through anyway? It means that the order is traded at a price worse than the best or a better price. The rule also ensures that all exchanges enforce policies that ensure consistent price quotations for every NMS stock. And when we say this, we include those from the major stock exchanges and several OTC or over-the-counter stocks. Other people also refer to the order protection rule as Rule 611 or the Trade-Through rule. Aside from the order protection rule, the other three provisions of NMS include Access, Sub-Penny, and Market Data Rule.
How does it work?
The Regulation NMS and Order Protection Rule were created for markets to have more liquidity and transparency. If we are to name things that can make it possible, better data access in general, better quote displays, and fair prices are what we need. In 2005, SEC passed this regulation. All that time before 2005, no rule protected investors from trade-throughs. It was explicitly true when it came to limit trades. Investors tend to get worse prices compared to the quotes that can be found on different exchanges. Hence, SEC passed this rule which aims to protect quotations for securities across the board. In this way, all market participants will get the best possible execution prices for the orders available to be executed immediately. Trading centers need to create, maintain, and enforce policies and procedures to avoid trade execution at worse prices than the quotations from different trading centers. The order protection also comes with the national best bid and offer requirement, which requires brokers to route orders to the execution venue that provides the customer’s best interest.
Why the criticism on the rule?
The order protection rule received criticisms in the long run. But why? They say that this mandates stock trade on exchanges showing the best quote prices. However, it is also a reason why there is excess fragmentation in trading venues. Hence, it adds in the market complexity and the connectivity costs to market participants. It made transactions more expensive because the trade-through restrictions somehow gave participants no choice but to route their orders to lit venues they did not really want to engage with. Also, they say that it became a reason why dark trading increased. Dark trading is when the buy and sell of stock do not materially affect the market. People think that the restrictions are the main factors why this happened. If we are to enumerate one more reason for criticism, we can say that others feel that it harms institutional investors who wish to make massive trades. They have no choice but to engage with small size quotations because of the restrictions.