Almost by definition, financial regulators have a thankless job. Industry participants rail against overly burdensome requirements; consumers say that their interests aren’t being considered enough. To make matters more challenging, regulators need to be able to see into the future even as technology increasingly changes the market in unforeseen ways—but everyone has an opinion on exactly how the rule will have consequences in the future.

The Regulation National Market System (Reg NMS) was established in 2005 and provides the fundamental principles of fairness in price execution and access to market data in US securities trading. The Securities and Exchange Commission (SEC) says that technological change and evolving market practices are making aspects of Reg NMS outdated.

Take, for example, odd lots. US equities trading is based on round lots—the standard unit of 100 shares of a stock that a dealer or broker uses to trade. In 2005, odd lots—orders of less than 100 shares of a stock—made up a small percentage of the market. And a decade later, odd lots still accounted for only 20% of market activity.

But then the market started to shift significantly.

According to research done by SEC staff using data from its analytics platform MIDAS, the number of exchange odd-lot trades as a proportion of the number of all exchange trades for all corporate stocks ranged from about 29% to 42% of trades in 2018; in 2019, the rate exceeded 50% several times. The SEC has also found that on average, the measure of bid-ask spread widens significantly when calculated using only round lots relative to the odd-lot quotations displayed on proprietary feeds.

The problem is that, because the NMS is so centered on round lots, all this odd lots liquidity does not appear on the feeds of real-time, consolidated data distributed to the market.

Earlier this year, the SEC rolled out a controversial rule proposal to expand and reform the content and distribution of public US equities market data. The rule has divided market participants, but US exchanges and trading firms do however seem mostly united on at least one aspect of the update: that the currently proposed solutions around odd lots would create more complexity for market participants and threaten the ability of brokers to provide best execution.

The odd lots problem is a problem that is worth tackling. I just don’t think the SEC has tackled it the right way.

Phil Mackintosh, Nasdaq

The controversy is not around the inclusion of odd lots quotations on the public feed, which market participants more or less agree should be the case, and which is what the SEC is proposing. Where the opinions start to fly is the manner in which the SEC wants to achieve that goal.

The SEC’s plan would attach the definition of a round lot to its share price, as opposed to the current definition of the standard 100 shares of a stock. There are several sticking points in this shift, but the most important one, say trading firms, is around the Order Protection Rule (OPR). Odd lots are not protected from trade-throughs under Reg NMS, and still would not be under the new proposal, which, exchanges say, undermines the transparency and price discovery benefits of including odd lots on the public data feeds in the first place, for both retail and institutional investors.

“The odd lots problem is a problem that is worth tackling. I just don’t think the SEC has tackled it the right way,” says Phil Mackintosh, chief economist at Nasdaq.

There are a number of reasons for the rise in odd-lot volume, especially in high-priced securities. One is algorithmic trading, which splits up large orders into smaller ones to avoid creating large price changes. Another is that over the years, corporations have stopped splitting stocks, and some prestige stocks have attained high prices. Retail investors don’t trade in round lots of those stocks. For example, if Amazon is trading at around $3,000 per share, a round lot of that stock would be $300,000. To put that into perspective, $200,000 qualifies as a block-sized trade, Mackintosh says. The average retail trade is $10,000.

“Most of the rest of the developed world has done away with the concept of round lots because computers don’t really care, and they moved back to integers. So if you trade one share, or you trade 97 shares, or 122 shares, it doesn’t matter. And now in the US, retail brokers are doing fractional shares. So realistically, in modernizing the market, we don’t need round lots at all,” Mackintosh says.

As the SEC looks to enact market reforms, the rise of odd lots has major implications for best execution.

For one, odd lots are not reported to—and thus do not appear on—the real-time consolidated feeds of market data distributed to the public by the Securities Information Processors (SIPs), unless they are of sufficient size to be aggregated into round lots.

There are two SIPs—one for Nasdaq-listed securities, and one for NYSE-listed securities. They calculate and disseminate basic, top-of-book market data, notably the national best bid and offer (NBBO). The NBBO is the best available bid and ask prices at which brokers must trade when buying or selling securities for their clients. It was created to level the playing field for investors, ensuring best execution for all. If more sophisticated users want depth-of-book information, including odd lot quotes, at lower latency, they need to buy enriched datafeeds sold by exchanges or have the rights to the underlying data and receive it from aggregators like Bloomberg.

It makes sense to start displaying odd lots because there is a lot of volume, meaningful dollar amounts that are traded that people are willing to buy or sell at prices that are better than the best bid and offer. So why aren’t we displaying that?

Jonathan Kellner, MEMX

However, if odd lots now make up a significant portion of trading volume, and they don’t appear on the SIP feeds, then not only is a growing segment of the market lacking transparency, but brokers who only see the SIP might think they are getting best execution for their clients, while there may be small buyers and sellers at slightly better prices in the market.

“Given the amount of volume in odd lots, it makes sense to make it a part of the data that is published to the SIP, and to make it broadly available,” says Jonathan Kellner, CEO of dealer-backed startup exchange Members Exchange (MEMX).”It makes sense to start displaying those because there is a lot of volume, meaningful dollar amounts that are traded that people are willing to buy or sell at prices that are better than the best bid and offer. So why aren’t we displaying that?”

Reg NMS II?

This is one reason why the SEC is looking to modernize the data disseminated to the market via these SIPs, saying that the SIP feeds are no longer fulfilling their goal of leveling the playing field for all investors.

“Because the content of current core data does not reflect these important market developments, many market participants say they cannot rely solely on SIP data to trade competitively and provide best execution to customers in today’s markets,” the SEC stated in its February consultation paper.

The SEC published the market infrastructure proposal on February 14 this year, following a related proposal published in January, which sought comment on governance provisions for the structure of exchanges’ NMS plans. The public had until May 18 to comment on the Valentine’s Day proposal, and the SEC is now considering the consultation responses from exchanges, buy-side firms, dealers, data vendors, and others.

The round lots redefinition is just one aspect of the changes represented in the proposal, which some buy-siders and exchanges are calling Reg NMS II, in reference to what they say is a fundamental overhaul to the NMS that touches on every rule in the regulation.

Apart from new data definitions, the proposal seeks to establish a decentralized consolidation model: the two SIPs disseminating the NBBO would be replaced with around 12 vendors, called competing consolidators, supplemented by self-aggregators (broker-dealers that would generate market data for their own use but would not distribute it externally). These competing consolidators would develop their own consolidated market data feeds, but could also sell data products. The NBBO would become multiple BBOs localized in these entities.

The decentralized competing consolidator model would reduce geographic latency for subscribers by facilitating the delivery of market data more directly, as it would not have to be sent to a separate location to be consolidated by the exclusive SIPs, the SEC says.

The SEC notes that “of the odd-lot transactions executing at a price better than the NBBO during all of the trading days in September 2019, approximately 38% of such transactions and 61% of the odd-lot volume were in sizes that would be round lots under the proposed rule.

At the same time, more data would go onto the SIP feed. “Core data” would be defined so as to include what the SIPs already disseminate, plus the odd lots data, certain depth-of-book data, auction data, and some regulatory data. To include the quotation data for smaller-sized orders round lots would be redefined: instead of being 100 shares, they would be based on a dollar value, with five tiers of round lots based on a stock’s average closing price on an exchange for the prior calendar month, ranging from $50 or less per share to $1,000 per share.

By setting these levels, the SEC hopes to capture more odd lots as round lots, which would therefore appear on the SIP feeds. The Commission notes that “of the odd-lot transactions executing at a price better than the NBBO during all of the trading days in September 2019, approximately 38% of such transactions and 61% of the odd-lot volume were in sizes that would be round lots under [the proposed rule].”

However, order display would be required without protection: that is, odd lots would still not be protected under OPR, also known as the trade-through rule. The OPR is a lynchpin of Reg NMS’s fairness principles, and makes trade-throughs—trades that are filled even though a better price was available on another exchange—illegal. But the rule was written in a time when round lots represented most of the market, and odd lots are not protected from trade-throughs.

The proposal keeps trade-through protection pinned to 100 shares, creating an NBBO based on the new tiered round lots, and a protected best bid and offer (PBBO)—applicable only to quotes of 100 shares or more.

Protection Racket?

A diverse array of exchanges—including NYSE, Nasdaq and Cboe, as well as newer, disruptive entrants to the market IEX and MEMX, which were founded in part as a response to industry frustrations with the NMS status quo—responded to the SEC’s consultation. Though their responses vary according to their commercial interests and points of view, all broadly agree that they are in favor of improving the data on the SIP and reforming round lots. But they differ from the SEC’s proposals on how best to achieve this.

NYSE, for example, agrees with the commission’s approach up to a point, recommending that it expand SIP content with depth-of-book data and an NBBO-only version for retail customers, and mandate round lot reform.

Elizabeth King, chief regulatory officer for NYSE, said in her consultation response, however, that the exchange believes the best way to address the lack of odd lot data on the SIP would be to include the best-priced odd lot quotation from each exchange in the definition of core data.

“Absent that, NYSE agrees that a market-wide graduated ‘round-lot’ definition based on each security’s share price could be a low-effort technical solution to ensure investors can access liquidity currently inside the SIP’s NBBO—provided the relationship between round lot and protected quote status is preserved,” King said.

Nasdaq’s global chief legal and regulatory officer, John Zecca, on the other hand, gives a more aggressive critique, kicking off the exchange’s 63-page consultation response by saying the proposal “is too risky to adopt.”

“The commission fails to recognize, and thus insufficiently analyzes, how the proposed rule would essentially rewire the equity markets,” Zecca said, adding that the proposal violates not only the Administrative Procedures Act (by failing to engage in a sufficiently robust qualitative or quantitative analysis), but the US Constitution itself, in that it “takes from exchanges their market data without adequate compensation.”

The exchanges agree, however, that order protection must be extended to odd lots. “In proposing to exclude from protection smaller-sized quotations in higher-priced stocks, the commission suggests (but does not outright state) that it shares the views of some market participants that Rule 611 [the OPR] has negatively impacted equity market structure, and that it should be repealed,” Zecca said in his response, adding that extending order protection to the proposed new round lots is necessary to ensure best execution.

MEMX’s Kellner agrees that this is a concern. “The OPR says that the displayed best bid or offer needs to be protected. For both institutional and retail—but especially retail—if you see a price on the screen, you expect to be able to get that price,” he tells WatersTechnology. “And we have all, ever since the OPR was introduced, been really focused on our ability to get the best bid or offer.”

The proposed method would create confusion in the market over what is available and what is protected, he says, placing the onus on brokers and the exchanges that route the orders to make decisions about what is best for the client. “Let’s say you start displaying the odd lots, but they’re not protected,” he says. “You might have something that is offered at $900 per share for a round lot. The odd lot could be $850, but because that $850 quote isn’t protected, a broker might say, ‘In order to ensure that I get 100 shares filled, I am going to pay $900.’” 

Kellner says MEMX isn’t against re-evaluating the OPR, but says it should be done completely separately from this infrastructure proposal. “The commission needs to do effective analysis, modelling, maybe even a pilot to determine if eliminating the OPR makes sense. But to just put it in this proposal, create all this confusion, and then potentially impact the current market structure is not the right approach,” he says.

Buy-side firms who responded to the proposal seem to agree with the exchanges on these issues.

BlackRock’s Hubert de Jesus, global head of market structure and electronic trading, and Samantha deZur, director of global public policy, wrote that the asset management giant “strongly opposes” the proposed changes to the OPR.

They note that the proposal says that best execution obligations apply to odd-lot orders, which the SEC believes would be enough incentive for market participants to engage with meaningfully sized orders as they already have visibility into odd-lot quotations. However, they add, academic research has shown that trade-throughs of non-protected odd lot orders are frequent, resulting in hidden costs for equity traders.

“Applying OPR to the new round lot definition at the outset is essential for promoting fairness in trading outcomes and achieving best execution for investors. Further, the introduction of an NBBO that deviates from the PBBO would increase complexity and sow confusion,” they wrote. Apart from the confusion for market participants having to apply disparate odd-lot aggregation methodologies and conflicting reference prices between the NBBO and the PBBO, they would be required to update their systems and routers.

“The substantial implementation effort associated with this revision to the OPR are an added and unnecessary cost, as no adjustments would be required if the newly proposed round lots were protected,” they add.

Charles Schwab’s letter, likewise, said that the investment firm believes that the OPR “should be extended to any new round lot sizes established by the proposal. With Reg NMS, the SEC found that price protection encourages limit orders as it increases the likelihood an investor will receive execution—which will foster confidence in the market.”

In Q1 2020, some 23% of Schwab customers’ limit orders for stocks priced higher than $100 are for fewer than 100 shares, and so would remain unprotected, the firm’s letter adds.

T Rowe Price, however, doesn’t see the SEC’s approach to the NBBO and PBBO as eliminating restrictions on trade-throughs. “Rather, we agree with the SEC that the OPR would be applied under the proposal similarly to how it is handled today,” the asset manager wrote in its letter, which is signed by Mehmat Kinak, global head of systematic trading market structure, and Jonathan Siegel, senior legal counsel of legislative and regulatory affairs.

Kinak and Siegel say they are not convinced that the proposal would alter asset managers’ best execution obligations as a result of potentially different reference prices between the NBBO and the PBBO, or that it was a burden for asset managers to ensure that broker-dealers achieved best execution. The buy-side should as a matter of course be evaluating broker-dealers’ best execution capabilities with nuanced assessments of multiple factors, they said.  “Having the knowledge and understanding of how one’s broker-dealer utilizes an NBBO versus PBBO in their routing or mid/peg-pricing should already be part of asset managers’ best execution due diligence. Simply looking at whether a broker-dealer satisfied the OPR should not, in our view, be a mechanical barometer for determining best execution,” they wrote.

Broker-dealers themselves have visibility into odd lots anyway—they just have to subscribe to the richer proprietary feeds, the letter states.

Extending the OPR to odd lot quotations would have significant trading implications, forcing market participants to display quotes in very small sizes. “This would not be a good outcome, as asset managers with large transactions would increasingly have to further ‘slice’ their trading activity into smaller increments to avoid signaling their full trading interest to the market,” they said.

A source at a smaller asset management firm tells WatersTechnology she was surprised to see what the proposal did with the PBBO. “That makes a lot of complexity around the NBBO and PBBO, where the PBBO is only quotes of 100 shares or more, but the NBBO is based on new round lot quotes. So if there is one share of Amazon, it’s not protected, but if there are 100 shares of Amazon, they are protected.”

However, she adds that this won’t have much of an effect “on the way we trade, or our best execution, but it would be confusing for retail.”

Changing of the Guard

With the consultation now closed, the SEC is considering the responses and meeting with various stakeholders. While some had hoped for an extension to the consultation process, sources on the buy side and at exchanges say they don’t expect to be given more time to consider the 595-page infrastructure proposal, Covid-19 disruptions notwithstanding.

The forces behind the Reg NMS update are two vocal individuals: SEC chairman Jay Clayton and Brett Redfearn, the director of the SEC’s Division of Trading and Markets. Clayton’s five-year term ends next year, and several sources said they believe that Redfearn, who has been at the Commission since October 2017, is unlikely to stay in his role much longer than Clayton in his.

With the clock ticking on Clayton’s tenure, he is going to want to put his stamp on the Commission, and in Redfearn, he has an ally. While the changing definition of odd lots might be left for another administration to rule on, the SEC—as it’s constituted today—is clearly interested in reforming the content and distribution of public US equities market data.

Despite the contentious fight that is shaping up between regulators, exchanges and market participants on the modernization of the markets—on odd lots and on broader issues—the regulators will find support in their efforts to level the playing field between the SIP and the direct feeds. The industry just wants to be heard on its concerns. 

As MEMX’s Kellner says: “We appreciate what the regulators are doing in terms of trying to make changes to the SIP and to market data in general… But there are some specifics that we think the commission should understand from a market data perspective what the goal is.”