Implementation v Intent I: Regulation National Market System (Reg NMS)

Only through continual comparison of implementation & impact against intent will regulatory change achieve its original goals.

Just as financial firms must be constantly adapting to changing conditions, so too must regulators. Rules must be reformed when markets are deemed to be falling short of their purpose; when the forces of demand and supply can no longer interact efficiently and run counter to the functions that financial markets are designed to play in society.

In the past two decades, and most acutely since the financial crash of 2008, regulators have sought to prevent the financial system from breaking out of its boundaries and reaching its worst excesses. Most famously, in 2010 President Barack Obama signed the Dodd-Frank act into law, which affected every corner of the United States’ financial services industry.

How successful has it been? Or to unpack the same question – to what extent has its implementation matched its intent? Much remains to be seen, for many of the measures mandated by Dodd-Frank are yet to be fully implemented. Likewise, MiFID II – which was first intended to go into effect on January 3, 2017 – was delayed for 12 months and is even now the subject of last minute clarifications and potential adjustments. As such, these big questions have no simple or immediate answer, though we will seek to explore competing perspectives on them in a series of blog posts concerning ‘implementation vs. intent’ in the world of financial regulation.

As our exploration of this idea will show, in the lead up to the official implementation of MiFID II on 3rd January 2018, it is worth keeping in mind that the impending date marks another phase of an ongoing process rather than discrete event. For an example of how this is the case for financial regulation globally, we can look to a piece of legislation that took effect just before the crash.

In 2005, the Regulation National Market System (Reg NMS) was promulgated by the US Securities and Exchange Commission. Described as “a series of initiatives designed to modernize and strengthen the National Market System for equity securities”, it had the dual aim of fostering both “competition among individual markets and competition among individual orders”. Prior to this legislation, there existed a significant degree of fragmentation between regional and national markets, such that the same stock sometimes traded at different prices at different trading venues. Reg NMS, as the name suggests, was designed to bring about a National Market System.

Over a decade after its implementation, however, and the US trade group for the securities industry is calling for a review of these rules. It has been stated that while Reg NMS has been successful at increasing competition, it is also responsible for having fragmented the market in a different manner than previously existed. Some believe this has encouraged the predominance of speed as the market’s key determinant to success or failure.

Earlier this year, Randy Snook – executive vice-president, business policies and practices at the Securities Industry and Financial Markets Association (SIFMA) – told the Financial Times that it is time “to review the intent of Regulation NMS, its real-world impacts to investors, and possible rule changes to increase its effectiveness.” Specifically, it is possible that what is known as the ‘order protection rule’ will be re-evaluated. Its original intention was to make sure that trades took place at the best-quoted price by encouraging venues to quote equivalent prices for a security. However, SIFMA has now suggested that a volume threshold could be instituted for ‘protected status’ and that large orders of a specified volume could be exempt.

In effect, these would represent attempts to update (or revise the implementation of) Reg NMS to ensure it continues to achieve its original intent. And this is nothing if not a good thing.

As we’ve written recently in New Europe, some regulation is more reactive in nature and some more evolutionary. What is important is for regulators to remain always adaptable to changing conditions. When the effects of implementation don’t match their intent, or when conditions change, regulators must not hesitate to rethink things.

How can regulators be kept on track? Paradoxically, and perhaps ironically, it is the financial markets and all market participants which must assist in this regard. The sooner we realise that regulators, financial markets and market participants have a symbiotic relationship, the more effective will be continued discussions on these issues, discussions which should always be driven by the goal of improving market efficiency and fairness.

Regulators have in many cases opened the door for such dialogue, a case in point being the recent move by ESMA to open a consultation into proposed changes to MiFID II before it has even been fully implemented. It is now up to us, as market participants, to engage in those discussions, to continue the evolution of financial regulation.

Hugo Kruyne, November 20, 2017.