Order Protection Rule (a.k.a. Trade Through Rule) is always a bit confusing given what it wants to achieve in a complicated, fragmented market environments.
Here I am trying to summarize and clarify some of the confusions ,that initially puzzled myself, and given references where it is possible.
Only Top of Book is Protected
First we need to understand what the rule is protecting and how does it enforce that.
Using US Stock as example, we will model our trading world as a list of so-called “trading centers” where stocks are quoted by all its participants while at the same time, order execution/modification/cancellation constantly changes the bid and ask quotes.
So each trading center can be modeled as one data source emitting constant flow of its quote books which changes quickly.
For example, below is what a typical depth of level 2 book for Apple looks like, with many levels of price for both buy and sell.
This trading center’s best bid and best ask is currently at 324.02 ~ 324.10 with spread being 8 cents.
If we aggregate all those different trading center’s best bid and best ask and sort them from high to low we would have something called “quote montage”.
It is called “Montage” because it does not give you top N best bids and ask quotes but simply glues best bid/ask from each trading center.
And that’s our protected quotations and that’s also what gets published onto the consolidated feed such as SIP.
To give an example:
if NYSE has below quotes (only price is showing):
BID ASK (NYSE)
and BATS has below quotes:
BID ASK (BATS)
Then the montage will be created using:
BID-EXCH BID ASK ASK-EXCH
NYSE 100 101 BATS
BATS 98 102 NYSE
So even if NYSE’s second best BID price (99) is better than BAT’s best BID price it’s not protected.
Now that we know what quotation is protected we can tell what kind of protection is enforced:
Basically you are supposed to give those quotation higher priority so if you got a trade executed at inferior price than the montage you virtually “trade through” them and you will have some hard time facing scrutiny of SEC.
So key thing here is: only top of book of each trading center is protected, not the depth of the book, even if they “can” be better.
Not every trading center is protected
US Stock trading market has become fragmented over the years and now if you send an order to your broken it might travel a long way before it gets executed.
It probably will attempt first your broker’s dark pool to see if there is any internalization opportunity to save cost for the broker (e.g. if Goldman is your broker they might try their own Sigma-X first).
Then it may try one or several low-to-zero-commission dark pools to save commission and reduce price impact by not leaking order info to the lit markets.
Those external dark pools are sometimes maintained with low commission to give HFT traders a chance to fill any order flow therein so would be different from those internalization-purposed dark pools.
It may then also try some the inverted rebate venue to get some rebate for the broker.
And finally it may go to one of lit markets seeking best execution by NBBO or post there if it is not marketable.
So overall you have lots of places to trade and that number nowadays in US is about 40 to 50!!
Not all of those trading centers are protected however.
For example Dark Pool are not included for the apparent reason they won’t even publish quotes book!
So what kind of trading centers are protected?
According to SEC there are 2 categories of trading centers:
- National Security Exchanges that provide fast automatic quotations, currently there are about 13 such exchanges
- a national securities association (currently FINRA through its Alternative Display Facility (“ADF”)
And here is a list from NASDAQ’s NASDAQ regnms FAQ:
And very naturally if you wish to route to those market centers when they have the protected quotes you need to hit you have to be sure you have the connection to them all.
National Best Bid Offer,a.k.a. NBBO is the best of the “montage” book we talked about earlier.
That’s the best price you are expected to get and the price you are not supposed to ignore.
To put it this way, even dark pool has to use that as reference price to decide on its crossing price. Though in practice some dark pool maintainers use slow SIP feed which may always give accurate NBBO.
When are they protected
Modern markets can trade longer time than you are awake each day.
Regular markets for US goes from 9:30am to 4:00pm ET and can do half day on holiday events.
But there are also post market trading in some markets with less liquidity and wilder prices for you to trade.
They exist for a reason. For example, if you are desperate to get rid of your position before end of day you might find post market trading your only choice.
So SEC has been clear in its rule that protection is only enforced during Regular Trading Hour.
Trade Through Definition
So now we can properly follow SEC in its definition of Trade Through:
A trade-through is defined as the purchase or sale of an “NMS stock” during “regular trading hours” (9:30 a.m. to 4:00 p.m. ET), either as agent or principal, at a price that is lower than a protected bid or higher than a protected offer. An NMS stock generally means any exchangelisted security (other than listed options) for which consolidated market data is disseminated.
Routing is not enforced if you can do better
So normally if there is a better price at a different trading center you are required to route there for better execution.
But remember the protected quotes are nothing but a “montage” so in our earlier example NYSE actually has better quotes than BATS’s protected quotes.
So here is the deal – if you are able to trade at equal or better price than another trading center’s protected quotes you are free to trade by your own quotes!
And this has actually been how some of the dark pool works by claiming to give “price improvements” than NBBO: for example to cross at mid point price that save half of the spread for both sides.
You have your discretionary of routing, sometimes
So we know if you don’t have better or equal matching quotes you are required to route.
But what if two exchanges happen to have the equal best “price”?
This is the so-called “trade at situation and you have the freedom to decide on where you want to route your orders.
Isn’t that great?
Protection Exception: Intermarket Sweep Orders (ISO)
ISO order is an interesting and frequently used exception to the order protection rule.
It is brought up to address institutional traders’ concern when it has to fill large qty quickly.
By the default rule it has to route small orders around to chase protected quotes and that normally is small in size, a couple of lots maybe due to the use of “display size”.
Worse due to slow feeds or High Frequency Traders that protected quotes may be long gone by the time your order gets there and you end up chasing phantom quotes.
And finally if you always have to satisfy relatively smaller-sized protected quotes before you chip into the depth of the books for chunky quotes, by the time you do so, other predatory algorithms may have figured out your intention already and use that to go against you.
To address this, SEC has this ISO exception that you are allowed to take out depth of book of a certain trading center as long as you have sent out the order by the better protected quotes to those other trading centers simultaneously.
No waiting and you are allowed to happily dig deep!
More importantly trading centers such as NYSE may have specially devised such order type to help you.
For example, NYSE offers an “NYSE IOC Order” that “will be automatically executed against the displayed
quotation up to its full size and sweep the Display Book® system, to the extent possible, with portions of the order
routed to other markets if necessary in compliance with Regulation NMS and the portion not executed will be immediately cancelled.
And NASDAQ provides similar MOPP orders:
ISO is your duty
Though NYSE and NASDAQ can help you fulfill ISO duty by allowing you to send special order types, it is largely your duty if you directly send ISO order types to them.
So if you, as a broker, send ISO to NYSE with the intention to capture NYSE’s depth of the book, you must make sure you have sent other orders by the displayed protected quotes at the same time.
Any trade though therein will be charged against you only so it is vital you preserve any vital evidence if you do plan to use ISO.
Day ISO can be a loaded gun
people normally use IOC ISO to have the order cancelled back if it is unable to get fully filled within its limit price, even if it has tried to capture local depth of book.
Day ISO however is a harder to use order type since anything not filled may be left at the book, without routing and potentially cause the markets to get locked or crossed.
And in that case, SEC will chase you for locking/crossing the markets.
Below are extracted from again NASDAQ’s NASDAQ Regnms FAQ:
Protection Exception: Benchmark Execution Price
For certain type of matching engines, they cross the order at benchmark execution price rather than market quote price at the time of crossing.
For example, if an engine holds periodic crossing phase of 10 minutes and cross both sides of participants with 10min VWAP price, it is okay the VWAP price can be a trade through compared against then-protected market quotes.
There are however certain restrictions to make the exception justified – for example, order has to be entered before start of the crossing phase otherwise someone may try to game the system.
There is no such global consistent protected quotes or even NBBO
Contrary to most common belief, there is no global consist protected quotes or even globally agreed NBBO.
It mainly has to do with technology challenge there in – even if everyone uses SIP as the sole source of quotes it may arrive at traders at different time due to propagation delay.
And that explains many of the exchange provided Co-location initiative which allows you to station your server in the same data center of exchange’s matching engine server’s.
In some extreme cases, COLO providers even promise to wire the same length of cables to each of the COLO users to make sure they have a level playing field, at least within the data center.
So that is one obvious technical difficulty but obviously not the only one.
SEC does not mandate you to use a specific feed for protected quotes.
In fact, private exchange direct feed is usually faster and more reliable than SIP feeds.
A sophisticate algorithm provider or HFT firm may choose to source from various exchange direct feed and create its own vision of protected quotes and NBBO.
It is usually more accurate than SIP which suffered from phantom quotes issue – the quote is stale and you are guaranteed to be not able to hit it.
Then again, even if you use the same exchange direct feed as another firm, those various feeds, carrying identical data, may arrive at your trading engines at different timing.
After all, you cannot Colo your server to every exchanges at the same time.
So you are fine to use any data feed you like as long as you are able to present evidence that you have followed and respected protected quotes that you saw at the time – especially you tend to trade through a lot and will need to explain to the regulators.
This has also brought with it the well know issue of Latency Arbitrage where a HFT engine may see more up-to-date quotes and use that to trade against users trading by the slower SIP quotes.
For example, Goldman’s Sigma-X was said to switch from slow SIP to Redline for better performance.
One Second Window Exception
This is a rather interesting exception and was probably invented due to the difficulty of maintaining a globally consistent protected quotes and NBBO view.
as quoted from SEC doc:
This exception is primarily designed to deal with the practical difficulties of preventing intermarket
trade-throughs during a fast-moving market when quotations can change rapidly. If a trade is
executed at a price that would not have been a trade-through of protected quotations as they
stood at any point within the previous one second (the one-second window), then the trade is
excepted from Rule 611.
And an example given in SEC rule is:
Trading centers would be entitled to trade at any price equal to or
better than the least aggressive best bid or best offer, as applicable, displayed by the other trading
center during that one-second window. For example, if the best bid price displayed by another
trading center has flickered between $10.00 and $10.01 during the one-second window, the
trading center that received the order could execute a trade at $10.00 without violating Rule 611
I am not sure how this works in reality and whether that can become a source of abusing.
Help yourself when things goes wrong
There are cases when one exchange is facing technical issues and struggling to keep your flow of updates of protected quotes, which may well gets stale or even lock/cross the markets.
Self help is the term that is used to describe the action other trading centers can take to declare that they will ignore the protected quotes on the troubled trading center.
Of course you need to notify the trading center which you declare self help agains in the first time.
And hopefully if they receive enough self help notification they would realize things go awry and begin to fix it.
Oddlot Quotes are not protected
The Rule does not apply to oddlot orders or to the oddlot portions of mixedlot orders.
Rule 600(b)(8) defines “bid” or “offer” as the bid price or offer price for one or more round lots of an NMS security. This definition is embedded in the definition of “quotation” in Rule 600(b)(62), as well as the definition of “protected bid” or “protected offer” in Rule 600(b)(57).
Consequently, trading centers are permitted to establish their own rules for handling oddlot orders and the oddlot portions of mixedlot orders. For example, although trading centers are not required to handle oddlot orders or the oddlot portions of mixed lot orders in accordance with the requirements for automated quotations set forth in Rule 600(b)(3), they are free to incorporate such requirements in their rules if they wish to do so.
Save your trade record
SEC is constantly monitoring trade through rate at various brokers so it is important you preserve any such trading documents and corresponding market data record to show that your trading engines has done the best it can and proper due diligence is not skipped intentionally or unintentionally.
For example, Goldman was fined a big sum of money to SEC for unable to follow NBBO in its dark pool Sigma-X. (link)
Below lists some useful sources of information while preparing this blog.
SEC RegNMS Memo
SEC RegNMS Rule
SEC RegNMS FAQ
NASDAQ RegNMS Facts Sheet
NASDAQ RegNMS FAQ
BATS Order Types
KCG Demystifying Order Types