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New Day Dawns at Exchanges

Here comes Reg NMS.

Monday marks the official start to the

Securities and Exchange Commission's

plan to modernize the regulatory structure of the U.S. equity markets.

As of Monday, the SEC says the 13 markets modifying their trading systems to be included in the national market system must be in compliance by now. That means that their electronic platforms must be up and running as well as connected to the other participants so that trades can be "routed" to the best price and execution.

The 13 markets include the

New York Stock Exchange


, the

Nasdaq Stock Market


, the American Stock Exchange, the Chicago Board Options Exchange and the

International Securities Exchange's


new electronic stock exchange. It also includes regional exchanges such as the Boston Stock Exchange, Chicago Stock Exchange, the National Stock Exchange, the Philadelphia Exchange and three electronic communication networks.

The "trading phase" as it is called, is a crucial part in the SEC's nearly three-year crusade to update Regulation NMS. The changes to Reg NMS mean that the trading landscape will no longer be dominated by the NYSE or the Nasdaq. Even smaller and less-liquid exchanges are now guaranteed trading market share, provided they have the best price and execution for customers.

As a result, regional and derivatives exchanges have been rushing to create electronic stock trading platforms to make sure that their systems are among the competition.

In 2005, the SEC approved four main rules:

    The order protection rule, where markets must maintain written policies and procedures designed to prevent the execution of trades at prices lower than displayed quotations.
    The access rule, which requires fair access to these quotations and requires exchanges to enforce rules prohibiting members from displaying quotes that lock or cross automated quotations.
    The sub-penny rule, which prohibits market participants from displaying or engaging in trade prices that are listed at increments smaller than a penny (except for transactions priced below $1 a share).
    The market data rule, which updates requirements for consolidating, distributing and displaying market information.

While some implementation dates have been pushed back -- the March 5 deadline was extended from Feb. 5 -- the SEC hopes to complete the initiative in October. (Brokerage firms and other traders will begin trading 250 pilot stocks under the new compliance rules in July and all stocks will begin trading under the new rules by August.)

James Angel, an associate finance professor at Georgetown University, says those practices to provide best execution were -- for all intents and purposes -- already in effect.

"For good business reasons anybody operating a market has to get best execution for customers, because if they don't they won't get good order flow," Angel says. That being said, "it will be very interesting to see what happens to the market share of the different trading platforms."

"The big players New York and Nasdaq are right now the targets that the entrants are shooting for," he adds. "Will new entrants fight price wars, like BATS? Or are they going to be coming in with slightly different business models? Will they have some kind of twist that will make the market a very different place?"

One exchange example eager to enter the competition is the ISE, which until last fall was just an options exchange.

In September, it rolled out a pilot version of its equities market and launched "MidPoint Match" -- a network that executes orders anonymously at the midpoint price of the national best bid and offer. It launched its fully displayed stock market in December.

The ISE owns 51% of MidPoint Match, while a consortium of 10 strategic investors -- made up of

Bear Stearns


, Citadel,

Deutsche Bank

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, Sun Trading and

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Andrew Brenner, head of the ISE's stock exchange, says the equities platform was built with Reg NMS in mind.

"Reg NMS is certainly a factor in the end goal of attracting order flow," Brenner says. "We believe that it is just as important, though, to offer a differentiated product such as the one we have created. We have priced it competitively and have one of the fastest turnaround times."

Brian Hyndman, senior vice president of Nasdaq's transactions services, says Nasdaq's changes made in order to comply with Reg NMS "weren't too difficult," but worries about other players newer to electronic trading, such as the NYSE.

"It's basically the way we operated for years, but it's really changing a lot for the New York Stock Exchange and some of the other players out there," Hyndman says. "I'm just not certain that New York or the other players out there are going to be ready yet. There is a lot of unproven technology being rolled out on Monday."

Hyndman does not believe Reg NMS implementation will cause major problems to Nasdaq's market share.

"Just because there are

more competitors out there, doesn't mean that they're going to garner any material market share just because they have a protected quote," Hyndman says. Rather, "the more-liquid exchanges are going to compete probably better in a Reg NMS world."

As for the Big Board itself, it built the hybrid system, which combines an electronic platform with old-fashioned floor trading, to comply with Reg NMS, but also to improve productivity, says Lou Pastina, a senior vice president at NYSE in charge of hybrid.

The move comes as the Big Board consolidates its trading floor. It has already closed one of five trading rooms, reducing several hundred positions. It completed the transition of all 3,600 stocks to hybrid in late January.

"The combination brings about a better market for us ... but the one thing that you can't predict are behavioral changes," such as Tuesday's trading mishaps, Pastina acknowledges.

Last Tuesday, the

Dow Jones Industrial Average

dropped 416 points in its worst single-day pullback since September 2001. Around 3 p.m. EST, the industrials, already down more than 200 points, plunged in just a matter of minutes, due in part to what appears to have been a heavy backlog of sell orders that had temporarily clogged the system. At one point, the Dow slumped 546 points before rebounding slightly.

NYSE is combating the problem by increasing capacity on its messaging systems, it says.

Joe Saluzzi, the co-head of equity trading at Themis Trading, said Tuesday's trading problems were "a good first test" for hybrid.

"They can't afford another meltdown," Saluzzi says. "If we go in with Reg NMS and again we have market conditions like this -- that could really test the system."