May 17, 2011

Mad Scramble to Skirt the NBBO

NBBO would be a good name for a rock band. But it stands for “National Best Bid or Offer.” It also appears to be some kind of joke, because everyone tries to avoid it.

The NBBO stems from legislation passed in 1975 by Congress to create a national market system. If you’re already snoozing, you’ll miss the good stuff. You cannot make up stories like this.

Back in the 1900s, several cases involving the NYSE and other exchanges and their proprietary data reached the Supreme Court. In each, the Court held that exchanges possessed an undeniable right to their proprietary quotations.

In other words, where we take for granted now that quotes for stocks are as basic a right as breathing, it used to be that keeping those quotes secret was as basic a right as breathing. (Since our markets flourished then and gasp now, we’d be idiots not to wonder which approach was correct.)

When the SEC asked for comments on new rules to establish a national market system and a true, national best price for stocks, it was unsure of its legal standing to do so. In an SEC press release from 2000 is this, from what humorist Dave Barry would call the “I Swear I’m Not Making This Up” category:

“We believe it is questionable whether the SEC has proceeded properly in proposing these Rules and we have attached, as Appendix A, a legal opinion which discusses this matter. It is long-standing and clearly established legally that the Exchange has a proprietary right in its transaction data and quotation information.”

Jump forward to today. All market centers in the National Market System are required by rule to display what used to be their proprietary property: their prices. (If you tack onto this the legal implication now that using valuable information may be criminal, it’s a wonder our markets consist of more than two parties anymore.)

This dubious path culminates in the following excerpt from a ruling filing with the SEC on May 6, 2011, from the Nasdaq. Be warned: Reading it without first consulting a physician may be hazardous to your health:

“In order to provide enhanced functionality, NASDAQ proposes to adopt an additional order type known as the Midpoint Peg Post-Only Order. Like a regular Midpoint Peg Order, a Midpoint Peg Post-Only Order is a non-displayed order that is priced at the midpoint between the national best bid and best offer (“NBBO”) (as determined using the consolidated tape). However, like a Post-Only Order, the Midpoint Peg Post-Only Order does not remove liquidity from the System upon entry if it would lock a non-displayed order…”

This goes on for pages! If you want to know more, Google “post only orders.” It’s a reaction from exchanges to the movement of trading off displayed markets. And what is the SEC response? To allow exchanges to hide orders too, and to price that non-displayed liquidity at points other than the NBBO.

You must think we’re daft. Hey, we’re just relaying the facts. Grasp one thing, IR pros, about how this stuff affects trading in your stock. All through the markets, in dark pools, on trading systems, at exchanges, there is a mad, desperate effort to avoid the NBBO. Which the investing public thinks is the best price.

Decades of rule-making and legislation and scores of billions of dollars from exchanges and brokers and traders have gone into this National Market System that is, it would appear, a colossal failure. The NBBO doesn’t work. Forcing price controls and behaviors on sentient beings fosters black markets. Elementary, Watson.

How do we undo this mess? Do what Stephen King told would-be writers – kill your babies. No matter how much you love something, if it doesn’t advance the story, slash it.

What if we just…scrapped the NBBO? If the CEO of every public company wrote to congresspersons a letter that said: “Dear Sir or Madam. Please ixnay the NBBO. Thank You. The CEO,” it would happen.

Or we can live with the stock prices you see every day moving all over the place that result from a maze of stultified rules so complex that only the most advanced machines can matriculate them. Barely. Thus all the trading halts, now averaging over 100 per day.

Choices, choices.

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