Change is coming, but the future of the Order Protection Rule remains uncertain

Key Takeaways

• Rule 611 of Regulation NMS was introduced in 2005 to prevent trade-throughs and ensure investors have access to the best available price.
• The rule is increasingly criticized for adding complexity and fragmenting liquidity while enabling latency-driven strategies.
• The SEC is considering reform or repeal, leading to debate over moving to a principles-based best execution model.

The Order Protection Rule, also known as Regulation NMS Rule 611 or SEC Rule 611, has been a central part of the US regulatory landscape for 20 years. Introduced by the Securities and Exchange Commission (SEC) in 2005 as part of a broader effort to modernize US equity markets, its primary goal was to ensure investors receive the best available price when their orders are executed. It prohibits “trade-throughs”, or executions at a price worse than the best bid or offer prices quoted on other exchanges.

However, the rule has become increasingly controversial in recent years. Critics claim that 20 years of change have rendered the rule obsolete, and that it increasingly serves to distort market incentives. The SEC is currently gathering views on whether the rule should be updated or removed entirely, and held an industry roundtable on this question in September. What is the current state of the discussion?

What is the Order Protection Rule?

SEC Rule 611 states that trading venues must establish policies to prevent execution at a price worse than the best (protected) quotes displayed on an exchange during regular trading hours. Protected quotes are defined as the best-priced limit order quotes at each exchange. These quotes must be:

• Automated;
• displayed publicly;
• immediately and automatically executable, and;
• disseminated via consolidated market data feeds.

While the rule does not mandate that orders be routed to the best price, it establishes the principle that investors should always have access to the best available price during market hours.

For its supporters, the Order Protection Rule is a key to ensuring a level playing field for investors across the US equities markets. Some argue that the rule delivers better price transparency and therefore a more competitive environment between exchanges and other trading venues. In theory this market structure provides incentives for investors to post/display their orders on exchanges, where they will be displayed and protected. This brings liquidity out of the “dark”, increases transparency, and improves outcomes for both sides of the equation (the order that is being filled at a worse price and the displayed order that is being traded-through).

Criticism of Regulation NMS Rule 611

However, the rule has also been subject to criticism, not least by the new SEC chair, Paul S. Atkins. He recently claimed that it has “not served investors or broker-dealers well”. The central criticism of the rule is that it has distorted the structure of the market by encouraging venue proliferation and choosing winners and losers. A wide variety of venues has grown up to capture order flow by offering competitive prices, even if only briefly. Liquidity providers began posting orders across multiple venues to avoid long queues on major exchanges. This “queue-jumping” behavior led to fragmented liquidity, as traders sought faster execution on smaller venues with shorter queues.

The rule’s strict price priority (but not time priority) also created opportunities for latency-sensitive traders to exploit timing gaps between quote updates and order routing. This led to gaming of the system, where sophisticated participants used intermarket sweep orders (ISOs) and other tactics to create opportunities for latency arbitrage and short-term trading strategies. Critics of SEC Rule 611 argue that venue proliferation and the resulting market fragmentation have led to increased complexity and costs for brokers and other participants.

Aside from its effect on market structure, the Order Protection Rule has also been criticized as increasingly obsolete. In a landscape where algorithmic trading and off-exchange execution are prevalent, critics argue that the rule is outdated and unnecessary. Brokers already have an obligation to achieve best execution, and a sophisticated range of tools and strategies with which to achieve it. Market forces should drive quality of execution based on the context of a particular order, trade, strategy, or scenario.

An uncertain future for SEC Rule 611

Momentum appears to be shifting towards the removal of the Order Protection Rule. But, it’s not yet clear what the new regulatory framework will look like, or what effects this change might have. Some stakeholders have suggested that changes to the rules could actually lead to further venue proliferation, although others argue that the regulation has little actual effect on market fragmentation.

To date, there is no clear consensus on what future rules in this area should entail. Some in the industry believe that these types of regulations simply add complexity without delivering better results, and that market forces should be allowed to determine execution outcomes. Others back a move towards a principles-based regime, which would impose a duty to achieve best execution, without dictating how this should be done. Such a move would align with a wider global trend away from detailed rules and towards establishing principles and intended outcomes.

Whatever the final decision, changes to the OPR must be integrated across the broader landscape. This does not just mean within the equities markets only. At the recent Security Traders Association (STA)  Market Structure Conference, the SEC chairman emphasized the importance of harmonizing changes with the Commodity Futures Trading Commission (CFTC). It may be that the two agencies will work more closely in future to ensure that equities and derivatives market rules are aligned.

Conclusion: Preparing for a post-Rule 611 market

The Order Protection Rule has been in force for 20 years, but it seems unlikely to last much longer. Whether it is reformed, replaced, or removed entirely, the landscape of the US capital markets is set to change. Market participants and other stakeholders must ensure they are actively following and contributing to the debate surrounding the future of best execution.