Trade-Through Rule Reform: The SEC’s Depth of Book Alternative

Trade-Through Rule Reform: The SEC’s Depth of Book Alternative

Order Code RL32788
CRS Report for Congress
Received through the CRS Web
Trade-Through Rule Reform:
The SEC’s Depth of Book Alternative
Updated December 14, 2005
Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Trade-Through Rule Reform:
The SEC’s Depth of Book Alternative
Summary
When a securities investor submits a stock trade order through a broker to buy
or sell stock that is listed on the nation’s dominant stock exchange, the New York
Stock Exchange (NYSE), the order joins an array of other orders for the stock that
are displayed by various interlinked market centers that also trade NYSE-listed stock.
These trading venues include various regional exchanges and alternative trading
systems. If the investor submits an order to buy or sell X number of shares of stock
in company YYY, he or she is legally entitled to whatever the best displayed prices
(quotes) across the various market centers are at that time. A trade-through occurs
if the best prevailing quotes are ignored, and an order is routed to a market center
offering an inferior quote. This is generally illegal under a rule known as the trade-
through rule. But some institutional investors, and automated alternative trading
systems (ATS) argue that saving a penny or so per share under the trade-through rule
can be less important than other execution attributes like speed, certainty of
execution, or trade anonymity. The NYSE’s largely manual trading protocol
generally has the best priced quote, but does not always produce the speediest
execution, or provide great certainty of execution compared to automated markets.

On December 15, 2004, the SEC voted to propose Reg NMS for public
comment. Among other things, the proposal presented two trade execution options:
(1) the market best bid and offer (bbo) regime, a trading protocol that, when a manual
quote (as in the case of the NYSE) represents the best price, traders would be able to
bypass or ignore it. When an automated quote (such as from an ATS) represents the
best prevailing price, it would be illegal for traders to bypass it. The protocol would
apply to both NYSE-listed and Nasdaq-listed securities, which are currently not
subject to the trade-through rule; and (2) a voluntary protocol known as the depth of
book (DOB) that would have incorporated the first option and would allow for the
simultaneous execution of an order’s remaining shares at incrementally inferior-
priced quotes as long as they were displayed. As in the case of the first option, the
SEC principally touted the DOB option as a means of encouraging the submission
of more limit orders. Limit orders put liquidity into stock markets, enhance price
discovery, and can thus help to lower trading costs. These putative benefits were
predicated on a widely held theory that limit order submission grows with their
likelihood of execution. There are, however, other potentially complicating factors
that underlie limit order submission that involve market conditions. Institutional
investors have been critical of the relative dearth of limit orders with which to
interact, a condition that a DOB might have partially helped to address. But a DOB
option was also likely to cost much more than the $167 million that the SEC
estimates the first option would cost. It also could have resulted in the exodus of
large numbers of institutional orders to automated trading venues that ensure order
anonymity, possibly hurting the traditional markets where small investors trade.
In June 2005, the SEC voted to opt for the first option, the market best bid and
offer protocol. By rejecting the DOB option and embracing the bbo option, which
will go into effect in April 2006, SEC cited that the DOB would harm inter-market
competition and would be costly and difficult to implement.

Contents
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Depth of Book Alternative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
The DOB: Some Precedents and Basic Arguments . . . . . . . . . . . . . . . . . . . . . . . . 6
Institutional Investors and the DOB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Technology and Cost Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Best Execution and the DOB
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Trade-Though Rule Reform: The SEC’s
Depth of Book Alternative
The various interlinked securities markets that trade New York Stock Exchange-
listed (NYSE-listed) stocks are required to route trading orders to the market center
displaying the best price or quote. If the order is routed to a quote that is not the best
quote, it becomes a trade-through and is generally illegal according to the trade-
through rule, a provision in the bylaws that govern the venues that trade in those
stocks. The restriction applies to market centers that provide both slower manual
quotes (as is largely the case with the NYSE) and automated or electronic quotes1 as
is the case with alternative trading systems (ATS).2
On December 15, 2004, as part of a wide-ranging policy rulemaking reform
proposal to the Securities Exchange Act of 1934, the Securities and Exchange
Commission (SEC) voted to propose Reg NMS for public comment. Among other
things, the complex proposal presented two basic stock trade execution protocol
options: (1) the market best bid and offer (bbo) trading regime, a protocol that would
dictate that when a quote (a stock trading order) originates from a manual trading
execution venue represents the current best buying or selling price in that stock,
traders would be able to bypass or ignore it — which they cannot currently do. But
when an automated quote (such as from an ATS) represents the best prevailing price,
it would be illegal for traders to bypass it; (2) and the depth of book (DOB)
alternative, a voluntary protocol that would include the first option and would allow
the simultaneous execution of an order’s remaining shares at incrementally
inferior-priced quotes as long as they were displayed.
In June 2005, the SEC voted to opt for the first option, the bbo protocol, stating
that it offered a proper balance between the imperative to promote competition
between orders and to preserve competition between markets. It rejected the DOB
protocol, stating that it would problematically restrict inter-market competition, and
would be costly and difficulty to implement. The reform goes into effect in April
2006.
This report provides an examination of the highly controversial and ultimately
rejected DOB proposal. It begins by providing background on the DOB’s regulatory
origins, then examines: (1) the mechanics of the DOB and some of its precedents; (2)
the central arguments and counter arguments surrounding the DOB; (3) how a DOB
1 This is basically defined as the ability to immediately interact with a quote.
2 ATS, which are also known as electronic communications networks or ECNs, are
essentially high powered computers that match buy and sell orders. ATS generally focus
on the trades of institutional investors and limit orders in which an investor sets parameters
on how high he is willing to buy or how low he is willing to sell certain amounts of shares.

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might have affected institutional investors; (4) technology and cost issues
surrounding a DOB; and (5) how the DOB would have fit into the broker’s duty of
best execution.
Background
When a securities investor submits a stock trade order through a broker to buy
or sell stock that is listed on the nation’s dominant stock exchange, the NYSE, the
order joins an array of other orders for the stock that are displayed by various
interlinked market centers that also trade NYSE-listed stock. These trading venues
include various regional exchanges and alternative trading systems. If the investor
submits an order to buy 100 shares of stock in company YYY and the lowest and,
thus, best displayed price across the various market centers trading the stock is $5.51
per share for that many shares, then he or she is legally entitled to that price.
Likewise, if the investor submits an order to sell 100 shares of the stock and the
highest and thus the best displayed price across the various market centers is $5.49
per share for that many shares, then he or she is legally entitled to that price.
However, if an order to either buy or sell stock ignores the best prevailing prices
(in this example $5.51/share to acquire the stock, and $5.49/share to sell the stock),
and it is routed to a market center offering inferior prices, it is a trade-through. One
of the reasons why a trade-through may occur is the existence of different kinds of
trading technologies, each with a unique set of advantages and disadvantages, which
may involve being able to provide the best prices, or may perhaps involve being able
to provide faster and more certain executions.

The trade-through rule can be found in the by-laws of the Intermarket Trading
System (ITS), an association of exchanges charged with governing the order routing
communication networks that facilitate trades in stocks listed on the NYSE and the
AMEX. The ITS is itself a product of the Securities Act Amendment of 1975 to the
Securities Exchange Act of 1934. Among other things, the 1975 amendment directed
the SEC to facilitate the establishment of a fully integrated system of securities
markets, the national market system (NMS).
The NYSE is predominantly a manual trading market in which most trade
executions are conducted through an auction process that takes place on a physical
trading floor.3 The manual trading system generally yields the best prices. But
3 In the NYSE’s manual trading environment, floor brokers hold customer orders in a stock
and enter them into continuous mini-auctions overseen by a specialist assigned to the
particular stock. The specialists are responsible for maintaining fair and orderly markets in
the assigned stocks and also receive orders via electronic routing, orders that they can use
to help fill floor brokers’ orders. This auction market has stock traders called specialists who
execute trades on a physical floor, announcing the prices at which they are willing to buy
(bid) and sell (offer). The specialists are primarily agents who undertake little financial risk
and receive commissions for matching buying and selling interests. Their central tool is the
limit order book, a compilation of unexecuted conditional orders to buy or sell shares at less
or more than certain specified prices that have been submitted to them. About 12% of the
(continued...)

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benefitting from recent technological advances, rival trading venues such as ATS and
Nasdaq market makers are now able to execute trades at speeds never imagined
decades ago, speeds generally faster than those on the NYSE.4
Various institutional investors have argued that saving a penny or so per share
under the trade-through rule can be less important than other execution attributes like
speed of execution, certainty of execution, and trade anonymity (which can help
prevent other investors from trading against them and bidding up prices). Handling
about 80% of the trades in its listed stocks, the NYSE tends to have the best quotes
(the best priced offers to either buy or sell various stock at any given time). But there
is no certainty that an investor will necessarily always secure those quotes in the
relatively slow floor trading (and dominant) part of the exchange where the entities
who execute trades have up to 30 seconds to decide whether or not to actually
execute a quote.
On December 15, 2004, the SEC’s commissioners voted four to one to propose
a modification 5 of an earlier and highly controversial February 2004 proposal, Reg
National Market System (NMS), which would “redesign” certain rules in Section
11A of the Securities Exchange Act of 1934.6
Among other things, the February proposal would have effectively preserved but
somewhat modified the trade-through rule on NYSE-listed stock, while also
expanding it to Nasdaq-listed stocks. Specifically, it would have codified the rule
across-the-board, expanding it beyond its present status as merely part of the ITS
3 (...continued)
orders on the NYSE are filled by an electronic matching system called Direct +, which is
limited to small-sized trading orders.
4 While the NYSE specialists operate in an auction environment in which they have
monopolies over the trading in specific stocks, Nasdaq market makers in Nasdaq stocks
compete with other highly decentralized market makers in the trading of various stocks. The
electronically linked market makers traditionally operate as principals, meaning that they
are willing to assume the financial risk of buying from and selling stocks to customers from
their own inventories in return for potential profit from the spread. Some Nasdaq market
makers trade NYSE-listed stocks, but like the ATS, they account for a small fraction of
those trades. Nasdaq-listed stocks are also traded on ATS (including Nasdaq’s
Supermontage and its newly acquired Brut) like Inet, and a number of fully automated
exchanges, the National Stock Exchange (formerly the Cincinnati Stock Exchange), and
ArcaEx. A tiny fraction of trades in Nasdaq-listed stocks are executed in manual market
centers like the Boston Stock Exchange.
5 “Regulation NMS,” Federal Register, vol. 69, no. 247, (Dec. 27, 2004), p. 77424.
Proposals are a requisite part of the SEC’s rulemaking process wherein it internally
interprets one of the several securities laws that govern the securities markets. Those laws,
which include the Securities Exchange Act of 1934, also provide the framework for the
agency’s oversight of those markets. But the statutes tend to be written rather broadly,
largely focusing on basic principles and objectives. The SEC’s central objectives are to
maintain fair and orderly markets and to protect investors. To help it realize the objectives
as the securities markets have evolved, the agency has used the authority granted to it under
the laws to “flesh them out” through the rulemaking process.
6 “Regulation NMS,” Federal Register, vol. 69, no. 46 (Mar. 9, 2004), p. 11126 .

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bylaws.7 Within up to 5 cents beyond a stock’s best prevailing buying and selling
prices, it would have allowed investors (like institutional investors) who use
automated markets to trade through (bypass) the better displayed price on a non-
automated market. On an order-by-order basis, it would have allowed investors to
do trade-throughs if they formally opted out of the trade-through rule.
Known as reproposed Rule 611, or the reproposal, the December proposal also
applied to all NMS securities, including those on the Nasdaq.8 But it would alter the
earlier proposal in a number of ways: When a manual quote represents the best price
in a particular stock traders would be able to bypass or ignore it.9 Automated quotes
would be protected by the trade-through rule: When an automated quote represents
the best prevailing price, it would be illegal for traders to ignore or bypass it. The
reproposal eliminated the opt-outs, an integral part of the earlier proposal. It argued
that by giving best price protection to automated but not manual quotes, the opt-outs,
a favorite of some institutional investors and ATS, were no longer necessary.10
Thus, under the December 2004 proposal, best priced quotes produced by
automated markets would generally have trumped other trade execution attributes
like speed of execution (not a significant issue in those markets, although there can
be some variability), and certainty of execution (the odds that an order will be
executed).
Making a general argument for the reproposed trade-through rule proposal,
William Donaldson, the then chairman of the SEC, noted that while it may be faster
to trade another order at a worse price and that while certain individual traders might
personally benefit from trade-throughs, the overall market could be hurt by traders
who ignore better priced orders [as long as they are displayed by automated
markets].11
The earlier and the newer trade-through rule proposals give added weight to
automated executions. The initiatives are also a reflection of the growing national
and worldwide embrace of automated trading over manual trading, developments that
have been instrumental in the NYSE’s decision to greatly ramp up the scale of its
own automated trading. In 2004, the exchange submitted plans for a new hybrid
7 As part of the ITS bylaws, trade-through rule enforcement is triggered by parties who
report that they have observed it being violated. Under both the February and December
proposals, market centers would have to monitor and report violations “up front.”
8 The Nasdaq is technically not an exchange but an association. In 2000, it submitted an
application to the SEC for conversion to exchange status.
9 Both proposals would also eliminate the current exemption from the trade-through rule
provided to block orders (stock trades of 10,000 shares or more).
10 By late Dec. 2004, approximately 35 Members of Congress had reportedly written the
SEC in support of the earlier opt-out provisions, while eight had written in support of an
unconditional trade through rule. Gregory Bresinger, “Congressional Members Press for the
Opt-Out,” Traders, Dec. 31, 2004.
11 “U.S. Regulators Clash over Trading Rule Changes,” The Asian Wall Street Journal, Dec.
17, 2004, p. M-9.

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trading system to the SEC for approval. It would marry its manual specialist-based
floor trading system with a greatly expanded version of an automated, electronic
trading system known as Direct +, which now handles about 12% of the exchange’s
trading volume. (It can only be used for relatively small-sized orders.)12
The Depth of Book Alternative
At present, brokers are required to enter only their best bid and offer for a stock
at any given time into a database of consolidated quotes from their fellow brokers.
But the reproposal offered an alternative protocol that would extend this requirement
to all of their prevailing quotes, not just their best ones: The SEC proposed a
voluntary regime under which brokers who sought price protection for all of their
quotes would have to display all of their bids and offers in a real time database that
is universally accessible to market centers trading the stock. In other words, a market
center with the best price would have to hand off the remainder of any stock trade
order to other market centers with the next best price if the first market center was
unable to complete the order, rather than continuing to execute the trade at inferior
prices based on the original or “top of the book” price.
Championed by the financial firms Goldman Sachs and Citigroup, this
alternative trading protocol alternative is known by a number of names, including
depth of book (DOB), voluntary depth, and a virtual central limit order book
(CLOB). The reproposal described the DOB as a mechanism for brokers who want
to fill orders, including large block trades, to “sweep” various markets for the best
incremental prices, simultaneously executing trades in the same stock across various
markets.13
One SEC official succinctly noted that the DOB basically meant, “show your
hand and you have a higher probability of success in having your order executed.”14
Among the opponents of a DOB were Fidelity Investments, the largest mutual fund,
the NYSE, and Nasdaq.
Consider the trading scenario under the SEC’s simple trade-through rule
proposal:
Assume that there is a Market A, which is displaying 500 shares at the national
best offer of $20.02 (and also has offers at each price level below the best offer).
Assume there is a Market B that is displaying 500 shares at $20.03 (its best offer) and
also has 4,000 shares at $20.04 that is not displayed. Also assume there is a Market
12 CRS Report RS21871, The Trade-Through Rule, by Mark Jickling, provides a detailed
examination of issues surrounding impact of the SEC’s trade-through rule proposal on
trading in NYSE-listed stocks.
13 For an additional fee, traders can currently avail themselves of real time depth of book
limit order display feeds for both NYSE-listed and Nasdaq-listed stocks.
14 Rachel McTague, and Kip Betz, “In Move Likely to Stall NYSE, SEC Reproposes Market
Structure Rules,” Dec. 20, 2004, BNA’s Securities Regulation and Law Report, p. 2221.

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C that is displaying 300 shares at $20.05 (its best offer), and that there is a Market
D that is displaying 800 shares at $20.07 (its best offer).
Under the SEC’s first trade-through rule option, if an order arrives at Market A
to buy a significant amount of shares that would satisfy all the displayed liquidity in
the other markets, Market A would only be required to send orders to satisfy the best
offers at Markets B, C, and D. Even though the 4,000 share order on Market B is for
a significant amount of stock, it would be ignored and would remain unexecuted in
favor of the inferior-priced orders in Markets C and D because they represent the best
prevailing quote from each market. But it appears that under a DOB, if the superior
priced 4,000 share quote from Market B was displayed, it would have priority over
the best but inferior prices on Markets C and D.
Another way of understanding how the DOB would probably have worked is the
following:
An individual investor whose broker is Merrill Lynch wants to buy 5,000 shares
of Walt Disney Co. at a price no higher than $27.05. At the time that investor’s order
is presented to Merrill, a Lehman Brothers broker’s customer is advertising 4,000
Disney shares for sale at $27.00 on the NYSE’s floor computer systems. Today, the
Merrill broker could buy the initial 4,000 shares for $27.00, but then would have to
wait to find an additional 1,000 shares either on the NYSE or another market to
complete that investor’s order at or near the desired price. But let’s suppose that the
Lehman broker all along had an additional 1,000 Disney shares to sell at $27.01.
Under the proposed rule revisions, the Lehman broker would be required to publish
his entire list of sell orders at the beginning, enabling the Merrill broker to
simultaneously purchase both the 4,000 shares at $27.00 and the 1,000 shares at
$27.01, the next-cheapest price, completing the investor’s order in one fell swoop.
Under a DOB, the two transactions would not have taken place on the NYSE,
where Disney shares are listed. The first 4,000 share transaction at $27.00 per share
could take place on the NYSE, while a second transaction, the purchase of 1,000
shares from a third broker for $27.02 per share could have occurred (for example) on
the Chicago-based automated electronic exchange, ArcaEx.
The DOB would have thus allowed other brokers who seek to fill orders,
including large block trades, to sweep all markets for the best price and to execute
trades simultaneously in the same stock across different markets. Brokers would thus
be allowed to pick off the best prices from various markets.
Some observers say that it is also important to emphasize that the DOB would
only be voluntary, but others predict that competitive pressures will probably result
in “first movers” prompting subsequent widespread use.
The DOB: Some Precedents and Basic Arguments
When investors submit an order to their broker to buy or sell stock, that order
is either a market order or a limit order. Market orders are requests to buy or sell

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stock at whatever current prices the market is offering. Limit orders are conditional
orders to buy or sell stock that set parameters on the acceptable prices. Examples of
a limit order would be an order to buy 300 shares of Xerox stock at $24.00 per share
or less, or an order to sell 1,000 shares of Google at $13.55 or more.
Limit orders produce a number of positive externalities for stock markets and
investors: They enhance market depth and liquidity,15 increase market transparency,
and improve price discovery.16 Generally, and particularly for small investors, the
more liquid a market is, the less volatile it is, and the lower should be the cost of
trading on it. Making the markets more attractive for the submission of limit orders
was a central goal of the SEC’s February 2004 trade-through rule proposal. The
agency largely framed its DOB policy option as a way to expand on that
attractiveness.
The idea of a DOB has some history. For example, in 2000, as part of a concept
release (a public policy “think piece”), the SEC staff proposed that consideration be
given to a more expansive version of its current DOB proposal,17 a policy option that
it claimed might also provide greater investor access to market enhancing limit orders
in the increasingly fragmented securities markets.18 Known as a CLOB, (central limit
order book) the policy option was supported by Arthur Levitt, Jr., then the chairman
of the SEC, a few high profile Wall Street firms like Merrill Lynch, Morgan Stanley,
Goldman Sachs, and at least one ATS. But it also confronted significant
congressional19 and industry-wide opposition. The principal criticism was that the
proposal would amount to a government imposed mandate that would hamstring the
ability of the securities industry to evolve and innovate via natural competitive
forces. The agency never implemented the CLOB.
About the same time, a number of institutional investors raised related concerns
that the markets were suffering from a dearth of accessible limit orders. And in 2000,
a diverse number of financial industry players, including the Securities Industry
Association (the trade group of brokerage firms), the Investment Company Institute
(the mutual fund trade group), and a number of mutual funds and institutional
15 Liquidity measures the degree to which an asset or security can be bought or sold in the
market without affecting the asset’s price. Generally, the higher the level of trading in a
particular stock, the more liquid is that market.
16 This is the method for determining the specific prices for securities based on the
interaction of demand and supply.
17 For example, unlike the DOB option that was proposed in December 2004, the CLOB
would have incorporated time priority: When there are several equally priced quotes,
execution priority would have been given to those that were submitted the earliest.
18 “Notice of Filing of Proposed Rule Change by the New York Stock Exchange, Inc. to
Rescind Exchange Rule 390; Commission Request for Comment on Issues Relating to
Market Fragmentation, Exchange Act Release No. 42,450, S.E.C Docket,” Feb. 23, 2000.
19 Among the proposal’s congressional opponents were Hon. Phil Gramm, then the chairman
of the Senate Banking Committee; the Hon. Tom Bliley, then the chairman of the House
Commerce Committee; and the Hon. Michael Oxley, then the chairman of the House
Finance and Hazardous Materials Commerce Subcommittee.

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investors, formed a group to explore various ways of enhancing limit order
transparency without enacting a CLOB.20
During the past decade, the nation’s stock markets have moved from pricing
stock in eighths of a dollar, to sixteenths of a dollar, and finally to pennies or
decimals (and subpennies in some cases). One manifestation of the move to decimal
pricing is that quotes tend to be spread across many more potential fractions of a
dollar. In the pre-decimal days, there may have been 10,000 shares of a given stock
available at the best bid and offer prices, now there may be only 200 shares at those
prices with a considerable part of the market depth in the form of quotes that may be
pennies off of the best bid. But by not being the prevailing best bid or offer, the
orders face an additional hurdle that they will not be executed, potentially
discouraging traders from continuing to submit limit orders. By granting trade-
through protection to non-best priced quotes, the SEC argued that the DOB should
help ensure that more limit orders are executed, thus encouraging investors to submit
more of them. A major cost of submitting a limit order is that it will go unexecuted,
an occurrence that the SEC and some others said should have been reduced with a
DOB.
This presumption of a robustly positive correlation between the odds that a limit
order will be executed and investor’s willingness to submit them is widely-
subscribed to theoretical orthodoxy.21 But actual empirical research on why investors
decide to submit limit orders is not very extensive. Some of the research that has
been conducted on investors’ willingness to submit limit orders has identified a
number of other salient market variables. They include average trading volume, the
size of the spread, and the level of market uncertainty.22
Additional criticism of the DOB came from the NYSE. Exchange officials said
that a DOB would have effectively killed the auction component of the exchange’s
proposed hybrid execution system, a view shared by a number of observers outside
of the exchange.23 From the critical “investor benefit” perspective, there is research
indicating that the NYSE’s specialist system tends to provide lower trading costs for
20 Laura Santini, “Wall Street Firms, Buy Side to Explore Price Transparency,” Investment
Dealers’ Digest, June 26, 2000.
21 Among others, officials at the Investment Company Institute, the national mutual fund
trade association, support the idea that by protecting non-best priced quotes, the DOB
should help foster greater interest in the submission of limit orders.
22 Ingrid Lo and Stephen Sapp, “Order Submission: the Choice Between Limit and Market
Orders,” EFMA 2004 Basel Meetings Paper; 14th Annual Conference on Financial
Economics and Accounting (FEA), Nov. 27, 2003. Some other financial observers contend
that probably the biggest thing that a market can offer to institutional investors to stimulate
their limit order flow is better trade anonymity. Also potentially undercutting the robustness
of the relationship between limit order execution and individual investor willingness to
submit them are surveys that report that the vast majority of individual investors lack a basic
understanding of what a limit order is. “Investors Flunk Securities Survival Quiz,” Wall
Street Letter, Aug. 6, 2001, p. 4.
23 For example, see John Thain [CEO of the NYSE], “The Quest for the Right Balance,”
The Wall Street Journal, Dec. 21, 2004.

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certain kind of stocks, while for other kinds of stocks Nasdaq’s more automated
dealer trading appears to provide lower costs.24
When small investors’ stock orders are internalized, a broker routes a
customer’s stock trade order to his firm’s trading desk for interaction with the firm’s
stock inventory, meaning that the orders bypass exchanges or market centers. Order
internalization is very commonplace in the securities industry.25 For years,
institutional investors have identified internalization as a significant reason why they
are unable to access substantial pockets of limit order flows, deleteriously affecting
overall market quality.26 The DOB would not have addressed internalization and the
isolated pools of liquidity that result from it.
Institutional Investors and the DOB

For institutional investors and the millions of small investors they represent, the
most significant cost of trading large blocks of shares is known as the price impact,
the change in stock price caused by the potential impact of executing large orders to
buy (with rising prices) or to sell (with declining prices). To help minimize the price
impact, institutional orders are typically divided up into chunks, which are
sequentially put out for execution over the course of a day or more. But this
segmented strategy also means that the information about their trades may be subject
to leaks and risk being “front run.” That is, traders with knowledge of the orders may
exploit that knowledge by buying or selling ahead of the institutions’ orders for their
own gain.27 Such trading can result in up or down price movements that are
detrimental to the institutional investor’s yet-to-be-filled order. Institutional trades
also tend to incur significant trade transactions costs, and opportunity costs due to
changes in market prices during the time it takes to complete a trade.
The DOB could have enabled institutional investors to get some orders filled
before leaks about their orders result in the orders being front run by other traders,
an ongoing concern for them. In addition, the ability to get potentially faster,
24 For example, see Kee Chung, Bonnie Van Ness; and Robert Van Ness , “Trading Costs
and Quote Clustering on the NYSE and NASDAQ after Decimalization,” Journal of
Financial Research, Sep. 22, 2004. The study found that the NYSE’s specialist system
offers low-cost executions for smaller, low-volume stocks, while the NASDAQ dealer
system offers low-cost executions for large, high-volume stocks.
25 A major public policy concern with internalization, which has also been voiced by SEC
officials, is that internalization may result in a brokerage firm’s interests taking precedence
over the interests of investors. Its adherents, however, counter that by making deep
proprietary liquidity available to clients, a brokerage firm can offer greater price
improvement on more orders.
26 For example, see Laura Santini, “Wall Street Firms, Buy Side to Explore Price
Transparency,” Investment Dealers’ Digest, June 26, 2000.
27 The cost of front running has dropped considerably with decimal pricing as the front
running trader merely has to offer to buy a share of stock at a penny more.

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sweeping trades could also mitigate some of the opportunity costs of trading in
securities markets with fluid prices.
But a potential cost of the DOB to institutional investors would have involved
the very same issue of potential leaks of trade information and front running: To
minimize price impact by trading anonymously, large institutional investor trades for
NYSE-listed stocks are often intentionally undisplayed by NYSE floor brokers (for
NYSE-listed stocks), or by ATS (for Nasdaq stocks). Known as reserve orders, these
hidden quotes stand ready to be executed by matching incoming contra orders. And
one of the concerns with the DOB was that a better-priced limit order that is hidden
in reserve could be ignored because displayed liquidity has priority over non-
displayed orders. But because a DOB could have resulted in reserve orders being
bypassed, there was another concern that there will be pressure to display them,
which can carry its own potential shortcomings.
With institutions seeking to avoid display of their orders, there are concerns that
there could be a significant migration of institutional orders to trading venues like
crossing networks that exist exclusively for them. One concern was that a substantial
migration to such markets could result in a significant diminution in liquidity and
a possible erosion in market quality in the traditional securities markets where small
investors’ orders are traded (and where the bulk of institutional orders are also
traded.)28 Such a migration would, however, take institutional orders significantly
away from the institution’s professed interest in finding greater opportunities to
interact with retail limit order markets, markets that tend to provide superior price
discovery.
Technology and Cost Issues

The DOB would have required trading centers to monitor a large number of
quotes that are protected from normal proscriptions on trading through displayed by
other markets, and route orders to execute against those incoming quotes. To do so,
the SEC emphasized that the technology required would have to ensure that (1)
market participants had a data source that identified the protected quotes; (2) such
quotes data would be available on fair and reasonable terms; and (3) market
participants would have fair and efficient access to the protected quotes at reasonable
costs.
The SEC’s proposal did not provide a cost estimate of implementing the
technology capable of handling a DOB. But the DOB would have built upon the
foundation of the less ambitious trade-through rule proposal. We can assume that it
could significantly exceed those costs: The SEC estimated that aggregate costs for
the trade-through reform would be $144 million in one-time costs; $18.4 million in
28 Larry Tabb, “The SEC’s NMS — To Incent and Protect,” Wall Street and Technology,
Dec. 21, 2004. In addition, officials at Fidelity, the nation’s largest mutual fund, opposed
the DOB largely on freedom of choice grounds. They asserted that the government should
not be dictating to investors where they should send their orders. Amy Borrus, “New York
Stock Exchange, No More Breaks for the Big Board,” Business Week, Dec. 6, 2004.

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compliance costs; and $3.5 million to update written policies and procedures, or a
total of $167 million.29 At least some of the costs of new technology probably could
have been passed on to investors.
Although the ATS and the venues that trade Nasdaq securities currently have
the technology to publish DOB quotes,30 industry sources say that a DOB could have
placed significant additional demands on current market data dissemination
technology, especially in terms of the need for much more capacity to carry the
greater volumes of data that would probably be produced. Through the years,
establishing connectivity among the various entities in the securities industry
participants has become both cheaper and easier. (There is also currently a glut of
telecom capacity in the several dozen or so largest metropolitan markets.31) And
while some securities industry observers acknowledge the declines in the marginal
cost of technology, they have also complained about its burgeoning total costs.
At least in the short-run, some questions were raised about the feasibility of
implementing the required technological upgrades in various parts of the securities
industry.32 A DOB might also have forced institutional investor trading desks and
online brokers who serve retail customers to retool the technology that allows them
to view quote data.33
Another issue, which the SEC itself raised in the reproposal, is whether the
DOB might have potentially heightened market systemic risk by providing for more
centralized and concentrated data “spigots” — which could possibly become single
points of failure. Market center outages are known to occasionally occur.34
The past several years have seen the growing use of trade facilitating technology
known as algorithmic trading software (sometimes called smart-routing technology).
Used by brokers for their institutional investor clients and at times directly by the
institutions themselves, the software can both analyze and implement efficient
methods for doing a trade in automated trading markets — trades that may involve
multiple market centers. The software is capable of doing “depth of book” types of
searches, which has raised questions about the need for a government regulation-
initiated DOB. But the technology, which uses statistical modeling is not perfect, is
not universally employed for institutional trades, and is generally not used for
29 “SEC’s Trade Proposal Irks Some in Industry,” Dallas Morning News, Nov. 29, 2004. As
a way of finessing potential data capacity problems, the reproposal notes that interlinked
market centers could decide to limit the DOB quotes to a certain fixed number of quotes
(such as five) beyond the best prices. Reg NMS, p. 77442.
30 “The Trade-Through Rule,” Wall Street & Technology, Feb. 1, 2004, p. A-2.
31 Andrew Goldsmith, “Out of the Box Thinking Equals More Cost Effective Telcom
Networking,” Globalnetworking.com, Jan., 2004.
32 Ibid.
33 “Reg NMS Tops the CIO Agenda,” Wall Street & Technology, Feb. 1, 2005, p. 16.
34 For example, during the power outages that struck the northeast and the midwest in Aug.
2003, some broker-dealers, ATS, and regional exchanges reported telecommunication
problems that caused some problems in their ability to conduct normal trading operations.

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accessing manual trading markets. And though it began as technology designed to
facilitate retail investor day trading, it is generally not available to most individual
investors.35 Users of the algorithmic trading software could have incurred additional
reprogramming expenses under a DOB.36
Another technology-related criticism of the DOB was that it would place the
government in the role of dictating the shape and form of future technology. Many
argued that these decisions are better left to the market participants themselves. They
noted that over the years, the advance of market oriented technological innovations
has been a significant part of the widely-acknowledged overall drop in trading costs
(the emergence of the ATS technology being a prime example of technology that has
helped reduce investor costs). It was also argued that the information-sharing
provisions of the DOB proposal would have limited such innovation, stymying the
ATS’ incentives to create faster, more efficient trading models, and constraining
exchanges’ incentives to innovate technology beyond that which may be minimally
required by regulation. In the reproposal, the SEC responded that under a DOB, each
market would have the freedom to choose the course of action most appropriate for
its particular competitive strategy.
Generally speaking, in both its February and December 2004 Reg NMS
proposals, the SEC appeared to be eschewing the heavily bureaucratic Intermarket-
Trading-System consortium-based model of market center linkages and pushing for
more privately-organized market center linkages — somewhat akin to the current
linkages connecting the trading venues that trade Nasdaq stocks.
Best Execution and the DOB
In fulfilling its mandate to facilitate a national market system, the SEC has
pursued four broad policy objectives: (1) competition among markets; (2)
transparency in the pricing of securities; (3) better linkages between market centers;
and (4) best execution of investors’ orders.
The latter goal, the best execution of investors’ orders is at the heart of the
issues that surrounded the agency’s trade-through and DOB reform proposals. Best
execution is the SEC’s requirement that in executing an investor’s orders, a broker
has a duty to seek the best execution that is reasonably available for its customers’
orders. This means that a broker must evaluate the orders it receives from all
customers in the aggregate and periodically assess which competing markets, market
makers, or ATS offer the most favorable terms of execution. Among the factors that
a broker needs to consider when executing its customers’ orders for best execution
include (1) the opportunity to get a better price than what is currently quoted, (2) the
speed of execution, and (3) the likelihood the trade will be executed.
35 “Tower Group Projects Algorithmic Trading Volume to Double to 27% by of U.S. Equity
Flow by Close of 2006,”Tower Group Press Release, Sept. 20, 2004.
36 “Reg NMS Tops the CIO Agenda,” p. 16.

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Depending on the specifics of a trade and who is doing the trading, best
execution can thus have a number of interpretations. For an individual investor who
is an active trader attempting to exploit market volatility, best execution may mean
fast executions at the lowest possible prices. But for an individual investor who is
a passive investor who lets his portfolio just “lie” for years, best execution may have
less overall significance. Many institutional investors are concerned with selling an
entire block of stock at a good price rather than selling only part of the block at a
somewhat better price, which helps frame their perception of what constitutes best
execution. Their particular perspective on what constitutes best execution will be
influenced by how they prioritize attributes such as trade anonymity, certainty of
execution, and fast executions in fast moving markets, for example.
Thus, historically, best execution has technically been an inexplicit, case-
specific construct. But through the years, SEC officials have placed particular
emphasis on the ability to get a better price as its core characteristic. It is a position
that appears to have been ratified in its later trade-through proposal of December
2004, which would have universalized top-of-the-book price protection where a
market’s best displayed bid or offer could not be traded through for an inferior price.
But by only permitting price protection for automated quotes, the SEC appears to be
at least partially breaking with its traditional treatment of “best execution” by saying
that providing price improvement is still critical but that it will confer a regulatory
advantage on automated, and not manual markets that do so.
The DOB proposal arguably represented an expansion of the earlier, February
2004 proposal’s interest in reinforcing the “ability to secure better prices” facet of
best execution: in order to legitimately access quotes that may be inferior to the best
price on a particular market but that may be superior to the best prices on other
markets, they would have to be displayed.