It’s time to kill the trade-through rule

Earlier this year, for the first time in history, U.S. equity markets traded more than $1 trillion in a single day. It was the kind of milestone that tends to generate celebratory press releases, and it did. But on May 20, before the House Financial Services Subcommittee on Capital Markets, lawmakers and market experts gathered not to celebrate the number, but to ask a hard question: Do the rules governing those trillions of dollars still fit?

At the center of the debate was Rule 611, one part of Regulation National Market System, or Reg NMS, which is an SEC framework adopted in 2005 that governs how stock trades are routed and executed across the U.S. equity markets.

Rule 611, also known as the Order Protection Rule or the trade-through rule, is a specific provision within Reg NMS that requires brokers to route orders to whichever exchange is displaying the best price. When it was passed, the rule’s logic was simple and appealing: if a better price exists somewhere else, why should anyone pay a worse one? But twenty years on, a growing number of market experts argue that the rule has warped the very market it was meant to protect.

The timing of the hearing was not accidental. SEC Chairman Paul Atkins, who now leads the agency, was one of two Republican commissioners who dissented when Rule 611 was adopted in 2005. His return to the chairmanship has reopened the debate.

Among the witnesses at the recent Congressional hearing to discuss Rule 611 was Mendoza Professor of Finance Robert Battalio, who has spent thirty years studying how orders are executed in U.S. equity markets.

Battalio arrived at the hearing with a bold argument: “A careful analysis of the data,” he told the subcommittee, “would reveal that Rule 611 is not needed.”  

The Market is Doing its Job

Battalio explained that to fully grasp his argument, it’s helpful to rewind to 1975, when Congress passed a set of Securities Act Amendments. Those amendments did three consequential things: they eliminated fixed brokerage commissions, mandated that trades and quote updates be broadcast to market participants in real time, and eventually led to the creation of a Securities Information Processor (a SIP) that aggregated and rebroadcast that data to the market, creating a new transparency.

The effects compounded over decades. Specialized trading firms, known as wholesalers, emerged who would pay brokers for the right to fill their customers’ orders, promising to do so at the best available market price or better. Because execution became a profitable activity rather than a costly one, online brokers like Charles Schwab and Ameritrade entered the market by offering faster, cheaper trades. In 2013, Robinhood had reduced its own commissions to zero, a development that other major brokers quickly matched. Today, most retail orders receive price improvement and are executed within microseconds. As a point of comparison, Battalio pointed out at the hearing, it takes roughly 350,000 microseconds to blink your eye.

“The retail trading experience has never been better,” Battalio testified. “The evidence is conclusive.”

His point is that this progress did not come from Rule 611. It came from a market environment with increasing competition and transparency. Those forces, he emphasizes, were set in motion fifty years ago, long before the trade-through rule existed. When the rule was adopted in 2005, Battalio argued, it addressed a problem the market was already solving on its own.

“It’s not clear the rules ever provided the protections they were intended to,” he said in an interview. Institutional investors are protected by sophisticated brokers and algorithms, he pointed out. Retail investors are protected by firms like Citadel and Virtu, which compete ferociously for order flow and are scrutinized by monthly execution quality reports that allow academics, journalists and regulators to verify whether customers are getting fair treatment.

The empirical backbone of this argument comes from Battalio’s own research. A paper he co-authored found that when the full range of benefits these wholesalers deliver to retail investors (not just the narrow price metrics tracked in the government-mandated reports that brokers are required to file) is measured, the real value they provide is roughly six times larger than the official figures show. Competition, not regulation, is what’s driving Citadel and Virtu to perform, he argued.  

A Rule’s Unintended Consequences

It’s not only that Rule 611 purports to solve a problem the market had already addressed, Battalio said; the rule has also created problems. Chief among them is market fragmentation.

Because Rule 611 requires brokers to honor the best-displayed price anywhere in the market, any exchange that posts a price becomes a venue that all brokers must connect to and route through. The result: the U.S. now has 17 registered stock exchanges, many of them commanding less than 1% of market share.

“Do we need 17 equity exchanges?” Battalio asked. “My guess is we don’t need that many — maybe three or four.”

The rule, as Battalio explained it, essentially gives any small exchange veto power over trade routing: “If somebody wants to trade at a price worse than what this little exchange is posting, they have to go get that order first,” he said. That introduces connectivity costs, compliance costs, and operational complexity that the market ultimately passes on to investors, without any real benefit.

Then there is a more subtle, and arguably more damning, problem that Battalio’s recent research has uncovered. The dataset that regulators use to measure trade-throughs, the NYSE’s Trade and Quote database, known as TAQ, turns out to have a systematic flaw. Trades and quote updates don’t always arrive at the central recording system in the order they occurred. Because of geographic and technological delays, quote changes that happened after a trade are sometimes recorded before it. The result is a look-ahead bias: the data makes it appear that a broker traded through a better price when, in fact, that better price didn’t exist yet at the time of the trade.

“Regulators seeking to evaluate compliance with the trade-through rule cannot use SIP data to measure trade-throughs,” Battalio noted in his written testimony, “because latencies cause trades and quote updates to be broadcast and recorded out of sequence.”

In other words, a portion of the supposed violations that have justified Rule 611’s existence may be artifacts of a flawed dataset, rather than evidence of genuine misconduct.  

The Student Becomes the Congressperson

Toward the end of the hearing, there was a moment that took Battalio by surprise. Congressman Warren Davidson of Ohio introduced himself to the panel, and recognized Battalio as a professor whose class he had taken at Notre Dame back in 2004. Battalio was moved.

“That just made my day,” he said afterward. “You like to see your students succeed.” He has since learned that Notre Dame has seven alumni currently serving in Congress.

It was a fitting coda to a hearing about whether a twenty-year-old rule still serves its purpose. Markets change. Students graduate. And sometimes, the professor ends up making the case for change to a former student who now helps write the rules.