The Rulebook and the Regulators

Study Notes:

Welcome to introduction to U.S. equity market structure, presented by the investors exchange.

In this course, we’ll be providing an overview of how the U.S. equities landscape is structured in order to give you an understanding of how your orders end up being executed in the market. The image some people have in their minds of a trading floor with humans shouting orders no longer reflects how trading actually works. Our aim is for you to better understand the reality of the U.S. equities market so you can make informed decisions about how you trade.

In this course, we compare the equity markets to a sport with rules, referees, a playing field, a ball, and players on the field. While it’s not a perfect analogy, it’s a good way to understand many of the dynamics in the market. We hope that this approach will be helpful for you, and encourage you to reach out to IEX with your comments and questions after you finish the course. In the meantime, put on your cap, lace up your cleats, and join us on the field.

Part 1: The rulebook and the regulators.

The most important part of understanding any sport is, of course, the rules, what’s the goal of the game, what’s allowed, and how are the rules enforced.

The purpose of the stock market: The Exchange Act of 1934.

The oldest Stock Exchange in the U.S., the Philadelphia Stock Exchange, was founded in 1790, followed by a number of other regional exchanges. But the foundation of our modern U.S. equity market, the way it looks today, was really laid out in a key piece of legislation that came out of the public crisis of faith in the public markets, following the stock market crash of 1929.

The Exchange Act of 1934.

The Exchange Act of 1934 created the Securities and Exchange Commission, known as the SEC, and regulates the trading of stocks and bonds. In creating the SEC, the Exchange Act gave it broad authority over the securities industry. It is because of this law that the SEC can make rules that govern how brokers, exchanges, and other entities can operate and enforce those rules. It also outlines certain trading activity like insider trading as illegal, and established the practice of regular corporate reporting. This ensures that when investors buy stock in a business, they know that every quarter they will get an update on the business, which they can then use to make an informed decision about whether they want to continue to own that stock moving forward. It’s like a rule in a sport saying that everyone has to be able to see where the ball is. No one can be forced to wear a blindfold. The exchange act also established the role of stock exchanges, which are known as self-regulatory organizations, we’ll talk about the exchanges more in the next lesson, but what the exchange act says about exchanges says a lot about the playing field they were putting in place. In the exchange act, it says the rules of the exchange are designed to prevent fraudulent and manipulative acts and practices to promote just and equitable principles of trade to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to and facilitating transactions in securities to remove impediments to, and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest.

The regulators: SEC and FINRA.

We’ve talked a bit about the SEC already through the lens of the Exchange Act of 1934. But what does it really mean that the SEC regulates the securities industry? The SEC is the governing body of the securities space. Their mission is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. In that capacity, the SEC has the power to make new rules about how trading works, just like an organization like the International Football Association Board can make adjustments to the rules of soccer. So, for instance, as technology has changed how people trade, the SEC has updated its rules to account for things like computer-based trading. The SEC also has an enforcement division that brings civil enforcement actions against companies and individuals that violate securities laws. In this capacity, the SEC is like the NBA commissioner who has the power to hand down disciplinary actions to players who break the rules of the game.

The Financial Industry Regulatory Authority, known as FINRA, is an independent nonprofit authorized by Congress to protect investors. It’s not part of the government, but like the exchanges, it’s a self-regulatory organization that has delegated authority. FINRA is focused specifically on the broker-dealer industry and has the power to write and enforce rules that brokers have to follow, examining firms for compliance with those rules and disciplining firms that have violated the rules.

The regulatory landscape “Reg NMS”: Order protection rule, access rule, sub-penny rule, market data rules.

While many aspects of the trading landscape have stayed the same over the years, trading today obviously looks very different than it did 50 years ago. Like virtually all aspects of our lives, trading has been massively changed by the development of technology, and regulation has had to change with it. The most influential regulation that has shifted the way trading works today is a 2005 consolidation of earlier legislation known as regulation national market system, known as “Reg NMS.”

You can think of this regulation and its impact as similar to when the designated hitter rule was adopted by the American League in baseball in 1973, or when the 24-second shot clock was introduced in basketball. The period before the institution of “Reg NMS” was a time of tremendous change for the market. The market had transitioned from being dominated by the New York Stock Exchange to being extremely fragmented with stocks trading at different prices with no central source of truth. “Reg NMS” set out to stitch the market together into one national market system. In doing so, it made several changes that changed the dynamics of trading forever.

First is the order protection rule.

This rule requires that you can’t trade at a worse price if a better price is available and accessible in the market. So, if you’re buying a stock and it’s available for $9.99 on one exchange, you can’t buy it for $10 on a different exchange. It’s an out of bounds play.

Second, the access rule.

The access rule made sure that different trading venues were connected to each other, and lowered the prices that they could charge for trading to make sure people could access them. This aims to prevent gaming of the order protection rule. By putting a cap on prices, this rule makes sure that an exchange can’t charge a ridiculous amount to trade and then can require that you pay it because they have the best price.

Next, the sub-penny rule.

This rule set the minimum price increment for a stock at one cent for stocks priced over one dollar. This is why you’ll never see a stock for sale at the kinds of prices you see at gas stations like 3.5999.

Last, the market data rules.

This created rules and advisory committees, populated by the exchanges, that determine how exchanges distribute market data and provided a new mechanism for how they could be paid for this work.

Since 2005, these rules have, of course, been applied and interpreted in a huge number of ways. We’ll see their impact over and throughout the rest of this course. In the next lesson, we’ll dig further into the stock exchanges and how they both establish the playing fields for trading and act as its immediate referees.

Note that videos were recorded in December 2019.

“IEX and Interactive Brokers undertake no duty to update the information contained herein, and the information is provided for informational and educational purposes only.”