Divided SEC OKs Overhaul of Markets

A divided Securities and Exchange Commission on Wednesday approved an overhaul of rules governing the nation’s stock markets, in effect forcing the New York Stock Exchange to modernize but giving the Big Board a reprieve from earlier plans that threatened its future.

The 3-2 vote capped a stormy battle over how to regulate the increasingly complex web of stock markets that don’t follow the same rules or execute trades at the same speed. The approach taken by the SEC, expanding on a rule that mandates that investors receive the best price on stock trades, sparked criticism from Congress, institutional investors and the markets themselves long before the vote.

When it goes into effect next year, the rule will require all markets to secure the best price for investors, even if that means sending orders to competing markets. The requirement has long applied to the NYSE but not to Nasdaq or fast-growing electronic venues that have sprung up in recent years. The rule also will require improved electronic linkages between the markets.

Republican Chairman William H. Donaldson, who joined two Democrats to cast the pivotal vote, said the rule reflected a “core value” of protecting investors. Although the effect is uncertain, the SEC estimated that the rule could save investors $321 million a year -- in an overall stock trading market of about $20 trillion a year.

“We have kept our eye on one overriding objective: the protection of investors, with particular attention to the concerns of small investors,” Donaldson said.

The vote laid bare a sharp philosophical divide on the five-member panel, with two of the three Republican appointees assailing the rule as an example of ill-conceived government intrusion in the marketplace.

Republican Commissioner Paul S. Atkins said the rule symbolized the “discarded, hyper-regulatory notions” of the 1970s and called on Congress to direct the SEC on handling the matter.

“I do think it’s time for Congress to give us clear and modern direction on what our priorities should be,” he said.

The rule, known as Regulation National Market System, or Reg NMS, won’t affect small investors directly. Supporters, however, said it would help small investors by expanding the best-price doctrine.

Others said the rule would force mutual funds -- which represent the pooled resources of small investors -- to send orders to the slow-moving NYSE and prevent them from getting faster execution, and ultimately better prices, from electronic competitors such as Archipelago and Instinet.

“This raises the cost of institutional trading and therefore reduces the performance of mutual funds and 401(k)s,” said Benn Steil, a market structure expert at the Council on Foreign Relations.

Opponents argued that in a fast-moving, volatile market, it was more important to be able to trade quickly -- saying that the “best price” is elusive when a stock is plunging or skyrocketing.

One of the most vocal opponents was Fidelity Investments, the nation’s largest mutual fund.

“We’re saying, ‘Why can’t we be the judge of how best to conduct trades for our customers?’ ” said Eric Roiter, general counsel of Fidelity’s mutual fund unit.

The rule doesn’t directly address the NYSE but in effect penalizes so-called slow markets, which is how the exchange would be characterized if it didn’t modernize.

Driven by the expectation of SEC action, the NYSE announced plans last year for a major transformation of its decades-old auction-style trading system. The exchange promised to increase its use of electronic trading to go alongside the scrums by human traders who jockey on its Lower Manhattan trading floor.

Although automated trading could hurt the livelihoods of some at the NYSE, the SEC rejected another proposal that threatened the exchange itself. That plan, known as “depth of book,” would have allowed institutional investors to electronically trade huge swaths of stock on the NYSE’s books. That would have all but eliminated the need for brokers.

At a minimum, experts said, the rule will dramatically revamp the inner workings of the market by rewriting some of the nuts-and-bolts requirements about how orders are traded.

“This is truly a revolutionary event,” said George Rodriguez, managing director at Algorithm Trading Solutions, an institutional brokerage firm in Newark, N.J. “The marketplace will look different in six months, very different in a year and will be unrecognizable in two years.”

At the most basic level, the SEC reinforced a bedrock principle that has guided the U.S. stock market for decades: the obligation of brokerages and mutual funds to always try to find the best price for investors, selling shares at the highest possible prices and buying at the lowest.

This is known as the “trade-through” rule because it bars investors from bypassing, or trading through, anyone offering a superior price.

The Nasdaq Stock Market and other NYSE competitors have long criticized the rule, saying the NYSE uses it to blunt competition.

The SEC seemed to buy that logic when it proposed updating the rule early last year. That plan would have let investors opt out of the trade-through rule. But the SEC struck that provision in response to the NYSE’s pledge to boost automated trading.

Overall, experts said, the NYSE emerged a winner. It must overhaul its operations, but it avoided the more onerous opt-out and depth-of-book provisions.

Reg NMS is “a major step forward for investors and markets, creating a fair and level playing field for all and a sound framework for the U.S. equities marketplace to grow, compete and remain the world’s best,” the NYSE said in a statement.

Supporters of the trade-through rule said scrapping it would give Wall Street leeway to abuse investors by, in effect, overcharging them on stock trades. According to an SEC estimate, perhaps 1% to 2% of trades may be completed at less-than-best prices, breaking down to an annual cost to investors of $209 million on Nasdaq and $112 million on the NYSE.

Republican Commissioner Cynthia A. Glassman declared Wednesday “a sad day” for the SEC. She termed the regulation “a massive regulatory intrusion into the operation of the market,” adding that “no one knows” whether it will work.

Commissioner Harvey J. Goldschmid, a Democrat, said the rule “strikes the right balance” and was “very much in the nation’s interest.”

It will begin phasing in April 10, 2006, and expand to all stocks June 12, 2006.

Peterson reported from Washington and Hamilton from New York.