What is the order protection rule?
The Order Protection Rule is one of the four main provisions of the National Market Regulation System (NMS). The rule is intended to ensure that investors receive an execution price equivalent to that which is listed on any other exchange where the security is traded. The rule eliminates the possibility of orders being traded, meaning executed at a sub-optimal price.
The Order Protection Rule requires each exchange to establish and enforce policies to ensure consistent pricing for all NMS stocks, including those on major exchanges as well as many over-the-counter (OTC) stocks. The Order Protection Rule Rule is also known as “Rule 611” or “Intermediate Trade Rule”.
Key points to remember
- The order protection rule is intended to ensure that investors receive the best price when their order is executed by removing the possibility of traded orders (executed at a lower price).
- It requires shares to be traded on exchanges that display the best quotes and requires trading centers to establish and enforce written policies and procedures that ensure this.
- The Order Protection Rule is a provision of the National Market Regulation System (NMS), a set of rules adopted by the SEC in 2005, and is also known as the “Trading Rule”.
How the command protection rule works
The Order Protection Rule – along with the NMS Regulation as a whole – was instituted to make financial markets more liquid and transparent through better access to data in general and improved display of quotes and price fairness in particular. Before the rule was adopted in 2005 by the Securities and Exchange Commission (SEC), existing rules for “trading” did not protect investors at all times. This was especially true on limit trades where investors sometimes obtained lower prices than those listed on a different exchange.
The order protection rule aims to protect quotes of a given security at all levels, so that all market participants can receive the best possible execution price for orders that can be executed immediately. It requires trading centers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices below protected quotes posted by other trading centers. The rule also established the National Best Bid and Offer (NBBO) requirement which requires brokers to route orders to sites that offer the most advantageous displayed price.
The other three provisions of the NMS regulations are the Access Rule, the Subpenny Rule, and the Market Data Rules.
Critique of the Order Protection Rule
Criticisms of the effectiveness of the order protection rule have arisen in the years since its enactment. These criticisms include the belief that by forcing stocks to be traded on exchanges that display the highest-rated prices, the rule contributes to excessive fragmentation between trading venues. This involved having increased market complexity and connectivity costs for market participants, making transactions more expensive overall. For example, trading restrictions may require market participants to route orders to lit venues that they would otherwise not do business with.
Another criticism of the rule is that it may have indirectly led to an increase in dark trading, a practice where stocks are bought and sold in such a way that they do not materially affect the market. This has been attributed to limits on competition between lit sites, with choices being made based on their speed and fees instead of stability and liquidity.
Critics have also cited the order protection rule for potentially hurting institutional investors who need to trade in large volumes but are forced to access small quotes. This has the effect of alerting short-term proprietary traders to the trading intentions of institutional investors.