What Is Trade Through?
A "trade through" occurs when an order to buy or sell a security is executed at a price that is inferior to the best available price displayed on another trading venue at that same moment. This phenomenon is a critical concept within the realm of Market Structure, particularly in highly fragmented markets where the same security might be quoted on multiple Exchanges. The existence of a trade through indicates that a Market Participant did not receive the optimal price available across all accessible markets.
Preventing trade throughs is a primary objective of market regulations designed to ensure fair and orderly markets. These regulations aim to protect investors by mandating that orders are routed to secure the Best Bid and Offer (NBBO) available. The concept of a trade through directly relates to the broader goal of achieving Execution Quality for all investors.
History and Origin
The concept of a trade through became a significant regulatory concern in the U.S. financial markets with the advent of electronic trading and increasing market fragmentation in the late 20th and early 21st centuries. Prior to comprehensive rules, a trade could occur on one exchange at a price worse than what was available on another, primarily due to lack of immediate connectivity or deliberate bypassing.
To address these inefficiencies and protect investors, the Securities and Exchange Commission (SEC) adopted Regulation National Market System (NMS) in 2005. A cornerstone of Regulation NMS is Rule 611, also known as the "Order Protection Rule" or "Trade-Through Rule." This rule specifically prohibits trade throughs by requiring trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other automated trading centers. The SEC's final rule release for Regulation NMS outlines these requirements, reinforcing the principle of intermarket price priority for displayed and immediately accessible quotations.9
Key Takeaways
- A trade through occurs when a trade is executed at a price worse than the best available price on another market.
- In the U.S., the prevention of trade throughs is primarily mandated by Rule 611 (the Order Protection Rule) of Regulation NMS.
- The rule aims to ensure investors receive the best price, enhancing overall market efficiency and fairness.
- Trade through rules apply to "protected quotations," which are immediately and automatically accessible bids and offers from automated trading centers.
- While exceptions exist, the general principle is to prioritize price across venues.
Interpreting the Trade Through
Interpreting a trade through violation involves understanding that an investor's order, whether a Market Order or a Limit Order, was not routed or executed in a manner that secured the absolute best price available across the National Market System. This typically means that at the moment an order was executed on one venue, a superior price (a lower ask for a buy order or a higher bid for a sell order) was actively displayed and immediately accessible on another.
The core principle behind preventing trade throughs is to promote Price Improvement and ensure that all investors benefit from the most competitive pricing across disparate trading venues. Regulatory bodies monitor for trade throughs to enforce compliance with market structure rules, ensuring that Broker-Dealers and trading centers prioritize their customers' best interests.
Hypothetical Example
Imagine Stock XYZ is traded on multiple exchanges. At 10:00 AM, the following prices are available:
- Exchange A: Best Bid = $20.00, Best Offer = $20.05
- Exchange B: Best Bid = $20.01, Best Offer = $20.06
- Exchange C: Best Bid = $20.00, Best Offer = $20.04
An investor places a Market Order to buy 100 shares of Stock XYZ. The National Best Bid and Offer (NBBO) at that moment is $20.01 (bid) and $20.04 (offer).
If a Broker-Dealer routes the investor's buy order to Exchange A and it is executed at $20.05, this would constitute a trade through. A better price ($20.04 on Exchange C) was available and accessible at the time of execution, meaning the investor did not receive the best possible price. The Order Protection Rule aims to prevent such occurrences by requiring the broker-dealer or trading venue to route the order to, or interact with, the exchange displaying the $20.04 offer first.
Practical Applications
The prevention of trade throughs is a fundamental aspect of modern Electronic Trading and market regulation.
- Order Routing Systems: Broker-dealers and trading venues employ sophisticated smart order routing (SOR) systems that continuously scan all protected quotation venues in the National Market System. These systems are designed to automatically route orders to the venue displaying the best price, thus complying with trade through rules and aiming for optimal Price Improvement.
- Regulatory Compliance: Trading centers and broker-dealers must have rigorous policies and procedures in place to prevent trade throughs, as mandated by the Securities and Exchange Commission. The SEC provides guidance and interpretations on Rule 611 and other related rules to ensure compliance.8
- Market Integrity: The rules against trade throughs contribute to the overall integrity and perceived fairness of the capital markets. By ensuring that investors receive the best available price, these rules foster confidence among Market Participants and reduce opportunities for predatory trading practices. Recent amendments to Regulation NMS continue to refine market structure, with objectives like reducing access fees for exchanges, which impact the cost of accessing the best displayed prices and can influence trade-through compliance.7
Limitations and Criticisms
Despite their investor protection goals, trade through rules and the broader Regulation NMS have faced various criticisms:
- Market Fragmentation and Complexity: Some critics argue that the rigid enforcement of price priority across numerous venues, while preventing trade throughs, can exacerbate market fragmentation. This fragmentation may increase complexity for trading firms and lead to higher connectivity costs, as they must connect to and monitor more venues to ensure compliance.6,5 This can also affect Liquidity by spreading order flow across many venues.
- Impact on Institutional Trading: For large institutional orders, strict trade through rules can sometimes make it more challenging to execute large blocks of shares without impacting the market price. Institutions might prefer to execute a large trade immediately with a single counterparty, even if a slightly better price is available for a small quantity on another exchange. However, the rule's strictness can force them to "sweep" multiple venues, potentially revealing their trading intentions and leading to adverse price movements or increased Volatility. This has sometimes led to increased use of alternative trading systems like Dark Pools, which are exempt from certain display requirements.4,3
- Technological Evolution: The market has evolved significantly since Regulation NMS was adopted in 2005, with advances in high-frequency trading and Electronic Trading. Some argue that the rules, while effective for their time, may not fully align with the current speed and sophistication of modern markets, and can lead to unintended consequences or "gaming" of the system through specific order types like Intermarket Sweep Orders (ISOs).2,
Trade Through vs. Best Execution
While closely related, "trade through" and "Best Execution" are distinct concepts. A trade through specifically refers to the violation of executing a trade at an inferior price to a protected quotation available elsewhere. It is a narrowly defined regulatory breach under Rule 611 of Regulation NMS, focusing on price priority across automated, displayed markets.
Best execution, on the other hand, is a broader, fiduciary duty of a Broker-Dealer to obtain the most advantageous terms reasonably available for a customer's order. This encompasses not just price, but also other factors like speed of execution, likelihood of execution, order size, and the overall Execution Quality of the transaction. While preventing trade throughs is a critical component of achieving best execution, best execution obligations extend beyond merely avoiding trade throughs to consider all aspects of the order handling and execution process. A broker can avoid a trade through, but still fail to achieve best execution if, for example, they route an order to a venue that offers a protected price but provides consistently slower executions than another accessible venue.
FAQs
What is the primary purpose of trade through rules?
The primary purpose of trade through rules, particularly Rule 611 of Regulation NMS, is to ensure that investors receive the best available price for their orders across all immediately accessible trading venues in the National Market System.
Are all trade throughs prohibited?
Generally, yes, trade throughs of "protected quotations" are prohibited. However, there are specific exceptions under Rule 611, such as for "Intermarket Sweep Orders" (ISOs), which allow for simultaneous routing to clear all better-priced protected quotes while executing elsewhere.1
Who is responsible for preventing trade throughs?
Broker-Dealers and trading centers (like exchanges or alternative trading systems) are responsible for establishing and enforcing policies and procedures designed to prevent trade throughs and ensure compliance with the Order Protection Rule.
How do trade through rules impact market liquidity?
Some argue that strict trade through rules, by fragmenting order flow across multiple venues, can negatively impact market Liquidity for large orders. Others contend that by ensuring price priority, they encourage competition and ultimately enhance overall market liquidity.
What is a "protected quotation"?
A "protected quotation" is a displayed bid or offer from an automated trading center that is immediately and automatically accessible, as defined by Regulation NMS. Only these types of quotes are subject to the trade through protection.