Trade throughs

What Are Trade Throughs?

Trade throughs refer to the execution of a stock trade at a price inferior to the best available displayed price at the time the order is routed. This concept is a critical component of market microstructure, a field of finance that examines the mechanics of how financial markets operate and how this affects price discovery and order execution. In essence, a trade through occurs when a market participant's order to buy a security is filled at a higher price, or an order to sell is filled at a lower price, than a superior, publicly available quote on another exchange or trading venue. The existence of trade throughs undermines market fairness and efficiency by preventing investors from consistently receiving the most favorable prices.

History and Origin

The concept of trade throughs became a significant concern with the proliferation of electronic trading and the fragmentation of U.S. equity markets across multiple trading venues in the late 20th and early 21st centuries. Prior to widespread electronic connectivity, it was challenging to know the best available price across all markets simultaneously. However, as technology advanced and more sophisticated trading systems emerged, the ability to access and display quotes from various venues became feasible.

To address the potential for inferior execution prices and ensure that investors received the best available price, the Securities and Exchange Commission (SEC) adopted Regulation NMS (National Market System) in 2005. A cornerstone of this regulation, Rule 611—also known as the Order Protection Rule or "trade-through rule"—requires trading centers to establish and maintain policies and procedures reasonably designed to prevent trade throughs of "protected quotations." These protected quotations are the best bids and offers displayed by automated trading centers., Th⁵i⁴s regulatory framework was designed to foster a more integrated and efficient national market system where competition among trading venues would ultimately benefit investors.

Key Takeaways

Trade throughs occur when a buy order is executed above, or a sell order below, the best available public price.
They are a violation of fair and efficient order execution principles in modern securities markets.
The SEC's Regulation NMS, specifically Rule 611 (the Order Protection Rule), was implemented to prevent trade throughs by requiring trading centers to protect best-priced quotes.
Preventing trade throughs helps ensure best execution for investors and promotes market integrity.
Exceptions exist within the regulatory framework that permit certain trades to occur at prices inferior to the National Best Bid and Offer (NBBO) under specific circumstances, such as Intermarket Sweep Orders (ISOs).

Interpreting Trade Throughs

Understanding trade throughs is crucial for investors and market participants because they represent a failure in achieving the most advantageous price. For an investor placing a market order, a trade-through means they did not get the most competitive price immediately available. This can lead to increased trading costs and diminished returns over time.

From a regulatory standpoint, the occurrence of trade throughs often signals a breakdown in a broker-dealer's duty of best execution. Trading centers—which include exchanges, alternative trading systems, and market makers—are obligated to have mechanisms in place to prevent such occurrences. The existence of trade throughs, particularly recurring patterns, can indicate issues with order routing practices, system inefficiencies, or non-compliance with regulatory requirements designed to protect investors and maintain market fairness. The system relies on the efficient dissemination of the National Best Bid and Offer (NBBO) across various trading venues.

Hypothetical Example

Consider a hypothetical scenario involving Stock XYZ, which is traded on multiple exchanges.

Exchange A: Best Bid = $50.00 (for 100 shares), Best Offer = $50.05 (for 200 shares)
Exchange B: Best Bid = $50.01 (for 50 shares), Best Offer = $50.04 (for 150 shares)
Exchange C: Best Bid = $49.99 (for 100 shares), Best Offer = $50.06 (for 100 shares)

The National Best Bid and Offer (NBBO) for Stock XYZ would be Bid: $50.01 (from Exchange B) and Offer: $50.04 (from Exchange B).

Now, imagine an investor places a market order to buy 100 shares of Stock XYZ. If their broker-dealer routes the order to Exchange A, and the order is executed at $50.05, this would constitute a trade-through. A better offer of $50.04 was available on Exchange B at the time, but the investor's order was executed at an inferior price. This trade-through means the investor paid $0.01 more per share than necessary, totaling an additional cost of $1.00 for the 100 shares, due to the failure to access the best available price.

Practical Applications

The concept of trade throughs holds significant weight in several areas of the financial industry:

Regulatory Compliance: Broker-dealers and trading venues must comply with SEC rules, particularly Regulation NMS, to prevent trade throughs. Non-compliance can lead to substantial fines and penalties. For instance, the SEC has pursued enforcement actions against firms for execution lapses that resulted in customers receiving inferior prices.
B³est Execution Monitoring: Firms employ sophisticated algorithmic trading systems and internal compliance departments to continuously monitor order execution quality and detect potential trade throughs. This is a critical aspect of their duty to provide best execution to clients.
Market Data Infrastructure: The effectiveness of trade-through protection hinges on the robust and timely dissemination of consolidated market data, including the National Best Bid and Offer. This ensures that all trading centers have access to the information needed to prevent trade throughs.
Liquidity Provision: For market makers and other liquidity providers, understanding trade-through rules influences their quoting strategies and how they interact with the overall order book across various venues.

Limitations and Criticisms

While Regulation NMS and its trade-through protections aim to benefit investors, the rule has faced criticisms and presents certain limitations:

Market Fragmentation and Complexity: Some critics argue that the Order Protection Rule, by forcing interaction across numerous venues, may have inadvertently contributed to increased market fragmentation and complexity. This can lead to higher connectivity costs for market participants and potentially impact overall liquidity and efficient price discovery. A Congressional Research Service (CRS) report has noted that opponents of the rule view its principal effect as anti-competitive, protecting traditional exchanges.
S²peed vs. Size: The rule primarily protects the "top of the book" (best price for typically small sizes), but not necessarily the full depth of an order book on a single venue. In a high-speed electronic trading environment, an order routed to a far-away venue for a fractional price improvement might miss a larger, readily executable block of shares on a closer venue, impacting institutional traders who prioritize size and speed over minimal price differences.
Intermarket Sweep Orders (ISOs): While ISOs provide an exception to trade-through rules, allowing immediate execution at a destination venue while simultaneously sweeping better-priced orders elsewhere, their proper use and the complexities they introduce can be challenging for some market participants.
Net Price vs. Gross Price: Concerns have been raised that Regulation NMS defines the National Best Bid and Offer (NBBO) based on gross prices, without accounting for exchange fees. This can sometimes lead to situations where an order is routed to achieve the best gross price, but the net price (after fees) might actually be worse for the executing broker-dealer or investor. Research from BestEx Research discusses these complexities, particularly concerning fee structures.

Tra¹de Throughs vs. Locked Market

While both trade throughs and locked market conditions relate to pricing issues in fragmented markets, they represent distinct phenomena.

Trade Throughs: A trade-through is an execution event where an order is filled at a price worse than the best available price on another trading venue at that precise moment. It is a violation of the Order Protection Rule designed to ensure that a buyer doesn't pay more or a seller doesn't receive less than the best quoted price.
Locked Market: A locked market occurs when the National Best Bid and Offer (NBBO) displays a bid price that is equal to the offer price (e.g., bid $10.00, offer $10.00). This indicates that two different trading venues are quoting the same price, but one is a bid and the other is an offer. While a locked market isn't a trade-through itself, it's a market anomaly that can lead to confusion and is also addressed by Regulation NMS (specifically Rule 610, the Access Rule) which seeks to prevent such situations by requiring reasonably designed policies and procedures. The key difference is that a locked market is a quote condition, whereas a trade-through is an execution condition.

FAQs

What is a "protected quotation" in the context of trade throughs?

A protected quotation refers to the best bid or offer (the highest bid or lowest offer) displayed by an automated trading center that is immediately and automatically accessible. These are the prices that trading centers are required to protect against trade throughs under Regulation NMS.

How do trade throughs affect individual investors?

For individual investors, trade throughs mean that their market order was executed at a less favorable price than what was available in the broader market. While the per-share impact might seem small for a single trade, repeated trade throughs can erode investment returns over time, making best execution a vital concern.

Can trade throughs be entirely avoided?

While regulatory rules like Rule 611 of Regulation NMS are designed to prevent trade throughs, certain exceptions exist. For example, an Intermarket Sweep Order (ISO) allows a participant to "sweep" across multiple venues to fill a large order, potentially executing at different prices (some of which might be inferior) while simultaneously sending orders to better-priced protected quotes. However, trading centers generally have a strong obligation to implement policies that minimize trade throughs.

What is the role of market makers in preventing trade throughs?

Market makers are central to providing liquidity and maintaining orderly markets. As they quote prices and execute trades, they are also subject to the rules designed to prevent trade throughs. Their systems and practices must be structured to ensure that they do not execute customer orders at prices inferior to the best available prices displayed by other trading centers.