Regulation NMS and Order Routing Basics

When you place a stock order through your broker, that order can travel to many different destinations before executing. Regulation NMS (National Market System) establishes rules governing where and how orders must be handled. Understanding these rules helps investors evaluate their broker's execution quality.

What Is Regulation NMS?

Regulation NMS is a set of SEC rules implemented in 2007 that govern the trading of U.S. stocks. The regulation created a framework for competition among trading venues while establishing protections for investors.

Before Reg NMS, the NYSE and Nasdaq dominated stock trading with limited competition. The regulation opened markets to alternative trading venues and required all venues to work together as part of a connected national market system.

The four main components of Regulation NMS are:

1. Order Protection Rule: Prevents trades at prices worse than the best available quotes
2. Access Rule: Ensures fair access to quotations across all trading venues
3. Sub-Penny Rule: Prohibits quotes in increments smaller than one cent for most stocks
4. Market Data Rules: Governs the distribution of trade and quote information

The Order Protection Rule

The Order Protection Rule (Rule 611) requires trading venues to prevent "trade-throughs"—executing orders at prices worse than quotes available at other venues.

If the best bid for a stock is $50.10 at the NYSE and $50.08 at Nasdaq, a sell order cannot execute at $50.08 when $50.10 is available. The order must be routed to the NYSE or the NYSE quote must be filled first.

This rule applies to the National Best Bid and Offer (NBBO), which represents the highest bid and lowest ask across all exchanges at any given moment. The NBBO changes continuously as quotes update across venues.

Exchanges and brokers must have policies to prevent trade-throughs. When a better price exists elsewhere, orders must be routed to capture that price.

Where Orders Get Routed

Your broker can send orders to multiple destinations:

Stock exchanges: NYSE, Nasdaq, NYSE Arca, Cboe BZX, IEX, and others operate as registered exchanges. These venues publicly display quotes and execute orders according to exchange rules.

Wholesale market makers: Firms like Citadel Securities, Virtu Financial, and G1 Execution Services pay brokers for the right to execute retail orders. This practice is called "payment for order flow" (PFOF).

Alternative Trading Systems (ATS): Also called dark pools, these private venues match orders without publicly displaying quotes before execution. Institutional investors use dark pools to trade large blocks without revealing their intentions.

Most retail orders at major discount brokers go to wholesale market makers. In exchange for order flow, these firms typically provide "price improvement"—executing orders at prices slightly better than the NBBO.

Payment for Order Flow Explained

Payment for order flow occurs when a market maker pays a broker for the right to execute that broker's customer orders. The market maker profits from the bid-ask spread while sharing a portion with the broker.

Consider a stock with an NBBO of $50.00 bid / $50.02 ask. A retail investor submits a market order to buy 100 shares.

Without price improvement, the order would fill at $50.02 (the ask price).

A market maker might offer to buy the order flow from the broker and execute the order at $50.015, providing $0.005 per share in price improvement. The investor saves $0.50 on the 100-share order.

The market maker can profit because:

• Retail order flow is generally "uninformed" (not based on information the market lacks)
• The market maker might simultaneously have a sell order to match against
• The bid-ask spread provides a profit margin even after price improvement

Brokers receiving PFOF often offer commission-free trading. The trade-off is that order routing decisions may favor venues that pay the most rather than venues offering the best execution.

How to Check Your Execution Quality

Brokers must disclose order routing and execution quality:

Rule 606 reports: Quarterly reports showing where each broker routes orders and any payment received. These reports are available on broker websites.

Rule 605 reports: Monthly execution quality statistics from exchanges and market makers, showing speed, fill rates, and price improvement. The SEC hosts these reports.

Your trade confirmation shows the execution price. Compare this to the NBBO at the time of execution (available on your broker's platform or financial websites) to assess whether you received price improvement or paid more than the quoted price.

For a market order to buy:

• Execution at the ask price = no price improvement
• Execution below the ask price = price improvement
• Execution above the ask price = possible trade-through violation

Worked Example: Evaluating an Execution

You submit a market order to buy 200 shares of XYZ stock at 10:30:15 AM. At that moment:

• NBBO: $75.20 bid / $75.24 ask
• Your execution price: $75.22

Analysis:

• Expected execution (at ask): $75.24 × 200 = $15,048.00
• Actual execution: $75.22 × 200 = $15,044.00
• Price improvement: $4.00 (or $0.02 per share)

This represents a $0.02 price improvement from the ask price. The market maker that filled your order provided better-than-quoted execution.

Now consider a different scenario:

• NBBO: $75.20 bid / $75.24 ask
• Your execution price: $75.26

This execution occurred at a price worse than the ask. Possible explanations:

• The quote changed between order submission and execution
• The displayed quote was for fewer shares than your order
• A system issue caused a trade-through (which should be reported)

Limit Orders and Price Protection

Limit orders specify the maximum price you will pay (for buys) or minimum you will accept (for sells). These orders execute only at your specified price or better.

A limit buy order at $75.20 will not execute above $75.20, regardless of where the order routes. If the stock never trades at or below $75.20, the order remains unfilled.

Limit orders provide built-in price protection but may miss executions if prices move away from your limit. Market orders provide certainty of execution but accept the prevailing price.

For larger orders or volatile stocks, limit orders reduce the risk of unexpectedly poor executions. For small orders in liquid stocks, market orders typically execute near the quoted price with minimal slippage.

IEX and Alternative Routing

IEX (Investors Exchange) was founded in 2012 to address concerns about high-frequency trading advantages. The exchange introduced a "speed bump"—a 350-microsecond delay—to reduce the advantage of faster traders.

Some brokers allow customers to direct orders to specific exchanges, including IEX. This feature lets investors choose venues based on their priorities (price improvement, speed bump, transparent routing, etc.).

Most retail investors do not need to specify routing destinations. The price improvement from wholesale market makers often exceeds benefits from alternative venues. However, investors concerned about PFOF can choose brokers that do not accept payment for order flow or that allow customer-directed routing.

Risks and Limitations

Order routing involves trade-offs:

Speed vs. price: Faster executions may sacrifice price improvement. Some venues prioritize speed while others focus on finding better prices.

Conflicts of interest: Brokers may route orders to maximize PFOF revenue rather than customer benefit. Regulatory requirements mitigate but do not eliminate this conflict.

Displayed vs. available liquidity: The NBBO shows only part of available liquidity. Better prices might exist in dark pools or hidden order types that the NBBO does not reflect.

Order size matters: Price improvement on small orders may not scale to larger orders. Institutional investors face different routing considerations than retail investors.

Next Steps

1. Review your broker's Rule 606 report on their website to see where your orders are routed and how much they receive in payment for order flow.

2. Check recent trade confirmations and compare your execution prices to the NBBO at the time of execution.

3. Understand whether your broker allows customer-directed routing if you want to specify order destinations.

4. For orders over 500 shares, consider using limit orders to control execution price rather than relying on market order price improvement.