US Equity Market Structure (1): The Rulebook and Regulators

This is the first post of a series on US Equity Market Structure (a total of 6).

I didn't write any of these posts; while I was learning the fundamentals about investment, I came across this series on Interactive Brokers' IBKRCampus. If you are interested you can go to their site here.

（Disclosure: I'm using Interactive Brokers for my personal investing, but I'm not paid by them to write about it.)

This series is mostly platform-agnostic, meaning that you don't have to be on Interactive Brokers to find this series useful. Enjoy.

Welcome to Introduction to the US Equity Market Structure, presented by the Investors Exchange. In this course, we’ll be providing an overview of how the US equities landscape is structured in order to give you an understanding of how your orders end up being executed in the market.

The image some people have in their minds of a trading floor with humans shouting orders no longer reflects how trading actually works. Our aim is for you to better understand the reality of the US equities market so you can make informed decisions about how you trade.

In this course, we compare the equity markets to a sport, with rules, referees, a playing field, a ball, and players on the field. While it’s not a perfect analogy, it’s a good way to understand many of the dynamics in the market. We hope that this approach will be helpful for you and encourage you to reach out to IEX with your comments and questions after you finish the course. In the meantime, put on your cap, lace up your cleats, and join us on the field.

The most important part of understanding any sport is, of course, the rules. What’s the goal of the game? What’s allowed? And how are the rules enforced?

The Purpose of the Stock Market: The Exchange Act of 1934

The oldest stock exchange in the US, the Philadelphia Stock Exchange, was founded in 1790, followed by a number of other regional exchanges. However, the foundation of our modern US equity market, the way it looks today, was really laid out in a key piece of legislation that came out of the public crisis of faith in the public markets following the stock market crash of 1929: the Exchange Act of 1934.

The Exchange Act of 1934 created the Securities and Exchange Commission, known as the SEC, and regulates the trading of stocks and bonds. In creating the SEC, the Exchange Act gave it broad authority over the securities industry. It is because of this law that the SEC can make rules that govern how brokers, exchanges, and other entities can operate and enforce those rules. It also outlines certain trading activities, like insider trading, as illegal, and established the practice of regular corporate reporting.

This ensures that when investors buy stock in a business, they know that every quarter, they will get an update on the business, which they can then use to make an informed decision on whether they want to continue to own that stock moving forward. It’s like a rule in a sport saying that everyone has to be able to see where the ball is—no one can be forced to wear a blindfold.

The Exchange Act also established the role of stock exchanges, which are known as self-regulatory organizations. We’ll talk more about the exchanges in the next lesson, but what the Exchange Act says about exchanges reveals a lot about the playing field they were putting in place. The Act says the rules of the exchange are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and in general, to protect investors and the public interest.

The Regulators: SEC and FINRA

We’ve talked a bit about the SEC already through the lens of the Exchange Act of 1934, but what does it really mean that the SEC regulates the securities industry? The SEC is the governing body of the securities space. Their mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

In that capacity, the SEC has the power to make new rules about how trading works, just like an organization like the International Football Association Board can make adjustments to the rules of soccer. For instance, as technology has changed how people trade, the SEC has updated its rules to account for things like computer-based trading.

The SEC also has an enforcement division that brings civil enforcement actions against companies and individuals who violate securities laws. In this capacity, the SEC is like the NBA commissioner who has the power to hand down disciplinary actions to players who break the rules of the game.

The Financial Industry Regulatory Authority, known as FINRA, is an independent nonprofit authorized by Congress to protect investors. It’s not part of the government, but like the exchanges, it’s a self-regulatory organization that has delegated authority. FINRA is focused specifically on the broker-dealer industry and has the power to write and enforce rules that brokers have to follow, examining firms for compliance with those rules and disciplining firms that have violated the rules.

The Regulatory Landscape: Reg NMS, Order Protection Rule, Access Rule, Penny Rule, Market Data Rules

While many aspects of the trading landscape have stayed the same over the years, trading today obviously looks very different than it did 50 years ago. Like virtually all aspects of our lives, trading has been massively changed by the development of technology, and regulation has had to change with it.

The most influential regulation that has shifted the way trading works today is a 2005 consolidation of earlier legislation known as Regulation National Market System (Reg NMS). You can think of this regulation and its impact as similar to when the designated hitter rule was adopted by the American League in baseball in 1973, or when the 24-second shot clock was introduced in basketball.

The period before the institution of Reg NMS was a time of tremendous change for the market. The market had transitioned from being dominated by the New York Stock Exchange to being extremely fragmented, with stocks trading at different prices with no central source of truth. Reg NMS set out to stitch the market together into one national market system. In doing so, it made several changes that have forever altered the dynamics of trading.

First, the Order Protection Rule. This rule requires that you can’t trade at a worse price if a better price is available and accessible in the market. So, if you’re buying a stock and it’s available for $9.99 on one exchange, you can’t buy it for $10 on a different exchange. It’s like an "out of bounds" play.

Second, the Access Rule. The Access Rule ensured that different trading venues were connected to each other and lowered the prices they could charge for trading to make sure people could access them. This rule aimed to prevent gaming of the Order Protection Rule by putting a cap on prices. It ensures that an exchange can’t charge a ridiculous amount to trade and then require that you pay it just because they have the best price.

Next, the Sub-Penny Rule. This rule set the minimum price increment for a stock at one cent for stocks priced over one dollar. This is why you’ll never see a stock for sale at the kinds of prices you see at gas stations, like $3.5999.

Finally, the Market Data Rules. These rules created advisory committees populated by the exchanges that determine how exchanges distribute market data and provided a new mechanism for how they could be paid for this work.

Since 2005, these rules have been applied and interpreted in many ways. We’ll see their impact throughout the rest of this course. In the next lesson, we’ll dig further into the stock exchanges and how they both establish the playing fields for trading and act as its immediate referees.