Beneath the hubbub surrounding Reg NMS, another regulatory issue has been quietly brewing since February. The National Securities Clearing Corp. (NSCC) has proposed a rule change that would end the practice of compressed clearing, also referred to as pre-netting. Originally proposed with an effective date of Jan. 1, 2007, the rule change would require firms to submit "locked-in" or completed trades to the NSCC in real time, rather than in batches at the end of the day, as is common. Further, the amended rule would prohibit the combination of trades for reporting purposes.

In compressed clearing, instead of reporting each trade individually, high-volume brokers consolidate multiple trades in a security into one report reflecting an average price for the security on a given day. The practice has evolved because of increasing trade volumes, driven by thin margins, decimalization and the need to break up large block trades across multiple venues. Since clearing firms are charged by the NSCC for each trade cleared, they are saving money by compressing reporting.

Proposed on Feb. 21, the rule change aims to "support straight-through-processing principles and eliminate operational risk related to the loss of data in the event of a business interruption," according to a notice issued by the NSCC. The premise is that if trades are not submitted in real time and there is a large-scale market disruption, the NSCC will not be able to monitor market risks as they evolve.

'Revenue Neutral'?

Recognizing that some participants could pay more under this scheme, the NSCC proposed restructuring its fees so that they would be "revenue neutral" for the utility; the implication is that this also would be "cost neutral" for the participants. But several brokers say that is not the case.

According to SEC comment letters filed by firms including Automated Trading Desk (ATD), UBS, Knight Capital, Wedbush Morgan, Tradebot and the Bank of New York, the NSCC proposal is critically flawed and proposes an undue burden on an industry already grappling with other new regulations. At best, some firms see the proposal as a misguided attempt to resolve risk issues; at worst, it is viewed as a deliberate move by an organization subject to the wishes of its owners, which include stock exchanges bent on quelling competition through regulatory arbitrage.

"There has been an enormous amount of work in the industry to beef up disaster-recovery protocols," notes Shane Swanson, general counsel and director of compliance at ATD. "Saying the NSCC is going to be the solution to this is a solution in search of a problem."

Additionally, while the NSCC plans to move away from per-transaction fees in favor of scalable fees, change its share minimum per trade from 300 shares to 100 shares and widen its share maximum from 6,000 shares to 100,000 shares to ease the cost burden on large-volume participants, market makers and clearing firms say their initial research shows the NSCC proposal actually could increase costs significantly. "They made certain assumptions and these resulted in estimates that were far too low," asserts Harvey Cloyd, a vice president at Wedbush Morgan Securities. "We saw in the critical areas of our invoices as much as a 70 percent increase [in costs]. You don't want to structure your rates so that firms are penalized for adding liquidity to the marketplace."

The proposal may even have the opposite of its intended effect, adds Cloyd, as it could potentially discourage market participants from trading as frequently. "Liquidity keeps markets in order," he says. "If you penalize that, you add volatility and risk to the marketplace."

'Anticompetitive Proposal'?

The strongest opponents to the NSCC proposal are those firms that operate matching venues, such as ECNs and brokers with internalization and crossing networks. They see the rule change as an anticompetitive move.

Exchanges and self-regulatory organizations (SROs) such as Nasdaq do not take the role of a counterparty on a trade. They report transactions to the NSCC's Regional Interface Organization (RIO) system, which states that Firm A and Firm B completed a trade. Exchanges are not billed for this type of reporting. Brokers and ECNs, which are registered broker-dealers, take the counterparty role in a trade, however, and thus must report to the NSCC. In turn, they are billed for the risk they are introducing into the market by trading.

Thus, the proposed regulation affects only alternative trading venues, rather than the established exchanges and those ECNs that are part of exchanges and Nasdaq, some market participants contend. "This is a direct attack on the nonexchange business model," ATD's Swanson says. "ECNs need to compress to sustain their business model. If you attack that model, you limit the ability of new competitors to come in."

Swanson's comment letter to the SEC was even more pointed: "We understand the NYSE Group was instrumental in advancing this proposal. The exchanges (and their related ECNs) will receive an enormous windfall as a result of this anticompetitive proposal. The nonexchange-related ECNs are likely to be squeezed out of the marketplace, while both trading and clearing costs for other market participants will increase. As a result, spreads will widen to the detriment of the investing public," the letter said.

The proposal also could hinder the common ECN practice of rebating market participants for order flow. "The traders' clearing firms will have to pass on the additional costs of clearing, and the ECNs, who strangely are required to pay a clearing cost on the very same trade, may not be able to offer as much of a payment for providing liquidity as they currently offer," notes Marty Kaye, president of the Track ECN.

The NSCC is part of the Depository Trust and Clearing Corp. (DTCC), which is jointly owned by market participants and the exchanges and market venues. While the NASD, NYSE and Amex recently divested their ownership stakes in the DTCC, both the NASD and NYSE still hold preferred shares in the DTCC, which gives them the right to name a director to its board. "The tone of some of the comment letters is a little reactionary," says Adam Honore, senior analyst at Aite Group. "But it is dubious that the NSCC is a monopoly and has people on the board who are competing with the letter writers."

Several firms have proposed that the NSCC's goals can be fulfilled by supplying real-time data from the consolidated tape system (CTS), which reports trades as they are committed, but before they are cleared - thus eliminating any cost impact issuing from firms' relationships with the NSCC. "Most trades are already reported in real time through the tape," ATD's Swanson points out. "Trades are going up on the tape, so the exchanges, NASD and Nasdaq show those as they occur in real time. So NSCC's proposal would be an incremental benefit at best." Swanson contends this proposal was "shot down without discussion."

Seemingly acknowledging the difficulties the proposal faces, on May 24 the NSCC altered its projected implementation date so that the first phase - the new fee model - takes effect on "the first day of the fourth month following the SEC's approval of the rule change"; the second phase - the real-time reporting requirement - would be effective six months after the Phase 1 implementation date.

Additionally, a DTCC spokesperson says that the NSCC "feels a great responsibility to keep our fees to participants low." According to the spokesman, the NSCC is bound to operate at an "at cost" basis and made record discounts and rebates worth $528 million back to the participants in 2005; fees in 2006 were lowered by $161 million, he adds.

Further, the spokesman denies any anticompetitive intent. "The decision to seek an end to pre-netting was put forth by DTCC's management and discussed and approved by the board of directors and numerous participants and is principally proposed as a way to reduce risk," he says. The SEC expects either to approve the change or institute a review process within three months of the publication of the rule in the Federal Register on April 28.