Applying NMS Principles to Crypto Markets

Key Takeaways

• Applying Reg. NMS to crypto exchanges could enhance transparency through reforms including a consolidated market data feed and equal data access regulations.
• A crypto-specific Securities Information Processor (SIP) could reduce fragmentation and improve market data accuracy.
• Implementing Rule 611 and an order protection rule in crypto markets could standardize trade execution.
• Challenges in implementing NMS principles in crypto include antitrust risks and barriers to entry for new exchanges.

The trading of equities and cryptocurrencies share similarities in their need for robust market data distribution. The U.S. equities market, regulated under the National Market System ("NMS"), has well-defined structures for distributing market data, primarily through the Securities Information Processor ("SIP") and proprietary data feeds. The cryptocurrency market, in contrast, lacks a unified regulatory framework, leading to disparate data access and market fragmentation. This article explores how the market data distribution system for NMS stocks could be applied to crypto exchanges and examines the potential applicability of Regulation NMS to the crypto ecosystem.

Under Regulation NMS, U.S. equities markets follow a structured data distribution system comprising:

1. Securities Information Processor (SIP): The SIP consolidates best bid and offer data from all national securities exchanges into a single, public data feed. This system ensures price transparency and fair access for all market participants.
2. Proprietary Data Feeds: Exchanges also offer direct feeds that provide richer data (e.g., depth-of-book information) at a premium.
3. Regulated Fair Access: Reg. NMS mandates that exchanges distribute data in a non-discriminatory manner, ensuring a level playing field among market participants.
4. Clear Market Participation Structure: The NMS framework applies to national securities exchanges and national securities associations, providing a clear delineation of which entities are included within the system. This regulatory clarity ensures structured participation and oversight.

Unlike NMS stocks, crypto markets operate on a decentralized and unregulated basis:

1. Exchange-Specific Data Feeds: Each crypto exchange operates independently, offering proprietary data feeds with varying levels of transparency and accessibility. There is no centralized NBBO equivalent.
2. Data Fragmentation and Latency Issues: Without a unified SIP, traders must aggregate data from multiple sources, leading to potential inefficiencies and price discrepancies across platforms.
3. No Fair Access Requirement: Some exchanges monetize data access by charging for advanced market depth information, and there is no requirement that an exchange provides their market data information with equal means of access.
4. Lack of Defined Market Participation: Unlike the NMS framework, crypto lacks a regulatory structure to determine which entities could be included within a consolidated market system. In the absence of formal oversight, participation would have to be governed by contractual agreements among exchanges or a newly established governing body. This could lead to dominant exchanges restricting access for new entrants, stifling competition and innovation.

Applying Reg. NMS to Crypto Exchanges

If elements of Reg. NMS were applied to crypto exchanges, the following reforms could be considered:

1. Consolidated Market Data Feed: Introducing a crypto-specific SIP to aggregate best bid and offer prices across major exchanges would enhance market transparency and reduce fragmentation.
2. Equal Data Access Regulations: Ensuring that crypto exchanges distribute market data fairly, akin to Reg. NMS's fair access requirement, would reduce competitive advantages for firms with privileged data access.
3. Intermarket Order Protection – A mechanism to prevent exchanges from executing trades at prices inferior to those available on other platforms could improve price efficiency.
4. Defined Market Participation Framework: To replicate the structured participation of the NMS system, a crypto regulatory framework would need to determine how new exchanges gain access to the market data system.

The Case for a Consolidated Market Data Feed and Equal Data Access Regulations

Unlike the equities market, where the SIP aggregates the best bid and offer from all exchanges into a single nationally available feed, crypto traders must rely on fragmented data sources, often leading to price inefficiencies.

A crypto-specific SIP could aggregate best bid and offer prices across major exchanges, enhancing market transparency, reducing fragmentation, and ensuring that traders have access to a more accurate reflection of the market. This would be particularly beneficial for smaller traders and institutions looking for reliable market data without relying on expensive proprietary feeds. However, implementing such a system would require coordination among exchanges, which currently operate independently and profit from exclusive access to their market data.

Equal Data Access Regulations would also play a critical role in leveling the playing field. Under Reg. NMS, equity exchanges must distribute market data fairly, preventing certain market participants from gaining a competitive advantage through privileged access.

However, enforcing such regulations in the crypto space presents several challenges. Unlike national securities exchanges and associations, which are governed under the NMS framework, crypto exchanges operate in a largely unregulated environment. Establishing a governing entity to oversee data distribution would require either regulatory intervention (see here) or contractual agreements among participating exchanges. This raises concerns that dominant exchanges might resist such changes or create barriers to entry for new market participants. Without an impartial regulatory body to oversee the process, a consolidated crypto market data system could inadvertently reinforce existing monopolistic tendencies rather than increase market fairness.

Rule 611 and the Order Protection Rule in Crypto Markets

Regulation NMS includes Rule 611, also known as the Order Protection Rule (OPR), which requires that trading centers route orders to better-displayed quotes before executing at inferior prices. This rule ensures price efficiency and prevents investors from being disadvantaged by market fragmentation.

Applying an order protection rule to crypto markets may be appropriate given the fact that there is no best execution standard currently mandated in the crypto space. Unlike equities, crypto traders are not required to seek the best available price across multiple platforms, leading to potential inefficiencies and price disparities. Implementing an OPR-like rule could help standardize trade execution and ensure that market participants receive fairer pricing.

However, enforcing such a rule in the crypto market would require significant regulatory coordination. Without a centralized oversight body like the SEC, ensuring compliance across global crypto exchanges would be challenging. Additionally, requiring exchanges to route orders to better-priced quotes could introduce technological and operational complexities, particularly given the decentralized nature of crypto trading.

Antitrust Concerns With a Centralized Crypto Market Data Provider

One of the primary challenges of implementing a centralized market data system for crypto is antitrust risk. Unlike the equities market, where the SEC provides oversight of competing exchanges and their operation of the SIPs, there is no clear regulatory framework for crypto exchanges collaborating on market data distribution. If major crypto exchanges were to come together without regulatory oversight to operate a centralized market data provider, it could raise concerns about price-fixing, anti-competitive behavior, and unfair market dominance.

Until a regulatory body is established to oversee such a system, these antitrust risks will likely remain. Without an entity like the SEC to ensure fair governance, crypto exchanges could use a consolidated data provider to disadvantage competitors, limit access, or create barriers to entry for new market participants. Additionally, without a clear framework for determining market participation, dominant exchanges could prevent smaller players from joining a consolidated crypto market data system, further entrenching their positions.

Challenges in Implementing NMS Principles in Crypto

While applying NMS-like regulations to crypto could improve transparency and efficiency, several challenges remain:

1. Regulatory Jurisdiction Issues: Crypto exchanges operate globally, making it difficult to enforce U.S.-centric regulations.
2. Exchange Resistance: Many crypto exchanges benefit from the current model, profiting from proprietary data feeds.
3. Technological Hurdles: A crypto SIP would require significant infrastructure to aggregate and disseminate data efficiently across decentralized markets.
4. Antitrust Risks: As noted, without a regulatory framework, a centralized data provider could lead to anti-competitive practices.
5. Order Protection Rule Implementation: Ensuring compliance with a Rule 611-style order protection rule in an unregulated environment would be difficult.
6. Barriers to Entry for New Exchanges: Without a governing body ensuring open participation, larger crypto exchanges could limit access to new market entrants.

Conclusion

The application of NMS market data principles to crypto exchanges could bring greater transparency and fairness to the digital asset markets. However, the decentralized nature of crypto trading and jurisdictional complexities present substantial challenges. Additionally, antitrust concerns regarding a centralized market data provider remain unresolved due to the absence of a clear regulatory body to oversee such an initiative.

Furthermore, while an order protection rule like Rule 611 could improve price efficiency in crypto markets, its implementation would be difficult without an overarching regulatory framework and enforcement mechanisms. Given the absence of a best execution requirement, an order protection rule could serve as an initial step toward standardizing market practices but would require substantial oversight to be effective.

Moreover, the lack of a formal participation framework in crypto markets means that market consolidation efforts could lead to exclusionary practices, with larger exchanges preventing new entrants from joining a structured market data system. A hybrid approach, incorporating elements of Reg. NMS while accounting for crypto's unique attributes, may be the most feasible path forward.