September 17, 2021

National Best Bid and Offer (NBBO)

National Best Bid and Offer (NBBO)
National Best Bid and Offer (NBBO)

What is the National Best Bid and Offer

The Code of Federal Regulations defines the National Best Bid and Offer (NBBO) as: 

“National best bid and national best offer means, with respect to quotations for an NMS Security, the best bid and best offer for such security that are calculated and disseminated on a current and continuing basis by a plan processor pursuant to an effective national market system plan.” 

The National Best Bid and Offer is a rule that requires brokers to get their customers the best available price.

That means if their customers send a market buy order, they must buy at the best asking price, and if their customers send a market sell order, they must sell at the best bid price. 

For example, let’s say John wants to buy XYZ stock with a market buy order.

On NYSE, XYZ’s best offer is $24.50, while the best offer on EDGX is $24.40. John’s broker must purchase the shares on EDGX because that is the best price.

The NBBO is part of a larger piece of financial regulation called Regulation NMS, which was passed in 2005 to address market concerns created by electronic trading.

In addition to the NBBO, Regulation NMS enforced decimalization, which required stocks trading above $1.00 to be quoted in $0.01 increments. 

The term NBBO is also a catch-all term referring to the best bid and offer across all major exchanges or the “top of book.” 

Why Is the National Best Bid and Offer Controversial?

For the average trader, the NBBO is basically just the level one quotes or current bid/ask spread that you can see for free on any financial website.

However, it’s a topic of much debate for experts that study the ‘plumbing’ (market microstructure) of financial markets.

The NBBO is determined by a Security Information Processor, or SIP, which basically disseminates the vast swath of price and volume that exchanges need to send out to clients.

According to a study in the Financial Review by Ding, Hanna, and Hendershott, the NBBO can be “slow” on some data feeds compared to others. This discussion reached a fever-pitch following the 2010 Flash Crash.

Why Does the National Best Bid and Offer Exist?

The NBBO regulation exists to ensure brokers get their clients the best price.

Nothing is deterring your broker from buying stock on a less preferable exchange without the regulation.

It also gives price priority, so the best-priced orders get priority in the order book queue. SEC rule 612, also known as the “sub-penny” rule, goes hand-in-hand with this rule.

Imagine you’re a market maker, and you’re making a market in ABC stock, which has a $10.00 bid and a $10.05 offer.

If you wanted to provide liquidity at the current bid price, you could just place a limit buy order for $10.00, but you wouldn’t be first-in-line because the current bidder got there first.

Your only option would be to bid at a higher price. Before Regulation NMS, you’d be able to post a bid at $10.001, just a fraction of a penny above the current bid, and now you’re first in line.

A small price to pay when exchange rebates alone cover that.

However, SEC rule 612 prevents this. 

Of course, this is an imperfect system, for reasons like those laid out by this SeekingAlpha blogger. 

Bottom Line

Regulations in each market and asset class vary drastically.

These regulations dictate the very procedures which brokers and exchanges have to follow.

So you should have a rough understanding of any regulation which might affect your market.

These are the things that are no fun to learn for most.

Instead, most of us would learn a new chart setup or a clever way to structure an options trade. However, gaps in regulatory knowledge can lead to needless losses.

I remember hearing a proprietary trader on a podcast discuss how he got fined by an exchange for sending orders that weren’t in round lots.

He didn’t know that this was against the exchanges rules for professionally designated traders and paid the price for it.