SEC "Gift" to the Industry: Four Market Structure Proposals, 3-2 Votes (In Part), but No Partridge in a Pear Tree

On December 14, 2022, the SEC proposed four separate equity market structure rulemakings, each of which, if adopted, will have significant effects on the markets and various industry participants. While designed to address what some would view as gaps in existing rules and increase competition, these proposals likely have market participants feeling more like they received the proverbial lump of coal two weeks before Christmas. The SEC also adopted amendments to Rule 10b5-1 for permissible insider trading plans, adding conditions to affirmative defenses and creating new disclosure requirements. 

In the aggregate, the market structure proposals would significantly alter the processes, decision-making, and economics for brokers, dealers (including wholesalers), ATSs, and exchanges in several predictable and unpredictable ways. The changes would represent the single largest update to market structure since the SEC adopted Regulation NMS in 2005. The proposals would also have significant effects on retail and other investors, and not necessarily in ways that will make them feel like their stockings were stuffed with plentiful goodies. 

An uninformed observer might think, after reading the proposals, that the current state of the US equity markets is anything but sound and resilient. Otherwise, why would the SEC take such dramatic steps? A more astute way of looking at this is to ask the question, “cui bono”? The answer to that is anything but clear, and arguably that goes for the SEC too, given that the agency asked 528 questions to the public in the four market structure proposals.

We have summarized the equity market structure proposals below and provided initial impressions and key takeaways. We will publish a separate alert on the 10b5-1 proposal and will also follow up with deeper dives on each of the equity market structure proposals.

Quick Takes

1. Holiday timing aside, many within and outside the securities industry have questioned the need for and scope of these proposals since Chairman Gary Gensler first signaled their imminence in a June 2022 speech. The Chairman was apparently undeterred by industry and congressional criticism and pressure regarding both the recent pace and volume of its rulemaking and use of agency resources. Interestingly, quite literally the first thing the Chairman addressed during the open meeting on Wednesday was to provide assurance that there will be sufficient time for public comment. However, the industry may only have three-plus months to sift through nearly 1,700 pages of rulemaking (including hundreds of specific SEC questions), attempt to understand the effects to their businesses and clients, and submit their written views within the public comment window. This will be a difficult task even with five or six months and even for the most well-resourced firms.
   
   
2. Each proposal considers the present market structure as its baseline in the economic analysis (EA). Any one of these proposals on its own is likely to alter behavior and market dynamics enough to change that baseline. Certain commissioners noted that the proposals do not collectively consider their holistic affect, i.e., how the implementation of one proposal might affect the other three, and the SEC staff was unable to opine on such issues during the open meeting. SEC staff asserted that each proposal stands on its own, but it is unlikely anyone can foresee how the implementation of one proposal will affect the others. There are also many other recently proposed and adopted-but-not-implemented rule changes that further compound this concern. We expect a major source of criticism to be that the SEC is doing too much, too fast, and not taking time to analyze the effects of its actions prior to proposing additional changes. Interestingly, and perhaps strategically, proposing four distinct changes rather than one bundled proposal should allow the SEC to make targeted modifications to and give approval of each one without jeopardizing the momentum of the others.
   
   
3. From a resource standpoint, recent events in the crypto space must have many wondering why the Chairman has had the bulk of TM and DERA staff laboring away for ungodly hours to tinker with equity market structure at a time when (A) the prevailing view is that US investors have never had it better (including free trading, access to research, real time quotes, and essentially guaranteed executions) and (B) essentially everyone thinks the SEC has not done enough to regulate the aspects of the crypto space that the agency believes are within its jurisdiction (i.e., little or no clear and actionable guidance on critical issues like custody of digital asset securities, across-the-board rejections of exchange-traded crypto products, and failure to explain “how” crypto participants can register, despite Chairman Gensler’s calls to proverbially walk through the turnstiles and register). As Commissioner Peirce noted, “[t]here is no emergency in our markets that demands a comprehensive revamping of how broker-dealers and market makers handle customer order flows.”
   
   
4. The order execution disclosure, tick size/fee cap, and retail order auction proposals all state that they apply only to equity securities. The Regulation Best Execution proposal applies to all securities, including crypto asset securities and fixed income. Is this a simple yet unwritten acknowledgement of the reality that presently there are no SEC-regulated crypto exchanges or is there a deeper and less obvious reason for the differentiation? This also begs the question of how the SEC would even attempt to apply Regulation Best Execution in the crypto markets, which generally do not have consolidated market data or operate pursuant to a unified national market system (unlike equities and options). The crypto asset security discussion in the Regulation Best Execution proposal also represents the first time the SEC has included any discussion of these assets in a formal rulemaking.
   
   
5. Trades executed in qualified auctions pursuant to the Order Competition Rule would not qualify for an exception from the trade-through requirements of the existing Order Protection Rule under Exchange Act Rule 611. Unlike the Order Protection Rule, the Order Competition Rule applies only to individual investors and also applies outside of regular trading hours.

Regulation Best Execution

Regulation Best Execution would apply to all securities and introduce a new SEC standard modeled somewhat off of the existing FINRA and MSRB standards. If adopted, all broker-dealers would be required to use reasonable diligence to ascertain the best market for a security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions, subject to specific exemptions. Sounds simple, right? It could not be any less so. This essentially means brokers need to seek and achieve the “most favorable price” for their customers’ orders.

• Regulation Best Execution would require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the best execution standard, including specific policies and procedures when executing a “conflicted transaction.”
  
  
• A conflicted transaction would be any transaction where a broker-dealer: (1) executes an order as principal, including riskless principal; (2) routes an order to or receives an order from an affiliate for execution; or (3) provides or receives payment for order flow.
  
  
• Required policies and procedures would need to specifically document compliance with the best execution standard for conflicted transactions in light of any payment for order flow.
  
  
• Broker-dealers would need to review execution quality no less than quarterly and review their policies annually. Introducing brokers would be exempt from certain requirements if they establish, maintain, and enforce policies and procedures that require them to regularly review the execution quality obtained from their executing broker compared to other brokers and document their review.

Regulation Best Execution may affect payment for order flow (PFOF) arrangements, given what the SEC describes as an inherent conflict. The SEC notes that passing on PFOF rebates to customers may suffice to de-conflict a transaction, and further that some broker-dealers may choose to stop receiving PFOF altogether to avoid the conflict.

In the discussion of crypto asset securities, the SEC interestingly notes it has limited information about the order handling practices of entities that engage in crypto asset securities transactions because such a small portion of that overall activity is occurring at regulated entities. Nonetheless, the requirements of the Regulation Best Execution extend to broker-dealers engaging in this activity. This may signal more to come from the agency in this area.

Order Competition and Auctions

The new Order Competition Rule (Exchange Act Rule 616) would define “segmented orders” as orders for NMS stocks from an account of a natural person in which the average daily number of trades executed in NMS stocks (essentially, those traded on exchanges) for that account was less than 40 in each of the six preceding calendar months. The rule would essentially apply to wholesalers and other internalizers and dark pools, described as “restricted competition trading centers,” meaning trading venues other than what the SEC has dubbed “open competition trading centers” (national securities exchanges and NMS Stock ATSs that meet proposed requirements for transparency, access, and volume). Restricted competition trading centers would be required to expose segmented orders to “qualified auctions” and would no longer be permitted to internalize retail order flow in most NMS stocks unless the trade price is at or better than the midpoint of the NBBO.   

Open competition trading centers would be required to offer qualified auctions that disseminate auction messages in consolidated market data, adhere to specified minimum pricing increments, and last for no less than 100 milliseconds and no greater than 300 milliseconds. Execution priority requirements would be based on best price and would prohibit giving priority to any order based on speed of response or the identity of the submitting broker (e.g., no priority for the broker-dealer that routed the segmented order to the auction). If a segmented order does not receive an execution in the qualified auction at a specified limit price or better, then it may be internalized at or better than the limit price.

Prohibiting priority based on speed and maintaining qualified auctions for specified periods of time focus competition on price and will likely neutralize speed advantages of high frequency traders amid the broader competition to execute against segmented orders. This also likely changes the longstanding practice of exchanges providing execution priority based on price then time priority as a tie-breaker.

These changes would constitute a substantial departure from current market practices, leading Commissioner Uyeda to rhetorically question “[w]hat changed, such that the Commission now deems it necessary to upend — rather than simply refine — the existing regulatory structure and replace it with a new regulation that prioritizes, by mandate, order-by-order competition over venue competition?”    

The SEC noted that in developing the Order Competition Rule, it drew on its experience with the operation of auctions for orders in listed options. In addition, the EA takes into account “both the regulatory structure currently in place and the unimplemented [Market Data Infrastructure] Rules.” The MDI Rules, adopted in 2020, updated and expanded the content of NMS market data and established a decentralized consolidation model in which competing consolidators, rather than the exclusive Securities Information Processors, are responsible for collecting, consolidating, and disseminating consolidated market data to the public. The proposal also “discuss[es] the status of the implementation of MDI Rules and how it would not affect the operation of and need for Proposed Rule 615.”

Rule 605 Order Execution Disclosure

The proposed amendments to Rule 605 would expand the scope of the rule to: (1) broker-dealers that introduce or carry 100,000 or more customer accounts; (2) single-dealer platforms; and (3) entities that would operate proposed qualified auctions (as noted above). Currently, Rule 605 only applies to “market centers” — i.e., market makers, ATSs, and exchanges.

The proposal would amend the definition of “covered order” and amend the categories of information and specific metrics included in 605 reports, such as categorization of fractional and odd lot orders. The proposal would also require inclusion of a summary report to enhance accessibility to the data.

The proposal requires new statistical measures of execution quality like average time to execution, median time to execution, and 99th percentile time to execution statistics, measured in increments of a millisecond or finer, and changes the realized spread statistics to 15 second and one minute realized spread. The litany of changes to statistical information required to be reported include measures related to average price improvement, realized spread statistics, size improvement benchmarks, and measures for non-marketable orders.

Tick Size and Maker-Taker Fee Caps

When the SEC giveth, the SEC also taketh away (from some). Pushing “segmented orders” to “open competition trading centers” will in part be balanced by the drastic reduction in access fee caps that will affect exchanges. The tick size proposal also accelerates the implementation of the round lot and odd-lot information definitions the SEC adopted via the MDI Rules and amends those rules to require the identification of a best odd lot order. Importantly, the proposal narrows, rather than widens, the minimum tick size for securities. This is in contrast to the Tick Size Pilot Program the SEC proposed in 2016 to determine whether widening tick sizes and spreads for smaller companies would result in additional liquidity in those securities — the results of the Pilot were near universally determined to be ineffective (and that’s a generous characterization).

These changes are intended to allow for new tick sizes that reflect advances in technology, but they also represent a significant reduction in current access fee caps that will change the maker-taker dynamics of market centers, including national securities exchanges.

The proposed amendments to Rule 612 would set forth variable minimum pricing increments for quoting and all trading on exchanges, ATSs, and OTC. Limited exceptions would exist for orders that execute at, but are not priced at, the midpoint of the NBBO and orders that are not based on quoted prices (like VWAP or TWAP trades). The tick size increment will vary based on the time weighted average spread of the security from one penny at the high end to 1/1000^th of a penny at the low end.

This proposal would also reduce the existing access fee cap that limits the fees exchanges and ATSs can charge (and functions to limit the rebates provided) for trading against the best priced displayed quotations in any market, from 30 mils (or 3 tenths of a penny per share) to 10 mils or less, depending on the minimum pricing increment of the underlying security, which is itself a function of the security’s price.

Looking Ahead

The industry and others can comment on the proposals until the latter of March 31, 2022, or 60 days after publication in the Federal Register. Needless to say, comment and criticism of these rulemakings will be robust. Affected market participants (which is almost everyone, including retail investors) should begin to prioritize the issues most relevant to them and submit formal comments. Even though the SEC remains in full remote work status, engagement with the Commissioners and their staffs and TM staff also should be a high priority.