Industry participants have weighed in on the Securities and Exchange Commission’s proposals to revamp equity market structure, with many urging the regulator to take an incremental approach, to implement the transparency proposal and drop the controversial auction proposal.
On Dec. 14, the SEC released four separate proposals on tick sizes and access fees; disclosure rules, retail auctions and best execution, which together represent the most far-reaching changes to market structure since Reg NMS was enacted in 2005.
Now that the comment period ended on March 31, the Commission’s staff will sort through thousands of comment letters submitted by broker dealers, market makers, asset managers, pension funds, exchanges, ATSs, lawyers, academics, trade associations and individual investors.
But there is uncertainty as to how the process will play out.
In May, Bloomberg Intelligence published a report analyzing the 14,805 comment letters, noting that over 5,000 letters came from individual investors who support the SEC’s revamp of U.S. stock trading. Many individuals used form letters or templates as part of an organized letter writing campaign provided by retail advisory group, We the Investors and forums like Reddit.
“Comments on an SEC proposal to drastically remake equity market structure pit an orchestrated letter writing campaign by individuals who vaguely favor the changes, against the precision opposition of institutions with $40 trillion in assets, retail brokers with over 102 million customer accounts and trading venues that hold 75% of the market,” wrote BI’s market structure team.
“The burning question now: How does the SEC measure the massive show of individual opinion against the industry,” wrote Larry Tabb, Head of Market Structure Research and Jackson Gutenplan, Senior Associate Analyst at BI. On Twitter, Tabb wrote that “98% of the individual letters are positive and institutions, not so much.”
Nearly half the letters from broker dealers and asset managers point to issues with the SEC’s economic analysis and justification for the changes, based on BI’s analysis of 250 comment letters. “Many believe the benefits to investors are overstated, the costs are underestimated, and the risks are ignored,” states the BI report, “Letter Wars: SEC’s Proposed Changes Get Thousands of Pros, Cons.”
The industry’s letters also raised concerns about the complexity and sequencing of the SEC’s four massive proposals, and how they impact one another, which could lead to unintended consequences and operational or systemic risks.
However, SEC Chairman Gary Gensler, speaking virtually at the BI market structure conference, said that each proposal addresses different issues, such as best execution from equities to fixed income, to crypto; another is about segmented auctions and order competition, and a third is about lowering the minimum price increment for quotes and trades.
Institutions also maintain the proposals overlap, and there is no way to know how they will impact markets if implemented simultaneously.
On an institutional panel, Dragan Skoko, Head of xBK and Outsourced Trading, which is part of BNY Mellon, said the proposals are all inter-related. “You have tick size changes, you have round-lot changes, you have introduction of auctions. What is hard to wrap your mind around is what is going to be the impact,” said the buy-side trader.
A consensus has begun to emerge around expanding 605 reporting for broker dealers to enhance transparency into retail execution quality, as a first step to collecting baseline data. Many are supporting minimum tick-size price increments for tick constrained stocks. However, most industry professionals oppose the SEC’s plan to route retail orders to qualified auctions and question the need for a new best execution rule, which is already provided by FINRA (Financial Industry Regulatory Authority).
Disclosure: 605 Reporting
Industry comments have coalesced around supporting the expanded 605 reporting for broker dealers to enhance transparency into retail execution quality, arguing this would give them baseline data with which to assess the other proposals.
A comment letter signed by CBOE Global Markets, State Street Global Advisors, T. Rowe Price, UBS Securities, and Virtu Financial Markets, recommends that the SEC amend Rule 605 disclosure rules to provide more comprehensive execution quality statistics on retail activity, and then pause to study the newly collected data before determining whether to move forward with the other proposals.
The disclosure rule is viewed as “win, win” because the industry has been requesting changes to 605 since 2014, noted panelists at the STANY annual market structure conference in March. Amended 605 is an update to the existing rule which applied to market centers including exchanges, ATSs and wholesale market makers. It would now require broker/dealers to file monthly quality of execution reports and increase the scope of transactions covered to include orders submitted outside market hours, odd lots, large orders exceeding 10,000 shares, and short sales, noted Mark Davies, CEO of S3, who spoke on a STANY panel. Transaction size and size improvement have also been added, so that the average trader who wants to trade 800 shares or a fractional share when the market showed 100 shares, can get perspective on this reality.
Retail brokers would need to make a summary report available. An average investor should be able to use the reports to digest and evaluate different choices in retail brokers.
Reg NMS: Minimum Pricing Increments, Access Fees and Round Lots
The second proposal that is popular is about updating Reg NMS to establish minimum tick increments for all NMS stocks for quoting and trading. The SEC found that a significant number of NMS stocks are constrained by the minimum pricing increment of $0.01 or one cent and could be more aggressively priced within the spread.
The SEC received more than 4,400 letters on the Reg NMS tick-size and access fee proposals. Institutions opposed the proposal as written on concerns over tick sizes of 1/10 and 1/5 of a cent, according to BI’s report.
“The SEC went a bit granular in the tick sizes and the number of stocks that need to be addressed,” said Chuck Mack, Vice President, Head of Equities at Nasdaq at the Bloomberg Intelligence market structure conference in March. “Our concern is too many tick sizes within the spread, affect the NBBO [national best bid and offer], and you get flickering quotes. If someone can jump in ahead of you, this reduces your incentive to quote,” said Mack.
SEC Chairman Gary Gensler said that a key reason for updating Reg 612 on minimum pricing increments is to “level the playing field between lit and dark markets.” Gensler noted that wholesale market makers can quote and trade in sub-penny increments. “When a third (of the equities volume) is going to the dark markets and we don’t have the same rules, I think leveling up some of that is important,” said Gensler.
Minimum tick sizes will impact institutions the most, noted the BI report. “Large asset managers were especially unhappy with the miniscule tick sizes, as the most granular increments tend to aggregate less at each price point, making it harder to trade bigger orders,” wrote BI’s analysts.
On a Coalition Greenwich webinar in April, panelists said there were issues that the industry could get behind. Mehmet Kinak, Global Head of Systematic Trading and Market Structure at T. Rowe Price, said the buy-side had discussed “one-size fits all markets” and deviating from them, recognizing that not all securities trade similarly.” But Kinek said the SEC proposals lack goal posts on how to measure success.
Michael Masone, Director and Head of Americas Market Structure at Citigroup said: “There seems to be a consensus on half a penny move for constrained names and there is synergy on moving to a wider increment for less liquid names. A tenth of a penny and two tenths of a penny are too granular an increment,” said Masone, who added, “this certainly creates more opportunity for penny jumping.”
In addition, reducing the quote increment to a tenth of a penny could leak information into the marketplace, and create an excessive amount of data to the proprietary data feeds, said Masone, who noted that the SEC had gone in the opposite direction with the Market Data Infrastructure Rule (MDIR), which is an effort to include more information on the SIP (Securities Information Processor) – the public consolidated feed.
Though individuals approved of the SEC’s access fee proposal, BI’s report found that the reduction of the current 30-mil ($0.030) fee to 5 or 10 mils, depending on the tick-size, bothered most institutional letter writers, according to BI’s report. Many thought the two-tiered fees were too complex, or that the lower tick size aligned with the smallest access fee and would lock markets. Others worried that too low an access fee would negatively affect spreads because most exchange fees are rebated back to market makers and the access fees subsidize rebate programs.
In the T. Rowe Price comment letter, Kinak wrote that “the one-size fits all lens emerges again for access fees by proposing the cap be reset from 30 mils to 10 mils for all stocks priced greater than $1/share as a practical matter.”
Most industry participants oppose the Order Competition Rule (OCR) which would force retail brokers to route most investor orders to qualified auctions, rather than to wholesale market makers which internally match the trades.
The Order Competition Proposal would require wholesalers to expose these orders to competition in fair and open auctions before executing them internally.
Critics argue that the SEC’s instructions around qualified auctions are highly prescriptive and will lead to information leakage and uncertainty compared to the guaranteed executions that investors receive via wholesaler’s electronic platforms.
Retail brokers that route investor orders to wholesale market makers which internally match the orders, in exchange for payment for order flow, are against the auction proposal.
“I think going into an unknown auction format is going to put a lot of the benefits that clients get today at risk,” said Jeffrey Starr, Managing Director, Operational Services at Charles Schwab, on the BI panel.
“Clients can go to an array of firms where they capture the price in milliseconds. Over 50% of the time we’re going to get a midpoint execution. If we’re going to risk that experience, the economic bar should be high,” said Starr on the panel.
In addition, there is debate over the mechanics of auctions and to what extent institutions will interact with retail flows. Under the SEC’s proposal, auctions will run for 100-300 milliseconds, which some commentators said is an eternity.
In a comment letter, JP Morgan Chase & Co. cast doubt on whether institutions would participate in the auctions with retail investors. “First, it is not likely that institutional and retail order flow would match in a meaningful way. Institutional and retail investors trade different stocks, in different sizes, at different times. Second, auctions would display and disseminate certain information that could identify investors and their positions. Institutional investors may forgo participation in the auctions to avoid information leakage.”
However, six pension funds representing $2 trillion in assets – including the Ontario Teachers’ Pension Plan Board, and the California State Teachers’ Retirement System – signed a joint letter citing the benefits of auctions but did not offer details on how they should work.
“…the Commission should simultaneously seek to increase opportunities for the orders of institutional and retail investors to interact, consistent with the Exchange Act objective of providing opportunities for investors’ orders to trade without the participation of a dealer,” wrote the six pension funds.
“Different types of long-term investors, by their nature, would tend to benefit by having their orders matched with each other, but in practice, they are generally precluded from doing so by the existing market structure.”
Some buy-side firms saw auctions as a positive development that would allow institutions to interact with retail orders, but they want the industry to innovate and compete to design it.
In a comment letter, Dimension Fund Advisors (DFA), an asset manager based in Austin, Texas, said: “The opportunity to compete for retail orders could be a positive development for some market participants, including institutional investors.
However, DFA added: “This should be a market-created solution, and we do not support a rule that would mandate auctions for all retail orders. In our view, requiring certain market participants to use a specific trading methodology – one that is not in use today – is an overly rigid solution, particularly since it is far from certain that the auctions would operate as proposed.” DFA added, “the extent to which retail investors would benefit from auctions is unknown, and implementing auctions is likely to create complexity for traders.” For these reasons, DFA recommended that the SEC withdraw this proposal.
Meanwhile, individual investors in their comment letters urged the Commission to move forward with auctions, citing concerns about conflicts of interest in having their orders routed to wholesaler platforms which they term “dark pools.”
It remains to be seen how the regulatory process will play out and whether the SEC will revise the proposals to incorporate the industry’s feedback. The timetable for the SEC’s decision is uncertain.
SEC Chair Gary Gensler said the SEC represents 330 million Americans. “Our clients are different than your clients,” Gensler told the industry at the BI event, adding that brokers and exchanges are out to maximize their profits. “Congress has laid out in specific ways that we have to focus on competition. We’re going to have some policy differences. We’re going to do it within the law and follow the economics,” said Gensler.