By Ivy Schmerken
Heading into 2024, US broker-dealers are anticipating a decision by the SEC on its four-equity market structure proposals, a set of rules which seek to revamp stock trading for both retail and institutional investors. But an additional proposal to ban volume-based pricing tiers could inject more complexity into the regulatory outlook for 2024.
The proposals have sparked industry debate around the technical and duplicative nature of the rules, which has raised concerns about how they will interact together.
“I think everybody is gearing up to see what happens, when it happens and then we’ll take it from there,” said Joe Wald, Managing Director and Global Head of Electronic Trading at BMO Capital Markets.
In December of 2022, the SEC released four market structure proposals – order competition, tick size and access fee reforms, Rule 605 related to order transparency, and best execution. On Oct. 18, the SEC put forth a fifth proposal to ban volume-based pricing tiers at exchanges for agency and riskless principal trades. The proposal could have implications for broker dealers that execute high volumes and receive discounts on access fees.
“All of these are quite dramatic proposals that would have a significant change on what we believe is an extremely efficient equity market structure,” said Kenneth Bentsen, President and CEO of SIFMA speaking on its industry briefing on Dec. 5.
On the other hand, the SEC has questioned whether retail investors are getting the best prices and has cited conflicts of interest in retail order routing associated with payment for order flow, and an unlevel playing field between lit exchanges and off-exchange markets.
For the sell-side, there is uncertainty as to how the SEC will proceed.
“It’s not entirely clear to us whether they will go forward with one or all of the proposals,“ said Bentsen. “One of our concerns is that all these proposals are interrelated, but they broke them up into pieces, particularly the first four, but they didn’t really look at them in a holistic manner,” he said.
At SIFMA’s equity market structure conference in November, panelists discussed the unintended consequences that the technical proposals could have on the brokerage business and investors.
“The concern for the SEC is improved mechanics. The concern (for brokers) is all the unintended consequences (and) tweaks of the economics of trading,” said Dina Thakarar, Head of Equity Derivatives Electronic Sales, UBS, who runs the options business for institutional clients and hedge funds.
Roll Out Rule 605 First
Despite industry pushback on several rules, at the SIFMA equity market structure conference in November
, brokerage executives voiced their support for the SEC’s 605 disclosure of order execution rule to provide baseline data for use in determining whether the other three reforms are necessary.
Some panelists said they expected the SEC to “fast track” the 605-order disclosure rule by voting to approve it by Dec. 17, 2023. One sell-side executive said the regulator is committed to resolving all four rules by April 1st.
On the December briefing, Bentsen said that SIFMA has urged the agency to move forward with the 605 order disclosure rule and put a stop on the other proposals.
“We have strongly suggested that the commission should proceed on the Rule 605 update because that does need to be updated, and frankly the marketplace would be well served because that will improve the data around market and execution quality, which the SEC is concerned about,” said SIFMA’s CEO.
An updated 605 transparency rule, which currently applies to market makers and those who trade principally, would be expanded to brokerage firms with over 100,000 accounts.
The enhanced 605 rule will show price improvement, and the percentage of orders that are price improved. “Right now, it is not part of the options landscape, but a lot of practitioners use that data to make decisions on where they route,” said an equity derivatives executive at the SIFMA options market structure conference.
According to Wald, institutions will benefit from enhancements to 605 given the broader trend of systematic trading and the drive to improve execution results.
“605 helps investors understand and evaluate on an empirical basis how their brokers are routing and how their brokers are performing with execution quality. People are much more focused on measuring and looking at execution quality and their process – where they trade and who they trade with. This has led to a lot of innovation and between new venues and existing venues,” said Wald.
A Fifth Proposal on Volume Tiers
While the industry is receptive to the 605-order disclosure rule, it’s possible that the SEC could proceed with some sort of modified tick-size improvement in which the industry has shown interest. As previously reported, the industry consensus is for half a penny move for tick-constrained names, rejecting the SEC’s more granular tick-sizes of 1/10 and 1/5 of a cent.
However, the regulator has received strong pushback from stakeholders related to the order competition rule, and there are concerns around the best execution rule. “We already operate under a best execution rule under FINRA and the MSRB, which was ordained by the SEC,” said Bentsen during the Dec. 5 briefing.
Meanwhile, Bentsen said the industry is still digging into the most recent proposal on volume-based tiering. The public comment period ends on Jan. 5. Already SIFMA is hearing a lot of concerns around volume tiering from the end-user community, particularly the buy side where they get the benefit of the tiered pricing, said Bentsen.
On Jan. 5, SIFMA filed a comment letter outlining the negative impact that banning volume-based transaction pricing could have on competition both among exchanges and broker-dealers.
“In our view, this proposal would negatively impact market efficiency and competition both among exchanges and among broker-dealers, raise costs for smaller and medium-sized broker-dealers and investors, and reduce exchange liquidity by disincentivizing the routing of orders to exchanges,” said Ellen Greene, SIFMA managing director, equity and options market structure.
According to Jesse Forster, Head of Equity Research, Market Structure & Technology at Coalition Greenwich, “[When] brokers pay access fees to the exchanges – they are tiered. That incentivizes each broker to send a certain amount of order flow to each exchange,”
“The discounts are generally volume-based and directly affect the access fees paid by brokers to remove liquidity or rebates paid to brokers for adding liquidity,” explained Forster.
“The SEC’s concern is that a broker might preference the routing for the broker’s benefit and not the customers. In some cases, a broker could split everything in the OMS between seven exchanges,” said Forster.
SEC Chair Gary Gensler said the playing field on which broker-dealers compete is unlevel. “Through volume-based transaction pricing, mid-sized and smaller broker-dealers effectively pay higher fees than larger brokers to trade on most exchanges,” said Gensler.
Gensler added: “Larger trading firms can offer customers more favorable transaction prices than smaller brokers. Further, this has contributed to a practice whereby mid-sized or smaller brokers—in an effort to capture higher rebates—route their orders through a handful of the largest brokers.”
Another criticism is that volume tiers and fees are not known until the end of the month, said Forster. In addition, fee tiers are not standard, and each exchange has their own fee rate card, noting that rates/rebates depend on volume sent (usually as a percentage of the exchange’s total consolidated volume that month,) liquidity, security price and other factors.
BMO Capital’s Wald said his firm has always had the position that there should be more transparency around volume-based tiers. “We’ve never had an issue around the competitive business model of rebates,” said Wald. “We believe that any member should have access to the tiers,” he added.
Exchanges maintain they need the tiers to compete with other exchanges and off-exchange venues. “Rebates and rebate tiers help attract order flow to our markets, [and] help improve the quality of markets and depth of book. We heard this, what problem are we trying to solve for?” said Joseph Bracco, Senior Vice President, Head of Sales, MIAX Exchange Group.
Meanwhile, panelists pointed out that the agency volume-tier proposal overlaps with the Reg NMS access fee proposal.
Gregg Berman, Managing Director, Market Analytics and Regulatory Structure at Citadel Securities, said the new volume-based tiering proposal directly contradicts the Reg NMS variable tick-size reform rule from last year, which makes it difficult for the industry to comment. “Whether or not you like volume tiers, what’s more important is that the volume proposal cannot be contradictory from what the NMS proposal was from last year,” said Berman on SIFMA market structure panel.
“In [the] NMS [rule] you can have volume tiers, but the volume tiers have to be based on the previous month of historical information,” said Berman, which is so that brokers can pass back the fees to their clients. “Now the (latest) proposal is we can’t have volume tiers for agency orders. Which is it?,” said Berman.
Despite the industry’s mixed reaction to most of the proposals, Wald expects there to be change this year. “It’s hard to prognosticate when they will happen,” said Wald. “When looking at Gensler’s track record with regulations, and listening closely to what he’s been saying, Wald said he thinks the equity market structure proposals will go forth sometime this year.
“I think there’s a better chance of all of them getting passed, maybe with some modification to the order-by-order competition rule,” said Wald referring to the proposal that would require retail brokers to route investor orders to mandatory public auctions seeking midpoint liquidity.
“Taking the tone from him [Gensler] directly, “I believe this is going to happen. Even though there is so much out there which could cause them to alter or change some of the bigger parts of it,” he said. But, if the SEC chooses to go forward with all four proposals, “With 100% certainty, there will be legal challenges to that,” said Wald.