SEC proposes series of seismic new trading reforms

The US regulator has shaken things up for the holiday season with a set of sweeping reforms designed to revamp and reinvigorate the US stock market. The TRADE brings you the latest, along with a detailed breakdown of the new proposals.

The US Securities and Exchange Commission (SEC) yesterday announced plans for a series of significant changes to the structure of the US stock market: including a new best execution framework, mandatory open auctions for certain retail orders (likely to significantly curtail payment for order flow), amendments to adopt variable tick sizes and reduce fee caps, and enhanced disclosure requirements for banks and brokers.

The move is widely seen as a response to the meme stock crisis of last year: in which retail investors (the ‘reddit army’) pushed up the price of penny stocks such as GameStop – to the detriment of institutional short players such as Citadel, and resulting in surges so high that many platforms were forced to impose temporary trading restrictions.

The SEC chairman Gary Gensler, a Biden-nominated democrat who has headed the watchdog since April 2021, has long campaigned for an overhaul of stock market regulation in order to ‘level the playing field’.

“The markets have become increasingly hidden from view, especially for individual investors,” he said yesterday. “These everyday individual investors don’t have the full benefit of various market participants competing to execute their marketable orders at the best price possible.”

The moves have been met with mixed feelings from the industry with some criticising the plans as micro-managing the markets, while others have welcomed the increased oversight.

“We believe the reforms announced by the SEC represent a constructive and positive effort to improve transparency, increase competition, and ensure that investors can access the best prices available in the market,” said Ronan Ryan, president and co-founder of exchange group IEX. “It has been 17 years since the existing equity rules were adopted, and since that time, the stock market has seen significant change – including the advent of high-frequency trading, a dramatic decline in displayed liquidity on exchange, and a substantial rise in off-exchange trading. Modernising regulation ensures that market competition among brokers, market makers, and exchanges continues to benefit investors.”

Bryan Corbett, president and CFO of the Managed Funds Association (MFA), was more cautious, adding: “Alternative asset managers rely on the strength and resilience of our markets to deliver for investors, including pensions, foundations, and endowments. We have long advocated measures to enhance market structure, so are pleased to see that the SEC is addressing minimum pricing increments (tick size), access fee caps, and transparency of better priced orders. We look forward to carefully reviewing the full slate of proposals and working constructively with the SEC to calibrate these rules to best serve investors and avoid unintended, negative consequences…. investors deserve nothing less than a thoughtful, thorough, and data-driven process in assessing these proposals.”

And Citadel Securities, the largest market-maker in the US, was openly skeptical, warning in a statement that: “The US equity market is the envy of the world, and any proposed changes must provide demonstrable solutions to real problems while avoiding unintended consequences that will hurt American investors.”

Virtu Financial, previously a vocal opponent of the proposed market overhaul, did not respond to requests for comment. However, last month it announced a lawsuit against the SEC to obtain more detail on the planned market structure rules around equity trading, following a freedom of information request on the proposals that it filed in June.

“We do not take lightly the step of suing our primary regulator, but it has become clear that the Chair of the SEC is more focused on politics and regulation by innuendo and hypothesis than earnestly engaging with an industry that has created the most fair and competitive equity markets for retail investors globally,” said Virtu Financial CEO Douglas Cifu, at the time.

Three of the SEC’s five commissioners voted in favour of the new rules on 14 November, while two voted against. The proposals will be open for comment until at least 31 March.

SEC proposals: A breakdown

Regulation Best Execution:

Currently regulated by FINRA, this would be the first time the SEC has established its own best execution framework. Covering brokers, dealers, government securities brokers, government securities dealers, and municipal securities dealers, the new rule would require broker-dealers to establish, maintain, and enforce written policies and procedures designed to comply with the proposed standard. They would also have to explain how they determine the best market and make routing or execution decisions for their customer orders, and outline their methods of complying with the best execution requirements. They would have to document any arrangement concerning payment for order flow (PFOF) for retail clients; and review the execution of their customer orders at least quarterly.

“I believe a best execution standard is too important, too central to the SEC’s mandate to protect investors, not to have on the books as Commission rule text,” said Gensler. “Today, equities often trade on off-exchange dark venues that have different business models and are less transparent than the familiar lit exchanges. Such developments in our markets make best execution that much more important. 

Rule to Enhance Competition for Individual Investor Order Execution:

Designed to protect retail investors, this rule would require certain orders of individual investors to be exposed to competition in “fair and open auctions” before they can be executed internally by any trading center that restricts order-by-order competition. 

Currently, retail brokers route more than 90% of retail orders to a small group of off-exchange dealers, known as wholesalers. This routing practice is known as a type of segmentation and reflects the fact that these orders impose lower costs on liquidity providers than unsegmented order flow. According to the SEC, wholesalers typically execute the marketable orders of individual investors internally, without providing the opportunity for other market participants to compete to provide better prices. As a result, these orders isolated from order-by-order competition, resulting in an estimated annual “competitive shortfall” (compared to the price that could have been achieved through open competition) of around $1.5 billion.

If adopted, the proposed rule generally would prohibit a “restricted competition trading center” such as a wholesaler from internally executing segmented orders unless they were first exposed to competition in a “qualified auction” operated by an “open competition trading center”.

“Today’s markets are not as fair and competitive as possible for individual investors — everyday retail investors. This is in part because there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges,” said Gensler. “I think it makes sense for the market, and for everyday individual investors, to allow the broader market to compete for their orders.”

Rules to Amend Minimum Pricing Increments and Access Fee Caps and to Enhance the Transparency of Better Priced Orders:

The SEC plans to amend its mammoth Regulation NMS (National Market System) to adopt variable tick sizes for the quoting and trading of NMS stocks, as well as reducing access fee caps for protected quotations and accelerating the transparency of best-priced orders – partially in an attempt to curtail and define dark trading.

“A large and growing amount of equity trading now goes into what many call the dark markets, particularly off-exchange market centers such as wholesalers and dark pools. Such off-exchange market centers, though, benefit from transacting using a different set of rules from the ones on national securities exchanges. This may undermine competition,” explained Gensler.

Specifically, the Commission proposes to amend Rule 612 of Regulation NMS to establish variable tick sizes for quotations and orders in stocks that are priced at, or greater than, $1 per share, and make them applicable to the trading of all NMS stocks regardless of price, subject to certain specified exceptions. Under the proposal, the primary listing exchanges would determine the applicable tick size based on the Time Weighted Average Quoted Spread for the relevant stock.

Amendments to Enhance Disclosure of Order Execution Information:

The SEC plans to update the disclosures required under Rule 605 of Regulation NMS, which has not been materially updated since its adoption in 2000.

“In the 22 years since Rule 605 was adopted, our equity markets have been transformed by ever-changing technologies and business models,” said Gensler. “Current Rule 605 disclosures have not kept up with our markets and provide investors with an incomplete picture of execution quality. This proposal, if adopted, would increase transparency for investors and facilitate their ability to compare brokers.”

The proposal would expand the scope of entities that must produce monthly execution quality reports to include broker-dealers with a larger number of customers. In addition, the proposal would modify the definition of “covered order” to include certain orders submitted outside of regular trading hours and certain orders submitted with stop prices.

Amendments to how orders are categorised would require the reporting of execution quality information for fractional share orders, odd-lot orders, and larger-sized orders. The time of order receipt and time of order execution would have to be measured in increments of a millisecond or finer and realised spread calculated at both 15 seconds and one minute.

All those subject to the rule would have to make a summary report available to the public.