The four separate rulemakings put forward by the US Securities and Exchange Commission (SEC) in December last year represent the most significant attempt to revamp market structure for US equities in recent memory.
It’s been around 18 years since the introduction of Reg NMS by the SEC – a series of initiatives designed to modernise and strengthen the national market system for equity securities – and those in favour of modernising argue that the US’ two-decade lag in regulatory evolution has paved the way for certain levels of arbitrage across the industry that needs to be stamped out.
“The development of the current rules was informed by technological capabilities that today seem hopelessly archaic. Eighteen years ago, a turnaround time of 500 milliseconds seemed incredibly fast. Now people operate in nanoseconds,” says Daniel Schlaepfer, chief executive and president of Select Vantage Inc.
“In the intervening years, people have developed strategies to arbitrage the outdated rules to their advantage, often to the detriment of market integrity. It’s been a long time since there’s been a revisit – Reg NMS was 2005 – and it’s a vastly different marketplace than it was back then.”
Among the SEC’s reforms is the proposal to amend certain rules under Reg NMS to adopt variable minimum pricing increments – or tick sizes – for the quoting and trading of NMS stocks. Elsewhere, is the suggested reduction of access fee caps for protected quotations and the acceleration of the transparency of the best priced orders available. Both, according to the regulator, are designed to enhance trading opportunities for all investors, ensuring that orders placed reflect the best prices available.
Given that equity market structure in the US has not seen any major updates since 2005, the SEC’s proposals will likely cause some growing pains. The reforms, whilst well intended, have proved divisive among participants, and many argue such a large implementation could be disruptive to how the market operates. If these proposals were to come to fruition in their current form, it would be a massive overhaul – with perhaps too much change in one go. While evolution of equities market structure in the US is long overdue, what form it should come in is up for debate.
Though many agree that some level of modernisation is necessary and beneficial to the industry, the devil is in the details. The SEC has opted for a granular and fairly complex approach, particularly with regards to the proposed new access fee and tick size regimes.
“The tick size proposal, in name only, is simple and one-dimensional, but in practice, there are changes to rebates, there are changes to pricing tiers, there are changes to odd lot data that’s being disseminated,” says Eric Stockland, managing director, electronic trading for BMO Capital Markets.
“This is like a big plumbing change and it’s going to impact institutions directly and affect what algos they use, what their implementation costs are, and just the way that stocks are even quoted and traded.”
While the changes to the access fee regime are designed to reduce the cost of accessing quotes for all types of investors, institutional investors have become increasingly concerned about the impact the proposals will have on the cost of trading and cost of liquidity sourcing, arguing that they could have a detrimental effect on incentives tied to liquidity provision that could disincentivise firms looking at trading.
“While the explicit costs of accessing that quotation may go down, the implicit costs, which I would say is the spread in the security, is going to go up and we think it will increase more than the actual explicit fee will decrease,” highlights vice president and head of US equities and strategy for North American trading services at Nasdaq, Chuck Mack.
“Institutions costs will go up in the end, which is probably not the outcome that they’re looking for. Looking at tick size too, if you don’t get that right, you can reduce and fragment liquidity and make it more costly to trade.”
Several of institutions’ main concerns surround the SEC’s tick size proposal, with many suggesting the broadening out of increments in which an institution can quote inside of the best bid offer could fragment liquidity at a given price point.
“When you broaden that out, institutions are going to struggle at a particular price, to find that block liquidity that they need to get in and out of what are very, very large positions,” says Jeff O’Connor, head of market structure, co-head coverage Americas at Liquidnet.
From an EU perspective, the European Securities and Markets Authority (ESMA) re-addressed its tick size regime in 2018 to combat concerns that Brexit will leave trading venues in the EU at a competitive disadvantage. Previous rules meant that the minimum tick size would be applicable to shares in accordance with the adjusted average daily number of transactions on the most liquid market in the EU.
However, ESMA noted that while this is an adequate liquidity indicator for most equity instruments, it may not be suited to instruments where the most liquid venue is located outside of the European Union, such as the UK post-Brexit. The new tick size regime proposed by ESMA meant that regulators of European trading venues will be allowed to calculate the average daily number of transactions on a case-by-case basis, taking into account the liquidity available on third-country venues in calibration of tick sizes.
“Proposals to reduce and harmonise tick sizes across exchanges and off-exchange venues make sense but must be appropriately calibrated to prevent any adverse impact on price discovery and lit liquidity,” says Edward Monrad, head of corporate strategy at Optiver. “Although it’s not perfect, the EU’s tick-size regime may offer a good blueprint for a dynamic tick-size regime.”
Minimum bid ask spreads
Last updated in 2005, the move to reduce the minimum bid ask spread to a penny was deemed as dramatic by industry participants, especially given the 25 cent spreads seen a few decades prior. According to the SEC, its proposals to amend minimum pricing increments are designed to enhance trading opportunities and to help ensure that orders placed in the national market system reflect the best prices available for all investors.
Those who are hesitant to the reform suggest systems will not be able to handle this. However, as the structure currently stands, significant volumes in stocks priced below a dollar that already trade at sub-penny increments, alongside existing inverted markets and the proliferation of embedded dark orders, suggests that current systems are more than capable of handling the changes that they are concerned about.
“Many stocks, given their risk and liquidity constraints, will trade much wider than a penny, and that is perfectly fine,” argues Ian Bandeen, chairman of the board of Select Vantage Inc.
“Indeed, some might say that facilitating trading at the highest level of efficiency that the markets will bear is exactly what we should be promoting. If firms can employ better technology to profitably provide tighter spreads for the most liquid securities, then we should encourage, not thwart, that evolution.”
Many argue the rapid proliferation of more advanced order entry and risk management technology has allowed market makers and participants to profitably provide sub penny spreads for over a decade.
“You have got to applaud the SEC for having the gumption to address these issues and taking on the hard battles,” adds Bandeen.
“There are some very powerful, well-entrenched special interests who will rightfully see this as a direct attack on their business models. At its core, the real issue revolves around who the markets should benefit – the vast majority of institutional and retail investors, or a narrow subset of powerful intermediaries. What the SEC is trying to achieve seems to be a return to fundamental first principles. Politically though, they are walking into a well-funded firestorm.”
Enforcing best execution
The debate surrounding who the markets should revolve around is echoed into the SEC’s proposal to put best execution in writing. As one of the four pillars of the SEC’s proposals, the new rule would establish a best execution regulatory framework for brokers, dealers, government securities brokers, government securities dealers and municipal securities dealers.
“If adopted, [Regulation Best Execution] would help ensure that brokers have policies and procedures in place to uphold one of their most important obligations: to seek best execution when trading securities, whether equities, fixed income, options, crypto security tokens, or other securities,” says Gary Gensler, chair of the SEC.
“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.”
The proposal would require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the proposed best execution standard, alongside requiring these policies and procedures to address how broker-dealers comply with the best execution standard and how they will determine the best market and make routing or execution decisions for customer orders.
“The best execution proposal is one that I don’t see getting through because in practice, we execute with the best market possible. Routers on a trading desk are still going to be forced to go to the best venue possible, so that doesn’t really change,” notes O’Connor. “There would be a big change if the retail auction component was to come to fruition. We would all have to adjust how we interact with the exchanges, it’s going to be another venue that traders need to send their child orders to. Certainly, there will be a lot of burden on broker dealers to adjust their routing and adding venues, but it’s not incredibly impactful.”
A retail lightening rod
Perhaps most divisive are the proposals set to fundamentally change the way the retail markets operate. As part of its best execution crusade, the US watchdog’s new proposals enforce that certain orders from retail investors be exposed to competition in fair and open auctions before such orders could be executed internally by any trading centre that restricts order-by-order competition.
“That particular proposal was a bit of a lightning rod for controversy, and we took a position where we’re advocating for market-based solutions rather than regulatory edict,” explains Stockland. “If there’s an opportunity for us and our clients to interact more with retail, we will absolutely be ready for that day one, and we have some ability within our strategies to behave opportunistically in response to retail opportunities.”
Payment for order flow (PFOF) – which is a form of compensation through transferring some of the trading profits from market makers to brokerages in return for directing order from a range of parties to be executed with them – and its widespread use has become a controversial topic globally. Many argue that this order flow – which the growing retail segment contributes significantly towards – should be won by publishing competitive quotes instead.
According to 606 reports gathered by the SEC, Citadel Securities forked out $2.6 billion in 2020 and 2021 on PFOF, most of it on options, followed by Susquehanna (G1X global execution brokers), which spent a $1.5 billion and Virtu which spent $654 million in the same period.
The SEC has concluded that retail investors do not currently benefit from a fair and competitive market, due to the lack of a level playing field among various aspects of the market, namely wholesalers, dark pools and lit exchanges. As part of its proposed overhaul, the regulator has highlighted that the markets have become increasingly hidden from views, especially for retail investors. Over 90% of marketable orders for stocks listed on US securities exchanges by retail investors are routed to a small group of off-exchange dealers (wholesalers) – reflecting that these orders impose lower costs on liquidity providers than unsegmented order flow, saidthe SEC.
And, these wholesalers typically execute the marketable orders of individual investors internally, without providing any opportunity for other market participants to compete to provide better prices – meaning they are not only segmented but are also isolated from order-by-order competition.
If executed correctly, the watchdog’s proposal could mean both retail and institutional investors will benefit from increased competition for orders.
“The loudest current fearmongers are primarily just the entrenched special interests with the most to lose from enhanced market efficiency and integrity. Bringing retail order flow back into the open markets will benefit everyone. Liquidity begets liquidity, and more liquidity means greater efficiency and less risk,” says Schlaepfer. “The only people who will be negatively impacted will be those whose business models relied on abusing outmoded rules to their exclusive benefit.”
What happens next?
The SEC first announced its equity market structure proposals in December last year, with a public comment period opened until 31 March. As of now, the SEC has not revealed which proposals will come into fruition and to what extent, but it goes without saying that the industry will be kept on it toes as the final verdict builds anticipation. The proposals themselves have resulted in wide industry discussion. Whether viewed as disruptive or not, they aim to improve competitiveness in the market – which is something that should be viewed as beneficial.
“These changes are about improving competition and efficiency in the market. We can debate the details and talk about the nuance, but ultimately, institutions benefit from a more efficient market,” concludes Stockland.