This article first published as Compliance in Focus on Markets Media. Compliance in Focus is a content series on regulatory topics for financial markets and the challenges compliance officers face in addressing surveillance and monitoring. Compliance in Focus is produced in collaboration with Eventus.
Among the bevy of U.S. Securities and Exchange Commission regulatory proposals issued in December 2022, some demand more prominence on broker-dealers’ radar than others.
Chris Montagnino, Director of Regulatory Affairs at Eventus, highlighted two proposals that could meaningfully impact how broker-dealers manage their data and surveillance obligations. One SEC proposal would amend minimum pricing increments, or tick sizes, for the quoting and trading of National Market System (NMS) stocks; the other proposal aims to enhance competition by requiring that certain retail orders be exposed to competition in auctions before such orders can be executed internally (or “upstairs”) by a “restricted competition trading center,” or wholesaler.
To be sure, it will be some time before either or both rule changes are finalized, and what the specifications will be if finalized. The public comment period runs through March 31. But before broker-dealers know which boxes they need to check, there are opportunities to assess the general preparedness of monitoring and surveillance technology, and how quickly and cost-efficiently that technology can adjust to new regulatory mandates.
“If your technology is flexible enough, it will be easier for you to adjust and recalibrate systems to the new, dynamic tick sizes as well as the new auction mechanism,” said Montagnino, a 28-year capital markets industry veteran who previously held senior positions in regulatory compliance and trade surveillance at several large broker-dealers.
“If you’re stuck in a legacy way of doing business, or if your legacy software is not flexible or adaptable, it’s going to be more challenging and will place a greater strain on resources to implement the required changes,” Montagnino continued.
With the tick-size rule change proposal, the SEC is seeking to amend Rule 612 of Regulation NMS to reduce minimum bid-ask spreads from $0.01 to sub-penny increments for stocks trading $1.00 and above; amend Rule 610 to reduce access fee caps for protected quotations in certain stocks; and accelerate the implementation of previously adopted round lot and odd-lot definitions.
“With the minimum pricing increments, you will have four buckets of minimum tick sizes, so you’ll need to systematically and continuously track whether an equity moves from one bucket or to another,” Montagnino said. “There will also be new requirements for the display of odd-lot quotations which will have an impact on monitoring and surveillance practices.”
There are also implications for how a broker-dealer surveils for market manipulation, which is critical to manage reputational risk and avoid the rising tide of SEC enforcement actions.
With more tick sizes, “there will be more levels at which to manipulate prices,” Montagnino said. “Are your systems sensitive enough to detect this trading in smaller increments? Big picture, if these rules come into effect, surveillance teams will have to examine their parameters and recalibrate where alerts are triggered as well as identify potentially new manipulative scenarios for monitoring.”
This proposal, if it moves forward, “would likely necessitate systems changes for a large number of market participants, including broker-dealers and exchanges, to allow for the submission, ranking, and display of orders at more granular pricing increments,” Law firm Sidley said in a December regulatory update. “Moreover, these minimum tick sizes will vary by stock and may change for each stock on a quarterly basis, which would require broker-dealer systems to be able to accommodate such changes.”
The SEC proposal for auctions, Rule 615, would mandate broker-dealers monitor account activity to see which orders must go through an auction and ensure those orders are routed to qualified auctions as required. Broker-dealers would have to ensure orders not executed in an auction are handled according to existing requirements.
“There will be a whole new data stream provided by the auction process,” Montagnino said. “This will include data about the auction itself, data about what orders are sent to the auction, how long orders remain there, which orders are executed in the auction, and which orders are sent back to the broker-dealer.”
“Broker-dealers would be required to establish policies and procedures reasonably designed to identify customer orders as segmented orders and would also need to establish additional policies and procedures related to the routing of segmented orders,” Sidley said in another regulatory update. “The proposed rule would likely create substantial operational challenges for broker-dealers.”
For its part, SIFMA, the industry group representing broker-dealers, released a preliminary statement on Dec. 14, 2022, the same day the SEC released its proposals. “The substantial changes proposed today by the SEC are incredibly complex with material impact to all market participants,” SIFMA said, asking the regulator to be “extremely careful” in its approach.
Regardless of how the proposed rule changes shake out, “there’s going to be an emphasis on the need for more flexibility and responsiveness from the technology you use to detect problems,” Montagnino said. “This highlights the historic challenge of communication between front and back-office systems. The back-office will monitor the trading activity to tag accounts that are subject to the new requirements, but that information will need to pass through to the front-office systems responsible for the proper handling and routing of the orders.”
