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Ten weeks after the U.S. Securities and Exchange Commission (SEC) unveiled a quartet of equity market rule-change proposals, one certainty is that there’s a lot to unpack. Market participants and operators alike will face compliance, operational and technology hurdles.
Nasdaq hosted a Review of SEC Market Structure Proposals webinar on February 16 that delved deeply into the details of the proposals and their implications.
“It’s a significant opportunity to shape U.S. equity market structure,” said Andrew Oppenheimer, Head of Business Development at Nasdaq, encouraging market participants to submit their own comments to the SEC by the March 31 deadline.
The SEC’s proposed rule to enhance competition for individual investor order execution via new auction mechanisms was highlighted as likely, the most controversial of the four.
Chuck Mack, Head of Strategy for North American Trading Services at Nasdaq, noted that the SEC’s intent behind this rule change is to increase competition among trading venues for retail orders and thereby improve execution prices for retail trades.
But there are several uncertainties. For one, Mack said that institutional and retail trade flow would need to interact more than they do now to generate the trading-cost decrease that the SEC seems to expect. There is also the logistical challenge of perhaps thousands of auctions taking place every day and questions as to how this order flow being diverted to auctions may impact lit trading in the form of the National Best Bid and Offer (NBBO).
Mack noted that the SEC’s expectations might not be what occurs when implemented.
Heinrich Lutjens, Head of Economic and Statistical Research at Nasdaq, said the general idea behind this proposal is that by introducing competition in retail orders, realized spreads will converge to levels seen on exchanges. The auction mechanism may bring about an issue with a “fading” NBBO – in which quotes move after an auction starts – but the SEC believes there will still be a net cost savings benefit for retail investors.
In another proposal, the SEC seeks to update the disclosure required under Rule 605 of Regulation NMS for order executions in national market system stocks.
Phil Mackintosh, Global Chief Economist at Nasdaq, who published research on the SEC’s rule-change proposals earlier this month, highlighted how this proposal would change order-type and order-size categories and include fractional share, odd-lot and larger-sized orders. Trading in low-priced stocks could be impacted the most.
According to Mackintosh, enhancing Rule 605 may be the least controversial of the proposals, and it fits squarely within the SEC’s long-stated objective of improving transparency.
There’s also the SEC’s proposed Regulation Best Execution, which would, for the first time, establish a Commission rule that codifies the longstanding duty of broker-dealers to obtain best executions for their customers.
Industry groups FINRA and MSRB already have their own best execution frameworks. “The vision is not entirely clear” regarding the SEC’s proposal, Brett Kitt, Principal Associate General Counsel at Nasdaq. “It wouldn’t supplant the other rules, but it doesn’t say how the rules will coexist.”
Features of the SEC’s best execution proposal include an expanded scope that spans asset classes, including not only equities but also options, fixed income and digital assets, as well as heightened best ex standards for “conflicted” transactions, which may include transactions that fall underpayment for order flow.
Finally, the SEC has proposed to amend certain rules under Regulation NMS to adopt variable minimum pricing increments, or “tick sizes,” for the quoting and trading of NMS stocks, reduce access fee caps for protected quotations and accelerate the transparency of the best-priced orders available in the market. Mack said this proposal focuses on “market micro mechanics.”
“There are a lot of individual rules within this proposal,” Mack said. “The proposal touches on many important items and represents a pretty significant change.”
Lutjens noted that lower access fees come with a tradeoff of lower rebates, which could negatively impact liquidity. Mackintosh pointed out that counterintuitively, it’s larger tick sizes that tighten spreads.
For now, the best window into the market’s thinking on the SEC proposals is the comment letters. Kitt noted more than 100 comments for each proposal as of February 16, mostly from individual investors. Many of those comment letters have expressed “some anxiety about the return of commissions for retail trading, but also the desire to ensure that markets operate fairly for retail investors,” Kitt said.
Institutional trading firms and industry groups have mostly emphasized the need for the comment period to be long enough to account for the complexity and interconnectedness of the rule proposals.
Going forward, Kitt said it’s reasonable to expect some rule finalization from the SEC as soon as this year. However, if significant opposition to any of the rules or viable alternatives emerges, the regulator may pivot and start over with redrawn proposals and new comment periods.
“We’re still at an early stage in the process,” Kitt said. “Things can change significantly.”
To view the webinar, click here.
