On December 14, 2022, the US Securities and Exchange Commission (SEC) proposed a fundamental restructuring of the US equity markets in the form of two rule amendments and one new rule proposal (the Equity Market Proposals). In addition, the SEC proposed new Regulation Best Execution (Proposed Regulation Best Ex) under the Securities Exchange Act of 1934 (Exchange Act). The comment period for each rule proposal will remain open until the later of March 31, 2023, or 60 days after the applicable proposing release is published in the Federal Register.
Although we are still reviewing the Equity Market Proposals and Proposed Regulation Best Ex and anticipate providing further insights, we share our initial thoughts below.
EQUITY MARKET PROPOSALS
Rule 605 Amendments: Order Execution Disclosures
The proposed amendments to Rule 605 under Regulation NMS would expand the scope and content of information that is disclosed under that rule in three main ways: (1) expanding the scope of entities subject to Rule 605; (2) updating the scope and content of the monthly reports that are required under Rule 605; and (3) requiring that summary reports of execution quality be available in a human-readable (as opposed to machine-readable) format.
Expansion of Covered Entities
Currently, only market centers (such as national securities exchanges, over-the-counter (OTC) market makers, and alternative trading systems (ATSs)) are required to produce publicly available, monthly execution quality reports under Rule 605. Under the proposed changes to Rule 605, the entities required to produce such reports would be expanded to include (1) broker-dealers that introduce or carry 100,000 or more customer accounts; (2) single-dealer platforms; and (3) entities that would operate proposed qualified auctions.
Expanded Monthly Report Requirements
The proposed amendments would include updates to the scope and content of the standardized monthly reports required under Rule 605. In particular, these changes would (1) expand the definition of “covered order” to include certain additional orders and order types; (2) modify the existing order size categories to base them on round lots rather than number of shares, and include additional order size categories for fractional share, odd-lot, and larger-sized orders; and (3) create a new order type category for marketable immediate-or-cancel orders, and replace three existing categories of nonmarketable order types with three new categories of order types.
In addition, the content of the reports required under Rule 605 would be amended to include such things as (1) average time to execution, median time to execution, and 99th percentile time to execution statistics; (2) realized spread statistics that would be required to be calculated after both 15 seconds and one minute; and (3) new statistical measures of execution quality.
Summary Reports
The proposed amendments would require all entities subject to the rule to make a summary report available that would be formatted in the most recent versions of the XML and PDF formats published on the SEC’s website.
Initial Thoughts
The amendments, if adopted as proposed, will significantly expand the data that is made available to the public about execution quality of equity transactions.
The expansion of the rule to include large broker-dealers is intended to promote competition among those broker-dealers, but will of course impose significant new requirements on the in-scope firms. This will require significant technological builds that will entail significant testing to ensure that back-office systems are adequately capturing required information.
While the requirement that Rule 605 monthly reports be made available in human-readable form will be a welcome change for many, it is unclear whether the average retail investor will find these useful.
Regulation NMS Amendments: Tick Size, Access Fees, and Transparency
The SEC is proposing to amend Regulation NMS to (1) amend the tick sizes under Rule 612 to establish a variable minimum pricing increment model that would apply to both the quoting and the trading of NMS stocks; (2) reduce the access fee caps under Rule 610 of Regulation NMS in conjunction with the reduction of the minimum pricing increments, and require national securities exchanges to make the amounts of all fees and rebates determinable at the time of execution; (3) accelerate the implementation of the round-lot and odd-lot information definition adopted in 2020 under the Market Data Infrastructure Rules (MDI Rules); and (4) amend the odd-lot information definition adopted under the MDI Rules to require the identification of the best odd-lot order.
Initial Thoughts
The proposed changes to appear to provide a lifeline to national securities exchanges as they compete for volume against the wholesalers that have increasingly claimed more volume.
In particular, the variable sub-penny tick sizes, in combination with the reduced access fee caps and the proposed requirement that fees and rebates be determinable at execution, may ultimately work in conjunction with Proposed Regulation Best Ex (discussed below) to, as the SEC likes to say, “level the playing field.”
Proposed Order Competition Rule: Retail Auction Rule
The SEC is proposing a new Rule 615 under Regulation NMS that would seek to enhance competition for the execution of marketable orders of individual investors. The rule would require certain orders of individual investors to be exposed to competition in fair and open “qualified auctions” before they could be executed internally by any trading center that restricts order-by-order competition.
The rule would apply to “segmented orders,” which would be orders for stocks listed on US securities exchanges (NMS stocks)
- made for an account of a natural person or an account held in legal form on behalf of a natural person or group of related family members; and
- in which the average daily number of trades executed in NMS stocks was less than 40 in each of the six preceding calendar months.
Exceptions would be provided for the following:
- Segmented orders received and executed when no qualified auction was being operated for such orders
- Segmented orders with market values of at least $200,000
- Segmented orders executed at prices that are equal to or more favorable for the orders than the midpoint of the national best bid and offer (NBBO) when the orders were received
- Segmented orders with customer-selected limit prices that are equal to or more favorable for the orders than the midpoint of the NBBO when the orders were received
- The fractional share portion of a segmented order received and executed when no qualified auction was being operated for such order that would accept the fractional share portion
The proposal would apply to “restricted competition trading centers,” which would be trading venues other than any national securities exchange and those ATSs that meet proposed requirements for an “open competition trading center.” Open competition trading centers would be those national securities exchanges or ATSs that meet proposed requirements for transparency, access, and volume.
Absent an exception, a restricted competition trading center would be prohibited from executing internally, or internalizing, a segmented order for an NMS stock unless the order first was exposed to competition in a qualified auction operated by an open competition trading center. The proposal would establish requirements for qualified auctions.
Initial Thoughts
This is perhaps the most consequential of the proposed rules and the one most likely to generate comment and controversy. It is unclear, as an initial matter, whether proposed Rule 615 solves any meaningful problem in the retail equity market other than taking away order flow from established wholesalers.
While we continue to parse the proposal, it is unclear whether any price improvements that retail customers obtain under the proposed auction mechanism will be offset by their having to pay commissions if broker-dealers become reluctant to accept payment for order flow (PFOF) out of fear of violating a best execution obligation, as discussed below.
Further, given the transformative nature of the proposal, there is a significant risk that the proposed changes would lead to unintended consequences.
REGULATION BEST EXECUTION
Proposed Regulation Best Ex under the Exchange Act would be composed of three rules—Proposed Rules 1100, 1101, and 1102—and would apply to brokers, dealers, government securities brokers, government securities dealers, and municipal securities dealers (collectively, broker-dealers).
Proposed Rule 1100
This portion of Proposed Regulation Best Ex would set forth the best execution standard and provide for certain exemptions from that standard.
- Best Execution Standard: As explained in the fact sheet, the proposed rule would specify that, in any transaction for or with a customer or a customer of another broker-dealer, a broker-dealer (or a natural person who is an associated person of the broker-dealer) would be required to use reasonable diligence to ascertain the best market for the security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions, subject to certain exemptions.
- Exemptions: As explained in the fact sheet, proposed Rule 1100 would exempt a broker-dealer from the best execution standard when
- another broker-dealer is executing a customer order against the broker-dealer’s quotation;
- an institutional customer, exercising independent judgment, executes its order against the broker-dealer’s quotation; or
- the broker-dealer receives an unsolicited instruction from a customer to route its order to a particular market for execution, and the broker-dealer processes that customer’s order promptly and in accordance with the terms of the order.
Proposed Rule 1101
Proposed Rule 1101 would address policies and procedures, conflicted transactions, and execution quality reviews, and also provide an exemption for introducing brokers.
- Policies and Procedures: Paragraph (a) of proposed Rule 1101 would require broker-dealers to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the best execution standard. These policies and procedures would have to address how broker-dealers will comply with the best execution standard and how they will determine the best market and make routing or execution decisions for customer orders.
- Conflicted Transactions: Paragraph (b) of proposed Rule 1101 would address situations where broker-dealers engage in “conflicted transactions” with respect to retail customer orders. In particular, this provision would subject these broker-dealers to additional obligations and apply to any transaction where a broker-dealer (1) executes an order as principal, including riskless principal; (2) routes an order to or receives an order from an affiliate for execution; or (3) provides or receives payment for order flow. Proposed Rule 1101(b) would require additional policies and procedures for conflicted transactions, and would require broker-dealers to document their compliance with the best execution standard for such transactions and any arrangement concerning payment for order flow.
- Execution Quality Review: Proposed Rule 1101(c) would require broker-dealers to (1) review at least quarterly the execution quality of their customer transactions; (2) compare it with the execution quality that might have been obtained from other markets; (3) revise accordingly their best execution policies and procedures, including order-handling practices; and (4) document the results of the review.
- Exemption for Introducing Brokers: Proposed Rule 1101(d) would provide an exemption to “introducing brokers” from complying with proposed Rules 1101(a), (b), and (c) if they (1) establish, maintain, and enforce policies and procedures that require them to regularly review the execution quality obtained from their executing broker; (2) compare that execution quality with the execution quality they might have obtained from other executing brokers; and (3) revise their order-handling practices accordingly. Introducing brokers would be required to document the results of the review.
Proposed Rule 1102
Proposed Rule 1102 would require broker-dealers to review at least annually their best execution policies and procedures, including their order-handling practices. Broker-dealers would be required to document such reviews and prepare and present written reports detailing the results of the reviews to their boards of directors or equivalent governing bodies.
Rule 17a-4
The proposal also would amend Exchange Act Rule 17a-4 to require broker-dealers to preserve records made pursuant to Proposed Regulation Best Ex.
Initial Thoughts
Proposed Regulation Best Ex appears to borrow heavily from existing FINRA Rule 5310 and MSRB Rule G-18. As such, broker-dealers that are FINRA and/or MSRB members will already have a baseline by which to assess the utility of the SEC’s proposal. That said, Proposed Regulation Best Ex cannot be viewed in isolation from the SEC’s Equity Market Proposals.
Indeed, at least when it comes to execution obligations in the equity markets, broker-dealers that would be subject to Proposed Regulation Best Ex would have to rely heavily on the data and reports that are produced as a result of the Equity Market Proposals if those proposals are adopted as proposed.
And although the SEC has not proposed to eliminate a broker-dealer’s receipt of PFOF, the additional requirements that Proposed Regulation Best Ex would place on broker-dealers that receive PFOF, coupled with the requirement in the proposed amendments to Rule 610 of Regulation NMS that rebate or other remuneration information be calculable before an order is executed, may ultimately have a chilling effect on the receipt of PFOF.
Moreover, the conflicted transaction provisions may have some unintended impact on the fixed-income markets, which are traditionally transacted on a riskless principal basis.
Finally, we note that the exemption for introducing broker-dealers is not a full exemption, as it still imposes significant requirements on these broker-dealers that are often addressed through contractual provisions in clearing agreements.