Pros and Cons of the SEC Market Structure Proposals

The Securities and Exchange Commission late last year proposed four new rules that would reform securities market structure, a package that Jim Angel, an associate professor at Georgetown’s McDonough School of Business, described as “1,658 pages of Christmas joy.”

The comment period for all four closes on March 31. On Thursday, the Psaros Center for Financial Markets and Policy at Georgetown University hosted an expert panel that discussed some of the advantages and disadvantages of these proposals.

Best Execution

The first proposal was Regulation Best Execution, or Reg BE. This proposal would put the SEC in charge of enforcing best execution standards from FINRA and require broker/dealers to find the best market for their customer under current market conditions.

David Lauer, the CEO of Urvin Finance, said that the SEC taking on Reg BE is a positive because Reg BE is not being enforced properly by FINRA, and SEC data show that many firms are not achieving best execution. “We have accepted good enough execution as good enough in this industry,” when the standard is supposed to be best execution, Lauer said.

Harvey Pitt, SEC chairman from 2001 to 2003 and CEO at Kalorama Partners, said that one problem with the SEC’s understanding of best execution is that it generally means finding the best price for retail investors. However, for institutional investors, other criteria may be applied in determining which execution is “best,” such as the ease or speed or the execution or its confidentiality.

Execution Disclosure

The SEC also proposed changing the execution disclosure requirements under Rule 605 of Regulation NMS. Under the proposal, broker/dealers with a large number of customers would be required to file monthly quality-of-execution reports. It would also expand the number of trades subject to execution quality disclosure, such as certain trades outside normal business hours or those with stop prices.

This proposal was perhaps the most popular among members of the panel, including those that were deeply skeptical of the other rules. Larry Tabb, head of market structure research at Bloomberg, said this proposal would improve transparency in retail execution and provide better insight into how firms execute trades. He specifically said that Robinhood Markets, a broker/dealer in retail trading, would now be subject to these reporting rules.

Adrian Griffiths, the head of market structure at the stock trading platform MEMX, agreed and said that Reg NMS was overdue for reform. The proposed change would improve the availability of market data and improve transparency. He added that transparency is a “catalyst for competition,” because consumers can make more informed choices, which in turn incentivize a more competitive market.

Lauer said this change should be “universally welcomed.”

Auctions:

Angel dramatically described the SEC’s auction proposal as something that would “end wholesaling as we know it.” Under this proposal, many retail orders would have to be exposed to a 100- to 300-millisecond auction. The proposal is intended to improve competition for retail order flow and trade volume between retail and institutional investors.

Lauer endorsed the proposal and said that a lack of competition for order flow is a “significant problem that they are trying to attack.” Lauer believes the SEC’s estimates of lost investor gains from a lack of order competition is probably underestimated and that the benefit to retail traders from this rule could be as high as $10 billion per year.

On the other hand, some retail orders, especially in less liquid stocks, are harder to execute and would get auctions in which there is little benefit from an auction, since few actors would be bidding for those trades. Other retail orders, such as index funds tracking the Standard & Poor’s 500 index, could have a lot of competition, according to Adam Nunes, head of business development at Hudson River Trading.

Griffiths agreed that low liquidity markets would be an issue for mandatory auctions and that the SEC should consider those more closely. Holding an auction for an asset with few trades would only slow down the process of completing the trade for little to no gain to the retail investor, which could hurt an investor’s experience and wind up reducing retail trades, especially in less-traded stocks.

Tick-Size

The SEC also proposed reducing the tick-size increments on exchanges to match those used by wholesalers, from penny increments to sub-penny increments.

Lauer said he supported the tick-size proposal because it would reduce the advantage that wholesalers have over exchanges, since they would have the same tick-size structure under the proposal.

Teresa Guillen, a partner at law firm Baker & Hostetler LLP, however, questioned the need for a change to tick-sizes. She said that though some stocks may have issues with tick constraints, the SEC’s proposal lacks a convincing explanation for why smaller increments for wholesalers than exchanges is problematic. She also was disappointed that the SEC did not address digital asset market structure.

Some of the panelists also questioned the wisdom of introducing so many proposed rules at once. Nunes described the four simultaneous proposals as the SEC doing “everything everywhere at once, ” referencing the Oscar-winning movie of that title. He noted that the rules are deeply interrelated with each other and need to be implemented sequentially. Nunes recommended starting with implementing the new Reg NMS and tick-sizes and then seeing what impact those rules have before moving on to others. The proposals on auctions and Reg BE would be better implemented if the market can see what adjustments need to be made after NMS and tick-sizes, according to Nunes.

Guillen agreed with this and said that “changing one thing will inevitably change other things,” so these interrelated rules should not be implemented all at once. As an example, she said that the cost-benefit analysis supporting the SEC’s auction proposal would become invalid after the NMS and tick-size changes take effect. Since those two rules would enhance competition, it would reduce the need for mandatory auctions.