On October 6, 2017, the Department of the Treasury (Treasury) released a report describing potential policy proposals for U.S. capital markets regulation that would “promote economic growth and vibrant financial markets while maintaining strong investor protections.”1 The Treasury issued the report in response to President Donald Trump’s Executive Order 13772, published in February, which called on the Treasury to identify financial laws and regulations that are inconsistent with a set of “core principles” identified by the President.2
With respect to equity market structure, the Treasury identifies seven specific areas it believes may need to be addressed to align with President Trump’s core principles. Each of these is summarized below.
Fragmentation of Liquidity and Promoting Liquidity in Less Liquid Stocks
The Treasury Report recognizes that recent regulatory and technological developments have fueled an increase in the number of trading venues on which to execute equity trades. While the proliferation of trading venues has enhanced competition, resulting in innovation and reduced transaction costs, the fragmentation of liquidity across these venues has also increased complexity and may negatively affect price discovery and execution quality. For thinly traded stocks, the Treasury notes that market fragmentation can be especially problematic; with limited volume spread across many venues, finding a trading counterparty has become more complicated.
To combat the effects of market fragmentation, the Treasury recommends that the Securities and Exchange Commission (SEC) should consider amending Regulation NMS to allow issuers of thinly traded stocks to elect that their stock trade on a limited number of venues until trading hits a minimum threshold. While the Treasury does not advocate a specific method to determine such a threshold, it suggests that average daily volume could be a useful metric. The Treasury observes that issuers have a unique interest in promoting the liquidity of their stocks and would be able to consult underwriters or listing exchanges to make the best decision on where their stocks should trade. Notably, the Treasury states that broker-dealers should still be able to internalize executions of thinly traded securities.
Dynamic Tick Sizes
The Treasury notes that participants in U.S. equity markets have seen a reduction in trading costs in recent years, crediting decimalization and the attendant reduction of tick sizes as contributing factors to this trend. However, the Treasury believes that the penny trading increments currently mandated by regulation are not optimal for all stocks. In particular, since trades with larger tick sizes generally provide market makers with more compensation per trade, thinly traded stocks would likely attract more market making if such stocks were traded with tick sizes larger than one penny. To address this, the Treasury notes that the SEC launched the Tick-Size Pilot (allowing for multiple, larger tick sizes) in October 2016, with mixed and inconclusive results so far. While the Treasury acknowledges that the effects of requiring different tick sizes for different stocks may complicate markets, the Treasury nonetheless believes that the SEC should consider allowing issuers to determine tick size for trading of their stocks across exchanges, as occurs in futures markets.
Maker-Taker and Payment for Order Flow
The Treasury Report identifies the manner in which market participants are compensated for transactions as an area in potential need of reform — specifically the “maker-taker” fee model and payment for order flow. Under a maker-taker fee model, a trading venue charges broker-dealers and other traders a fee for “taking” liquidity posted on the exchange and conversely pays a rebate to a broker-dealer for posting an order (i.e., “making” or adding liquidity).3 The structure is designed to encourage market participants to post liquidity on the trading venue. Payment for order flow is compensation paid to a broker-dealer for directing orders to a particular market maker or trading venue. The Treasury notes that these fee and payment arrangements can distort the incentives of broker-dealers tasked with executing clients’ trades under the obligation of best execution. The stated concern is that rather than routing client orders to a venue that may best accomplish a client’s execution objectives, a broker may instead be incentivized to route to venues that pay the broker a large trading rebate.
The Treasury recommends a multifaceted solution to address the maker-taker and payment for order flow issues. First, it recommends that the SEC adopt the amendments to Regulation NMS Rules 600 and 606 proposed in July 2016.4 These changes would enhance the required disclosures relating to payment for order flow or other compensation received by a broker-dealer in connection with executing a client’s orders and would provide additional execution statistics and information about conflicts of interest for institutional and retail investors to evaluate. Second, the Treasury endorses an access fee pilot that would allow the SEC to assess the impact of reduced maker-taker fees on execution quality and liquidity.5 While endorsing an access fee pilot, the Treasury stated that it may be appropriate to exempt thinly traded stocks from restrictions on maker-taker rebates and payment for order flow if such exemptions would facilitate greater market making in those stocks. Finally, the Treasury believes that the SEC should consider requiring broker-dealers to refund rebates and order flow payments back to their customers, allowing brokers’ incentives to be more appropriately aligned with those of their customers.
Existing rules governing the distribution of market data allow exchanges to sell proprietary, noncore trade data (e.g., data detailing depth-of-book quotations and odd-lot orders) at prices determined by the exchanges, subject to review by the SEC.6 The vast array of information found in proprietary data packages sold by each individual exchange is imperative to the operation of high-frequency trading firms (HFTs)7 and, as the Treasury states, some brokers believe that monitoring proprietary data feeds from each exchange is essential to the performance of their best execution obligations. These brokers and HFTs, who make up an important segment of the market, compete on speed and breadth of information processing and typically purchase costly proprietary data from all or nearly all exchanges. Proprietary data from one exchange cannot effectively substitute for data from another exchange. Given the demand for such data and lack of substitutes, the price of proprietary data feeds has rapidly increased in recent years. This pricing dynamic has led to the Treasury’s belief that “the market for proprietary data feeds is not fully competitive.”8
To address the concerns of the market participants described above, the Treasury recommends that the SEC and the Financial Industry Regulatory Authority (FINRA) issue guidance clarifying that brokers may satisfy best execution obligations by relying solely on core Security Information Processors (SIP) data, as opposed to requiring brokers to purchase costly proprietary data feeds from each exchange. Further, the Treasury recommends that the SEC more closely scrutinize fees charged for proprietary data to ensure that the fees are “fair and reasonable” and “not unreasonably discriminatory.” Finally, the Treasury recommends that the SEC should consider amending Regulation NMS to allow alternative data consolidators to compete with centralized SIPs, which the Treasury believes could foster innovation in the market data space.
Order Protection Rule
The Order Protection Rule prohibits a broker-dealer from executing an order at a price that is worse than the best displayed price across all trading venues (i.e., the NBBO). The rule has helped to foster competition among exchanges as it allows any exchange to attract order flow any time it has the NBBO. The Treasury believes, however, that the Order Protection Rule has contributed to the complexity and fragmentation of U.S. equity markets. Brokers attempting to fulfill their best execution obligations often have to monitor or connect to trading venues that rarely offer meaningful liquidity but happen to be displaying the best price for a given stock at the time of execution. The Treasury notes that this presents a problem when broker-dealers attempt to execute a large block order, as having to execute small portions of the block against quotations displayed on several different venues increases the risk of tipping off other traders to the presence of a large trading interest, ultimately raising the execution costs of the block order. Broker-dealers often defend against this risk by trading in dark pools, which further fragments the market and reduces market transparency.
The Treasury recommends that the SEC consider amending the Order Protection Rule to withdraw protected quote status from exchanges that do not meet a minimum liquidity threshold. If the SEC finds that such withdrawal would discourage formation of new exchanges, then the Treasury recommends that newly registered exchanges be granted a period of time to reach the established threshold.
Reducing Complexity in Equity Markets
The Treasury reports over 2,000 different variations of equity order types (e.g., fill or kill, nondisplayed orders and nonroutable orders).9 The Treasury states that some institutional traders, who tend to trade in large blocks, have expressed concern that short-term HFTs may exploit these order types in a manner that allows them to determine the trading intentions of institutional traders, ultimately raising transaction costs to institutions. The Treasury further notes that some traders may not understand how HFTs and others exploit order types to gain information advantages. Because, in the Treasury’s view, the proliferation of order types has exacerbated market complexity, the Treasury recommends that the SEC consider whether trading venues can harmonize order types and examine whether certain order types sustain enough volume to merit continued existence.
In November 2015, the SEC proposed to amend Regulation ATS to increase public information about alternative trading systems (ATSs) that trade National Market System (NMS) stocks (NMS Stock ATSs),10 the overwhelming majority of which are dark pools with limited transparency. The Treasury agrees with the SEC’s goals of increasing public information about NMS Stock ATSs, as this information would allow investors to make more informed decisions about whether to execute transactions on these venues. However, the Treasury recommends that the SEC revise aspects of the proposal to eliminate requirements for NMS Stock ATSs to publicly disclose confidential information that would be unnecessary and unhelpful to investors. For instance, the Treasury questioned the utility of the requirement in the SEC’s proposal that NMS Stock ATSs publicly disclose details of “outsourcing arrangements concerning any of its operations, services, or functions.”11 However, if the SEC can demonstrate that such information would improve its oversight of equity markets, then the Treasury recommends that the SEC require only confidential disclosure.
The Treasury Report lays out a set of equity market structure policy recommendations that the Treasury asserts would improve the overall vibrancy of U.S. markets to foster economic growth, consistent with the stated regulatory goals of the Trump administration. With respect to many of the issues discussed in the Treasury Report, regulatory agencies have already taken initial steps by issuing certain policy proposals and appear poised to finalize a number of these reforms.12 In particular, Chairman Clayton has indicated that the SEC plans to launch an access fee pilot and adopt proposed amendments to Rule 606 and Regulation ATS in the near future, with broad industry support for adopting amendments to Rule 606.13 The newly selected Director of the Division of Trading and Markets, Brett Redfearn,14 has been a leading voice in discussions related to these and other key market structure initiatives.15 In addition, we understand that FINRA plans to issue further guidance on best execution as it relates to the use of SIP data. It remains to be seen whether regulators will act on the other recommendations of the Treasury Report.16
1 U.S. Department of the Treasury, A Financial System That Creates Economic Opportunities: Capital Markets (October 6, 2017), available at https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf (Treasury Report). The Treasury also released an accompanying five-page “fact sheet,” available at https://www.treasury.gov/press-center/press-releases/Documents/2017-044856_CAPITALMRKTS_factsheet_v1%20FINAL-FINAL.pdf.
2 See Executive Order 13772, available at https://www.whitehouse.gov/the-press-office/2017/02/03/presidential-executive-order-core-principles-regulating-united-states.
3 Other venues have adopted variations of the maker-taker fee structure. For example, “inverted venues” offer rebates for taking liquidity and charge fees for providing liquidity.
4 See Sidley Update “SEC Proposes Rules to Enhance Order Handling Information Available to Investors,” available at https://www.sidley.com/en/insights/newsupdates/2016/08/sec-proposes-rules-to-enhance-order-handling.
5 This is consistent with the Equity Market Structure Advisory Committee’s (EMSAC) recommendation for an access fee pilot and recent remarks by SEC Chairman Jay Clayton. See the EMSAC recommendation, available at https://www.sec.gov/spotlight/emsac/recommendation-access-fee-pilot.pdf. See Chairman Clayton’s remarks, available at https://www.sec.gov/news/speech/remarks-economic-club-new-york.
6 Market participants may purchase core data (i.e., last sale prices and National Best Bid or Offer or NBBO) packages from centralized securities information processors (SIPs).
7 Another key difference between SIP data and proprietary data is that trading firms can often consolidate and analyze proprietary data faster than the time it takes centralized SIPs to consolidate and disseminate data.
8 See Treasury Report at 63.
9 See Treasury Report at 66. It cites the following as its sources for the statistics. Herbert Lash, Complaints Rise over Complex U.S. Stock Orders, Reuters (Oct. 19, 2012), available at http://www.reuters.com/article/us-exchanges-ordertypes/analysis-complaints-rise-over-complex-u-s-stock-orders-idUSBRE89I0YU20121019. See also Paul G. Mahoney and Gabriel Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation, Virginia Law and Economics Research Paper No. 2017-07 (Apr. 19, 2017), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955112.
10 See Sidley Update “SEC Proposes New Rules to Increase the Transparency and Oversight of Alternative Trading Systems that Transact in NMS Stock,” available at https://www.sidley.com/en/insights/newsupdates/2015/11/sec-proposes-new-rules-to-increase.
11 See Treasury Report at 67.
12 Examples of this are the launching of the Tick-Size Pilot and the proposal of amendments to Regulation ATS and Rule 606.
13 See Chairman Clayton’s testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs on “Oversight of the U.S. Securities and Exchange Commission,” available at https://www.sec.gov/news/testimony/testimony-clayton-2017-09-26.
14 See SEC Names Brett Redfearn as Director of the Division of Trading and Markets, available at https://www.sec.gov/news/press-release/2017-198.
15 Director Redfearn has written numerous statements to the SEC calling for changes to NMS Plan governance and addressing what he believes are problems with self-regulatory organization immunity and conflicts of interest that harm broker-dealers. See Director Redfearn’s comments to the EMSAC, available at https://www.sec.gov/comments/265-29/26529-43.pdf and https://www.sec.gov/comments/265-29/26529-64.pdf.
16 Sidley notes that in March 2015, the SEC proposed amendments to SEC Rule 15b9-1 to require broker-dealers active in off-exchange trading to become members of a national securities association. Neither the Treasury Report nor recent remarks from Chairman Clayton mentions support for this initiative.
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