SEC Proposes Rule to Enhance Competition for Certain Individual Investor Orders

Key Takeaways

The practical effect of Proposed Rule 615 would likely be to require most retail investor orders in NMS stock to be exposed in a qualifying auction on a national securities exchange. The exposure could also occur in a qualifying open competition auction at an NMS Stock ATS. But currently there are no NMS stock ATSs that would qualify because they do not display quotations and because there are few, if any, that account for 1% or more of the average daily volume in NMS stocks. Ultimately, Proposed Rule 615 would appear to cause most retail investor trading in equities to more closely resemble how trading occurs today in the U.S. listed options market — in which orders for listed options must be exposed to other market participants and executed on a national securities exchange.

Numerous questions remain, however, regarding how the Proposal would function practically, including how effective auctions would be for transactions in illiquid stocks or during rapidly changing market conditions. Additionally, although the Proposal does not explicitly bar payment for order flow (PFOF), it appears to be designed to substantially reduce the incentives for PFOF. Without PFOF, it is possible that many retail broker-dealers may no longer be willing or able to support the no-commission trades to which their customers have become accustomed.

Additionally, the proposed open competition auctions could last for only 300 milliseconds⁵ (which is also generally consistent with options exchange auction mechanisms, which can be as short as 100 milliseconds). This would mean that only sophisticated market participants capable of responding within that brief period could participate in the auctions. That aspect seems to undermine the stated goal of Proposed Rule 615, to promote the ability of firms to trade directly with individual investor orders. Relatedly, Proposed Rule 615 also has important implications for the dissemination of market data. The announcement of auctions would be disseminated through the consolidated market data feeds, which are typically slower than exchange proprietary feeds. By the time a market participant relying solely on consolidated market data feeds receives notice of a forthcoming qualified auction, it may not be possible to send an order to participate in it. This may provide greater incentive for market participants to subscribe to exchange proprietary data feeds — which would be contrary to certain objectives of the SEC’s 2020 Market Data Infrastructure Rules.⁶  

If Proposed Rule 615 is adopted, broker-dealers that facilitate trading on behalf of natural persons covered by the rule are also likely to face interpretive challenges in determining which orders are segmented orders. 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. Thus, the proposed rule would likely create substantial operational challenges for broker-dealers and also potentially lead to disruptions in trading. 

Finally, the Proposal marks a significant departure from the current design of the national market system, which until now has been to facilitate but not design innovations in market structure — for example, by allowing individual trading venues to innovate and compete with each other without mandating the type of venue or means of execution for equities transactions, such as an auction. 

Background

According to the SEC, broker-dealers currently route more than 90% of marketable orders of individual investors in NMS stocks to a small group of six off-exchange dealers, often referred to as “wholesalers” or “wholesale market makers,” that internalize these orders (i.e., they trade bilaterally as principal against such orders). While these wholesalers often provide some price improvement relative to the best publicly quoted prices for round lot sizes on national securities exchanges, the SEC believes that retail investors would benefit from greater competition in the execution of their orders and that other market participants would benefit from opportunities to execute against such orders. The SEC notes in its proposal, for example, that price improvement is not the same as competitive order execution.

The Order Competition Rule   

Definitions

Bringing the requirements and scope of Proposed Rule 615 into focus requires an understanding of a number of new definitions that would be added to the SEC’s Regulation NMS. Several of the most important definitions are as follows.

• Segmented order would generally mean an order for an NMS stock that is 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 members⁷
  • in which the average daily number of trades executed in NMS stocks was less than 40 in each of the six preceding calendar months
• Originating broker would mean any broker with responsibility for handling a customer account, including, but not limited to, opening and monitoring the customer account and accepting and transmitting orders for the customer account.
• Open competition trading center would mean certain (i) national securities exchanges or (ii) NMS stock ATSs that would be authorized to operate qualified auctions. Among other things, open competition trading centers would be required to have an aggregate average daily share volume of NMS stocks of 1% or more over four of the preceding six calendar months and publicly display quotations.
• Qualified auction would mean an auction operated by an open competition trading center in accordance with Proposed Rule 615(c).
• Restricted competition trading center would mean any trading center that is not an open competition trading center and is not a national securities exchange.

Broker-Dealer Obligations

A broker-dealer that is an originating broker would be obligated to establish, maintain, and enforce written policies and procedures reasonably designed to identify the orders of customers as segmented orders and would be prohibited from routing a segmented order without identifying it as such. Any broker-dealer that receives an order identified as a segmented order would be prohibited from routing it without identifying the order to the routing destination as a segmented order. This requirement is intended to help ensure that no segmented order reaches a restricted competition trading center without being properly identified as a segmented order (even if routed through multiple broker-dealers or trading centers). A broker-dealer that has knowledge of where a segmented order is to be routed for execution would be prohibited from submitting an order (or enabling an order to be submitted by any other person) where the order could have priority to trade with the segmented order in the continuous order book of an open competition trading center.

Exposure of Segmented Orders to a Qualified Auction

The core component of Proposed Rule 615 is that a “restricted competition trading center” would be prohibited from internally executing a segmented order for an NMS stock until after a broker-dealer exposes the segmented order to competition at a specified limit price in a qualified auction operated by an “open competition trading center.” If the segmented order is not executed in the qualified auction, then a restricted competition trading center may internally execute the segmented order, as soon as reasonably possible, at a price equal to or more favorable than the specified limit price of the qualified auction.

Requirements for Qualified Auctions

Proposed Ruled 615 would also set forth specific requirements for the qualified auctions of an open competition trading center regarding segmented orders, as follows.

• Auction messages would be provided for dissemination in consolidated market data pursuant to Rule 603(b) of Regulation NMS.
• Auction messages would indicate the identity of the open competition trading center, details of the order (symbol, side, size, limit price), and the identity of the originating broker for the segmented order.⁸
• The duration would be no shorter than 100 milliseconds and no longer than 300 milliseconds after an auction message is provided for dissemination in consolidated market data.
• Segmented orders and auction responses would be priced in an increment of no less than $0.001 if their prices are $1.00 or more per share, and in an increment of no less than $0.0001 if their prices are less than $1.00 per share, or at the midpoint of the national best bid and offer (NBBO).
• No fee could be charged for submission of a segmented order or an auction response. Any permissible fees and rebates would be capped at $0.0005 per share for segmented orders and auction responses with prices of $1 or more per share.
• Execution priority requirements would largely resemble the priority logic for auctions on options exchanges, providing that the highest-priced auction responses to buy and the lowest-priced auction responses to sell will have execution priority. Additionally:

• Auction responses for the account of a customer would have priority over auction responses for the account of a broker or dealer at the same price.
• Priority would not be based on the time of receipt of an auction response, provided that it is received within the prescribed time period (i.e., within 300 milliseconds).
• Orders resting on a continuous order book of the open competition trading center operating the qualified auction would have priority over less favorably priced auction responses.
• Displayed orders resting on a continuous order book of the open competition trading center operating the qualified auction would have priority over auction responses at the same price, while auction responses would have priority over undisplayed orders at the same price.

Exceptions to Proposed Rule 615

Proposed Rule 615 would include the following five exceptions from the order competition requirement, which would apply to segmented orders:

• received and executed when no qualified auction was being operated for such orders
• having market values of at least $200,000
• executed at prices equal to or more favorable for the orders than the midpoint of the NBBO when the orders were received
• 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
• that represent a fractional share portion of a segmented order and that are received and executed when no qualified auction is being operated for such order that would accept the fractional share portion