Today is the final day for the trading industry and investors to submit comments on one of Securities and Exchange Commission Chair Gary Gensler's most controversial proposals: a partial overhaul of the U.S. trading system.
The package is so complex and potentially far-reaching that Gensler has broken them into four separate proposals. Two of them have sizeable industry support and are likely to be adopted. But two others are facing serious opposition and, at least one — the effort to replace payment for order flow by an auction process which came out of the GameStop meme stock controversy — may end in litigation to prevent it from seeing the light of day.
Better prices for small investor trades?
The most controversial of the proposals involves a change in the way some retail orders are executed. Gensler has been critical of payment for order flow (PFOF), whereby some retail brokers (including Schwab, ETrade and Robinhood) route orders to electronic market makers known as wholesalers (including Citadel and Virtu), who pay the brokers for access to that order flow. These wholesalers may send the orders to exchanges, but often match the orders against their own internal order flow.
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The wholesalers profit from the difference between the buying and selling price. The fees brokers receive have allowed brokers to charge zero commission to their clients.
However, Gensler has claimed that pension funds and other institutional investors are not able to interact with that retail order flow. He also claimed the brokers are putting their financial gain ahead of their requirement to provide the best prices to their clients.
To increase competition, Gensler is floating the idea of setting up auctions in which trading firms would compete with each other to fill investors' orders before they could be executed internally.
"These everyday individual investors don't have the full benefit of various market participants competing to execute their marketable orders at the best price possible," Gensler said in a December statement. Gensler claims investors could save about $1.5 billion annually, compared with current practice.
Auctions: the industry lines up against it
The auction proposal has generated a large volume of comment letters to the SEC.
Many submission letters have been submitted by individual retail investors who support the proposal. A substantial number were motivated by events around Gamestop, AMC and other "meme stocks' in early 2021, and many believe that payment for order flow was a part of that problem.
"These proposals are potentially crucial steps towards addressing the issues we saw in January 2021 and making the markets more fair for retail investors," Better Markets, an independent nonprofit that promotes public interest in financial reform, said in a recent post on its website.
Most of Wall Street, however, vehemently disagrees.
The concern: the proposal is so complex, the costs so difficult to assess, that there is the potential for significant market disruption.
"SIFMA's members believe the order competition rule should be withdrawn," Kenneth Bentsen, President and CEO of the Securities Industry and Financial Markets Association (SIFMA), said in a statement to CNBC. SIFMA is a trade group representing securities firms, banks and asset management companies.
"The SEC failed to make a valid case for doing it, and it will not only be disruptive to the market, it will hurt the stakeholders the SEC purports to help," Bentsen said. "In addition, the cost/benefit analysis done by the SEC is flawed. Several academic research studies show that this proposal, if enacted, would raise costs for retail investors. The U.S. equity markets are incredibly efficient and resilient and investors, especially retail investors, have the greatest ease of access, lowest cost of trading and best execution in history. There is intense competition in the marketplace both upstream and downstream, especially with regard to retail investors. This flawed proposal will do more harm than good, and it is based on data that does not reflect today's market."
A letter jointly submitted by the NYSE, Citadel and Charles Schwab also recommended that the proposal be withdrawn entirely, as does another joint letter submitted by Cboe, State Street Global Advisors, T. Rowe Price, UBS and Virtu Financial.
"We believe that the Commission should not move forward with its proposal to mandate equity auctions for marketable retail orders," the joint Cboe letter said, suggesting instead that the SEC consider other approaches to enhance execution quality "that do not pose risks to competition, liquidity and efficient capital formation in our equity markets."
Nasdaq has also registered its opposition to the proposal, saying "the SEC risks too much by solely focusing on qualified auctions," instead recommending that the SEC should define a minimum price improvement threshold that broker-dealers must meet in order to internalize retail order flow.
SEC Commissioners Hester Peirce and Mark Uyeda, both Republicans, also filed statements opposing the proposal.
"This latest effort to order competition threatens to create disorder in the capital markets, the functioning of which is so important to the rest of our economy," Peirce wrote in a statement.
"We have not done the work necessary to justify the extensive changes we are considering," she said.
Ready for a lawsuit?
Some are already threatening litigation if the proposal goes through.
"Ultimately, it's going to end up, unfortunately, sadly, probably in litigation [if Gensler] decides to go down this road," Virtu CEO Doug Cifu said in an interview at the Securities Traders Association of New York conference on March 27th at the NYSE.
Cifu specifically cited the Administrative Procedures Act (APA), which governs the way government agencies may propose and establish regulations.
The SEC must follow procedures outlined in the APA. If not, it can get sued.
One securities attorney with knowledge of the APA, who asked to remain anonymous, told me there were several dimensions to a potential lawsuit.
"The strongest way to challenge an agency is to say that the agency is doing something outside of their statutory authority," the attorney said, noting that he thought it unlikely such a challenge would succeed in this case.
The attorney also noted there were two types of APA challenges. "The first is a procedural challenge. You can say, I didn't have adequate notice or the opportunity to comment. You might make that type of claim where the SEC is relying on data or information they're not making public."
Much more common are claims that the rulemaking is arbitrary and capricious. "You could claim the SEC considered improper factors in its analysis, you could claim it didn't consider other relevant factors, or it didn't address reasonable alternatives."
Another argument which is almost certain to be made is an inadequate cost benefit analysis: the SEC must demonstrate that what it is trying to do is worth the cost, and any lawsuit will almost certainly claim the SEC did not adequately consider the cost of this proposal.
The attorney declined to comment on the likelihood of a lawsuit. However, another attorney familiar with the submissions that have been made, who also asked to remain anonymous, noted that, "Some of these submissions look they are the opening round of a litigation process."
Are you ready for trading in sub-pennies?
The minimum trading increment was set at a penny nearly 20 years ago. A second proposal being considered could alter that.
Under current regulations, exchanges such as the NYSE and Nasdaq cannot generally execute a trade at anything less than a penny increment (or a midpoint), however market wholesalers (dealers internalizing their orders) can trade in any sub-penny increment, including hundredths of a penny. Dark pools, which are off-exchange trading venues, can also execute in sub-penny increments.
Gensler says this has created a trading advantage for these off-exchange market centers, so he is proposing to require one minimum trading size regardless of the venue.
What size should the minimum increment be? Gensler is proposing making it smaller than a penny for many securities.
Why start trading in sub-penny intervals? It's been known for some time that many stocks are "tick-constrained", that is, they almost always have a bid-offer spread that is one cent wide. This implies that if the tick size was smaller than a penny, investors might get better prices.
How much smaller an increment? It depends. Under the proposal, many securities would have a tick size of half a penny. Those that are "tick constrained" might have even smaller increments, such as a tenth of cent.
How well is your broker executing your trades?
A third proposal would require market participants to disclose more information on how well they are executing trades for their clients.
Market participants known as "market centers" (exchanges, dark pools, and wholesalers) are required to submit monthly reports indicating how well they are executing client orders. Gensler has been critical of this rule, known as Rule 605, noting that the requirements have not been updated since it was adopted in 2000. He has said investors today need a better understanding of how well their trading orders are being executed.
First, Gensler wants more disclosure to investors of how trades are executed, and he wants those reports to be in a format that everyday investors can read.
Second, Gensler wants to expand the group that has to issue reports on execution quality to include large broker-dealers, in addition to market centers.
"I think investors should have easy access to information that details just how good of a job their brokers are doing," Gensler said in a statement on the proposed rule.
Best execution: the SEC wants its own rules
In addition to more information on how well firms are executing orders, Gensler is proposing a new rule, Regulation Best Execution, that would establish a national best execution standard to ensure broker-dealers send orders to the venue that will get the best price for buyers and sellers.
There already are existing rules on best execution established by the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization (SRO) that regulates broker-dealers. There's also a separate rule for broker-dealers in municipal securities adopted in 2016 by the Municipal Securities Rulemaking Board (MSRB).
But Gensler says the SEC needs a rule of its own.
"I believe a best execution standard is too important, too central to the SEC's mandate to protect investors, not to have on the books as Commission rule text," he wrote in a comment letter when the proposal was first considered in December of last year.
What would an additional SEC rule mean? Gensler says it would "enhance investor protection by providing for additional enforcement capabilities, including the ability to bring remedial actions and impose sanctions for violations of the new rule."
In plain words: having its own set of rules means the SEC can sue potential violators.
Where Wall Street stands on the proposals
While Wall Street firms seem universally opposed to the auction proposal, that is not the case with some of the other plans.
The proposal to allow trading in sub-pennies appears to have industry support, though there is disagreement on which stocks should trade at a half-penny spread or a tenth of a penny. The NYSE, Citadel and Charles Schwab comment letter was generally supportive of the concept of reducing the minimum quoting increment from a penny to anywhere from a half-penny to a tenth of a cent.
The same comment letter also supported improving information on execution quality.
However, the proposal for a Regulation Best Execution is drawing considerable opposition. The NYSE, Citadel, and Charles Schwab comment letter went so far as to recommend the proposals be entirely withdrawn, not rewritten, noting that both FINRA and MSRB's already have best execution rules, and implied the SEC's rules would be needlessly duplicative and confusing. The joint letter from Cboe, State Sreet, T. Rowe Price, UBS and Virtu also said it was unnecessary.
What will happen?
Now that the comment period has ended, the Commission will review the comments on all four proposals. That will likely take several months, or longer. From there, it has several options: 1) reopen the comment period, 2) tweak the proposals, and if they are substantial, send them out for additional comments, 3) drop one or more of the proposals, or 4) proceed to the final rulemaking stage.
Theoretically, the SEC could vote on any or all of the four proposals in a shorter time period. However, while Gensler and the Democrats have a 3-2 majority on the Commission, the proposals (particularly the auction proposal) are so complex that that is unlikely.
This is just the start
This is just the start of many proposals in front of the SEC. There are 35 proposed rules still outstanding, including on climate change disclosure, human capital management, board diversity, cybersecurity risk governance, data privacy, share buybacks and others.
If there is a single theme emerging from the SEC under Gary Gensler, it would be that he is seeking more disclosures on everything corporate America is doing. Gensler believes this would increase market transparency and, in some cases, make markets more competitive.
And that is where the disagreements start: when does the ever higher cost of providing more transparency overwhelm the benefits?
As for efforts to make markets more competitive, the core of the proposal around payment for order flow, "We think the markets are very competitive," Kenneth Bentsen, CEO of SIFMA, told me.