By John M. Jascob, J.D., LL.M.
Several national exchanges have filed petitions seeking review of a final SEC rule that creates a transaction fee pilot for national market system (NMS) stocks. In two separate filings with the federal D.C. Circuit Court of Appeals, Nasdaq and members of the NYSE Group have challenged the controversial pilot, which imposes new restrictions on the fees and rebates that national securities exchanges may charge or offer to their broker-dealer members for transactions in NMS securities in specified test groups (New York Stock Exchange LLC v. SEC; NASDAQ Stock Market LLC v. SEC, February 14, 2019).
Although its petition was not available at press time, Cboe Global Markets stated that it was also petitioning the D.C. Circuit to review the SEC rule creating the pilot program. In a news release, Cboe Global Markets stated that it had filed the petition because “the pilot is so intrusive, ill-conceived and likely to harm the equities markets, there was no choice.”
Transaction fee pilot. The SEC adopted the transaction fee pilot on December 19, 2018, following a somewhat heated debate in the comment period between the exchanges and industry trade and watchdog groups. Created under new Rule 610T of Regulation NMS, the pilot is designed to study NMS stocks and the effects that exchange transaction fee and rebate pricing models may have on order routing behavior, execution quality, and general market quality.
The SEC’s pilot subjects exchange transaction fee pricing, including "maker-taker" fee-and-rebate pricing models, to new temporary pricing restrictions across three test groups and requires exchanges to prepare and publicly post data monthly. The pilot, which will last for a maximum of two years with a potential one-year sunset period, applies to all NMS stocks and includes all equities exchanges.
“No empirical support.” In asking the court to vacate the rule as being arbitrary and capricious and beyond the SEC’s authority, the NYSE Group exchanges believe that implementation of Rule 610T would result in the exchanges losing significant revenue to market competitors not subject to the rule. In addition, certain issuers of securities would be injured by the rule through, among other things, the rule's impact on these issuers' ability to compete with issuers of securities not restricted by the rule.
In a comment letter in November 2018, the NYSE Group had criticized a white paper issued by the SEC’s Division of Economic and Risk Analysis (DERA), which found that found that increased tick sizes in the SEC’s previous Tick Size Pilot Program had no impact on the prices of tick pilot securities and, therefore, did not harm issuers of those stocks. In the view of the NYSE Group, the DERA study relied on a selective, narrow, and irrelevant data set and provided no empirical support that the transaction fee pilot would not harm issuers and the market for their securities. According to the NYSE Group, securities subject to transaction fee pilot’s pricing restrictions would trade at wider spreads than comparable, unrestricted securities. Thus, issuers of those restricted securities would likely be forced to offer larger discounts to raise capital through secondary follow-on offerings to remain competitive with issuers offering comparable, unrestricted securities.
“More risk than reward.” Prior to filing its petition, Nasdaq had also argued strenuously that the transaction fee pilot would provide “more risk than reward” to the U.S. equity markets. In a comment letter on December 19, 2018, Nasdaq noted that incentives offered to market makers are important to delivering the tight spreads and actionable liquidity necessary for good market quality. Moreover, Nasdaq wrote, data shows that achieving good market quality in smaller capitalization growth companies is difficult and sometimes requires bundled incentives to market makers. Accordingly, the transaction fee pilot would present significant risks to the market by removing liquidity incentives from a comprehensive list of stocks on a pilot, and perhaps indefinite, basis.
Specifically, Nasdaq fears that we may see a material degradation in market quality for U.S. growth stocks which rely on cross-market incentives for competitive quotes. This, in turn, would harm the ability for the U.S. equity market to attract and retain IPOs. In Nasdaq’s view, “data show that there are significant downside risks and no clear upside benefits to the pilot.”
The consolidated cases are No. 19-1042 and No. 19-1043.