By John Filar Atwood
Certain elements of the national market system rules such as those related to order handling and execution have not been updated since 2005, and SEC Chair Gary Gensler intends to change that. Citing issues exposed by the GameStop meme stock events of 2021, including imbalances created by dark pool and wholesale trading, he has the Commission staff working on proposals to update national market system rules.
In remarks at the Piper Sandler Global Exchange Conference, Gensler outlined the many questions he posed to the staff to help it construct effective market system rule changes. It is a complex and multi-faceted area, so his questions were spread across the following six topics: (1) minimum pricing increment; (2) national best bid and offer (NBBO); (3) disclosure of order execution quality; (4) best execution; (5) order-by-order competition; and (6) payment for order flow, exchange rebates, and related access fees.
Minimum pricing increment. He is concerned about the disparities among the different trading venues over the minimum increments at which securities are priced, or tick size. In transparent markets, he noted, investors see prices in one-penny increments while wholesalers can fill orders at sub-penny prices and without open competition. In his view, all venues should have an equal opportunity to execute at sub-penny increments.
Accordingly, he asked staff to make recommendations around leveling the playing field with respect to two facets of tick size. The first is possibly harmonizing the tick size across different market centers so that all trading occurs in the minimum increment. The second is potentially shrinking the minimum tick size to better align with off-exchange activity given the sheer volume of off-exchange sub-penny trading.
NBBO. Gensler said that he has asked the staff to consider three issues related to the NBBO, which is a quote designed to aggregate information across different exchanges. The NBBO provides important pre-trade transparency to investors, he added.
One key issue, he said, is that the NBBO only includes round lots of 100 shares or more. Recent staff calculations indicate that in March 2022, 55 percent of trades were executed at odd lots. Gensler noted that retail investors, the investors most likely to buy or sell at odd lots rather than in 100-share lots, are unable to see the odd-lot prices.
To address this issue, the Commission adopted a new market infrastructure rule in March 2020 that created a new round lot definition of between 100 shares and one share and added odd-lot information to core market data. The problem, according to Gensler, is that under the transition schedule for the rule implementation of the new definition could be years away. Accordingly, he has asked the staff to consider whether the Commission could accelerate implementation of the new round lot definition.
Gensler also asked the staff to consider whether it can move up the transparency rules surrounding odd-lot trading data. He said that he also has asked the staff to think about whether the SEC should create an odd-lot best bid and offer so that investors would know the best price available in the market regardless of share quantity.
Order execution quality. Another problem with the national market system rules is that retail investors cannot compare execution across brokers, such as how much price improvement they provide to their clients, he said. The problem stems from the fact that only market centers such as dark pools, wholesalers, and exchanges are required to provide those disclosures in monthly Rule 605 reports.
Gensler would like the staff to make recommendations around how the Commission might update Rule 605 so that investors receive more useful disclosure about order execution quality. He also requested recommendations on whether to require that all filers of 605 reports provide summary statistics of execution quality, such as the price improvement as a percentage of the spread.
Best execution. On the issue of best execution, Gensler believes it is time for the SEC to consider proposing its own best execution rule. At the moment, only FINRA and the Municipal Securities Rulemaking Board have rules on best execution requiring broker-dealers to exercise reasonable diligence to execute customer orders in the best market so that customers receive the most favorable prices under prevailing market conditions.
In addition to asking the staff to consider a new best execution rule, he also believes that broker-dealers and investors might benefit from more detail around the procedural standards brokers must meet when handling and executing customer orders.
Order-by-order competition. Gensler is interested in a regulatory approach that best promotes as much competition as possible for retail investors on an order-by-order basis. Standing in the way is market segmentation, including the movement of a majority of retail marketable orders to wholesalers who pay for that order flow. The segmentation isolates retail orders and may not benefit the retail public as much as orders being exposed to order-by-order competition, he said.
He asked the staff to propose an approach to enhance order-by-order competition, which may be through open and transparent auctions or other means. In considering any recommendations for stock auctions, Gensler suggested that the staff draw upon lessons from the options market, which has been operating auctions for retail orders for many years.
Payment for order flow. Finally, Gensler addressed the issues of payment for order flow, exchange rebates, and related access fees. The staff’s GameStop report said that payment for order flow may incentivize broker-dealers to use digital engagement practices such as gamification to increase customer trading, he noted, adding that the European Union is actively considering banning payment for order flow.
He asked the staff to draft recommendations on how to mitigate conflicts surrounding payment for order flow, and to address the payment of rebates to traders by exchanges. Specifically, he suggested that the staff consider is whether exchange fees—what someone pays to access a quotation on an exchange—and rebates should be more transparent. He also requested a staff analysis of how the access fees might change in light of a potentially lower minimum tick size, noting that a lower minimum pricing increment might require proportionately lower access fee caps.