SEC-Proposed Regulations to Reform Stock Trading

SEC-Proposed Regulations to Reform Stock Trading

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March 1, 2023
SEC-Proposed Regulations to Reform Stock Trading
The Securities and Exchange Commission (SEC), which
Figure 1. Equity Market Structure
regulates capital markets, announced four proposed rules on
December 14, 2022, to reform the market structure for
trading. The proposed regulation affects how stock trading
orders are executed, priced, and disclosed. If finalized,
these SEC proposals could constitute the most significant
changes to the regulation governing stock trading since
2005, when Regulation National Market System (Reg
NMS) was introduced. This In Focus provides background
on the market structure for equity (stock) trading and

discusses the four proposed rules on best execution, order
Source: SEC.
competition, order execution disclosure, and order pricing.
Many regulatory requirements promulgated by the SEC and
the industry self-regulatory organization—the Financial
Equity Market Structure
Industry Regulatory Authority (FINRA)—govern securities
A trading center that brings together multiple securities
trading and market structure. These requirements include
buyers and sellers generally has to (1) register with the SEC
rules designed to promote market transparency (e.g.,
as a national securities exchange or (2) operate as an
publicly displayed quotations and other disclosure and
alternative trading system (ATS) and register as a broker-
reporting requirements), ensure fair access and fair
dealer. A national securities exchange is a securities
representation (e.g., standards of care for customer
exchange that has registered with the SEC under Section 6
transactions to mitigate conflicts of interest and other risks),
of the Securities Exchange Act of 1934 (P.L. 73-291).
pricing restrictions, and market data distribution.
ATSs are SEC-regulated electronic trading systems that
match securities orders for buyers and sellers. Some ATSs
SEC Proposed Rules
are referred to as “dark pools” because, unlike national
According to the SEC, the benefits of the proposed reform
securities exchanges, they do not publicly display the size
include (1) leveling the playing field for different segments
and price of their orders. A broker is any person engaged in
of equity markets, such as national securities exchanges,
securities buying and selling for others, while a dealer is
wholesalers, and dark pools, where trading activities take
any person engaged in securities transactions from the
place; (2) increasing transparency on execution quality and
person’s own account. Because most securities firms act as
facilitating investors’ ability to compare trading venues and
both brokers and dealers, they are called broker-dealers.
increase market competition; and (3) promoting
competition through fair and open auctions.
Figure 1 illustrates the typical equity market structure for a
stock trade. When an investor goes through a broker-dealer
Some industry participants pushed back on the SEC’s
to place a trade, the broker-dealer could route the customer
rulemaking. For example, a senior official from zero-
order to one of several execution venues (trading centers).
commission retail brokerage firm Robinhood said, “I’ve
Execution refers to the process of fulfilling a buy or sell
never seen a rulemaking effort of this size and complexity
order. These venues include national securities exchanges
and interconnectedness being done all at the same time, this
and off-exchange venues such as ATSs, single-dealer
quickly, with so little advance study and discussion.”
platforms, and wholesalers (also referred to as market
makers). Transactions also go through a clearance and
A NASDAQ study shows that about 40% of U.S. stock
settlement process, whereby transaction details are verified
trading volume takes place off-exchange. The SEC’s
and money and shares are transferred between the accounts
market structure reform proposals may increase competition
of the buyer and seller.
and transparency and drive trading volume from off-
exchange venues to national securities exchanges. In
anticipation of this shift, share prices at several wholesalers
decreased sharply at the announcement of the SEC’s
proposals, potentially reflecting investors’ views on the
proposals’ potential adverse impact on the wholesalers.
Two of the four proposed rules are more controversial. The
SEC commissioners advanced the proposals on best
execution and order competition in a split vote. Two other
proposals relating to order execution disclosure and order
pricing were advanced unanimously.
https://crsreports.congress.gov

SEC-Proposed Regulations to Reform Stock Trading
Best Execution
prices. Such open competition is generally nonexistent for
The duty of best execution requires a broker-dealer to
the 90% or so retail orders processed by wholesalers.
execute customers’ stock and other securities trades at the
most favorable terms under prevailing market conditions.
Critics argue that multiple academic studies have shown
The SEC has no existing regulation on best execution,
that retail investors are not receiving worse price execution
while FINRA already has a best execution rule (Rule 5310),
under the current system. Financial reporters at Barron’s
which was first established in 1968 by its predecessor, the
and others have challenged the SEC’s calculations in the
National Association of Securities Dealers. Because of best
proposed rule, saying its estimates were overstated and
execution’s importance to investor protection by fostering
uncertain. Critics believe the replacement of a functional
the best broker-dealer conduct, the SEC believes it would
system with a highly complex, costly, and unproven new
be important to set its own standards. The SEC’s proposed
process may or may not increase competition, but it would
rule establishes best execution standards that aim to ensure
likely introduce new risks such as potential execution
that broker-dealers have completed reasonable due
challenges, operational uncertainties, and adverse effects on
diligence to provide an execution price for a customer order
retail investor participation in investment activities.
that is the best possible under reasonable circumstances,
subject to certain exemptions. Additional requirements
Order Execution Disclosure
would apply when the broker-dealer has a conflict of
The SEC proposed to expand the scope of Rule 605 of Reg
interest. It also requires broker-dealers to develop written
NMS, which governs the disclosure requirements for
policies and procedures for such standards. In addition, the
trading order executions. The agency emphasizes that
proposed rule establishes time intervals for broker-dealers
trading practices have changed significantly since Rule
to review the execution quality of customer transactions (at
605’s adoption in 2000, yet the rule has not been updated
least quarterly) and their best execution policies and
for two decades. The proposed amendments aim to help
procedures (at least annually). The SEC estimates aggregate
improve data availability for understanding trading order
one-time compliance costs of $165.4 million and ongoing
execution quality across broker-dealers and trading centers
annual costs of $128.9 million for broker-dealers.
(e.g., national securities exchanges, market makers, and
ATSs), thus enhancing transparency and competition.
While broker-dealers already have some procedures in
place to meet FINRA’s existing best execution
The proposed amendments include (1) expanding the
requirements, many aspects of the SEC proposal extend
monthly execution quality reporting requirements to large
beyond FINRA’s current requirements. Critics believe the
broker-dealers, single-dealer platforms, and entities that
proposal is unduly detailed and prescriptive and may force
would operate qualified auctions as proposed in the order
firms to modify existing business practices to meet these
competition rule; (2) expanding the orders covered for
obligations, making the proposal expensive and difficult to
reporting to include certain irregular orders submitted
comply with. For example, under certain conditions,
outside of regular trading hours, non-exempt short sale
broker-dealers must go beyond “material potential liquidity
orders, and others; (3) amending the information required
sources” to seek the most favorable prices for customer
by re-categorizing order sizes and types and adding new
orders. SEC Commissioner Hester Peirce, who voted
reporting items; and (4) subjecting all reporting entities to
against the proposal, believes such prescriptive
summary reports that are formatted as Extensible Markup
requirements are not as sensible as allowing more discretion
Language and PDF for standardization.
for broker-dealers to mitigate conflicts of interest through
greater due diligence.
Order Pricing
The SEC proposed a new rule to amend the minimum price
Order Competition
increments (tick size), reduce access fee caps for certain
The SEC proposed a new rule on order competition that
quotations, and accelerate the compliance with price
requires certain retail orders to be put up for auction before
transparency requirements for certain data feeds (e.g.,
they could be executed internally by any trading venues that
information for trade orders of less than standard units,
restrict order-by-order competition. The proposal aims to
referred to as “odd lot”).
address a concern associated with retail investor orders that
are currently largely routed to wholesalers (90%) instead of
Currently, national securities exchanges face restrictions on
being exposed to competition from a broad range of market
certain pricing increments, which are limited to $0.01, as
participants. The SEC estimates this “competitive shortfall”
opposed to increments produced by market conditions that
to be $1.5 billion per year, or 1.08 basis points (0.0108%)
sometimes favor narrower than $0.01 increments, especially
per dollar traded by wholesalers, for investors.
for stocks with low per-share prices. Because Rule 612
under Reg NMS constrains quoting, but not trading, under
The proposed rule generally prohibits a wholesaler from
certain conditions, wholesalers can execute sub-penny
internally executing (i.e., fulfilling the orders themselves)
increments, while national securities exchanges are unable
certain orders, called “segmented orders,” unless the orders
to do so (because their trades are often generated from the
are exposed to competition in qualified auctions operated
ranking of quotes). This has led to a years-long policy push
by qualified trading centers (i.e., open competition trading
from national securities exchanges regarding their ability to
center), subject to some exemptions. The proposed new
attract trade orders through sub-penny increments that are
approach could enable more market participants—such as
perceived as more reflective of market conditions.
hedge funds and pension funds—to compete for trade
orders and potentially achieve more favorable execution
https://crsreports.congress.gov

SEC-Proposed Regulations to Reform Stock Trading
The SEC’s new proposal, among other things, would allow
such, it would level the playing field for exchanges and
the exchanges to quote some tick size in less than one-
wholesalers with regard to pricing increments.
penny increments. The proposal would amend tick size
requirements under Rule 612 to establish a variable
Eva Su, Analyst in Financial Economics
minimum pricing increment for both the quoting and
IF12336
trading of Reg NMS stocks for all on-exchange and off-
exchange trading venues, subject to certain exceptions. As

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