Divide erupts over SEC push for reforms

The Securities and Exchange Commission is mulling changes designed to update and reshape segments of the U.S. equity markets, with potential implications for institutional investors that have drawn praise and criticism.

In December, the SEC issued four rule proposals, each with varying levels of complexity and controversy. The four proposals total more than 1,600 pages and had simultaneous public comment periods that closed March 31, drawing hundreds of responses.

"These are such important changes in market structure that have not been proposed or changed in almost 20 years," said Ronan Ryan, New York-based president and co-founder of IEX Group Inc., which operates the IEX Exchange.

The SEC in 2005 established Regulation National Market System, or Reg NMS, to modernize the U.S. equity system, and Mr. Ryan said the regulation needs an update. "It would be an absolute, unequivocal shame if nothing were to change," he added.

Others are supportive of changes to Reg NMS but have myriad concerns with the SEC's proposals.

"As a baseline matter, the SEC failed to identify a market failure that would justify the dramatic structural changes proposed, yet the proposals, individually and together, would result in fundamental changes with uncertain and consequential results," Kenneth E. Bentsen Jr., president and CEO of the Securities Industry and Financial Markets Association, Washington, said in a statement.

The proposals in question would:

• Lower trading increments and access fees on exchanges, including amending minimum pricing increments, also known as tick sizes, to establish a variable minimum pricing increment model that would apply to both the quoting and trading of NMS stocks.
• Broaden the entities subject to a disclosure rule, which requires a market center that trades stocks to make public monthly electronic execution reports that include uniform statistical measures of execution quality. The entities that would have to file the reports include broker-dealers who introduce or carry 100,000 or more customer accounts; single-dealer platforms; and entities that would operate proposed qualified auctions.
• Require certain retail equity orders be exposed to open auctions before such orders could be executed internally by any trading center that restricts order-by-order competition.
• Establish a best execution standard for brokers, dealers, government securities brokers, government securities dealers and municipal securities dealers to use "reasonable diligence to ascertain the best market for the security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions," according to an SEC fact sheet.

Broadly, the proposal concerning trading increments and access fees on exchanges, and another expanding the entities required to issue reports on execution quality have support in the industry.

Leaders from six major pension funds jointly submitted a comment letter backing the SEC's proposal to reduce the access fee cap for all NMS securities to $0.001 per share from the current level of $0.003. Exchanges charge access fees for execution of an order that are then frequently used to fund rebates to broker-dealers that provide liquidity on the exchange.

The pension funds — the $442.9 billion California Public Employees' Retirement System, Sacramento; C$536 billion ($395.7 billion) Canada Pension Plan Investment Board, Toronto; $306 billion California State Teachers' Retirement System, West Sacramento; C$247.2 billion ($183.5 billion) Ontario Teachers' Pension Plan Board, Toronto; $179.3 billion Texas Teacher Retirement System, Austin; and the C$158 billion ($116.6 billion) Alberta Investment Management Corp., Edmonton — said in their comment letter that the existing cap, adopted in 2005, does not reflect the enormous efficiency gains from technology advances since that time.

The existing system "clearly disadvantages institutional investors" because institutions "on average tend to seek to access rather than provide liquidity on exchanges, so the burden of high fees falls on them disproportionately," the pension funds said.

But when it comes to the SEC's proposals on best execution and order competition, the industry pushback has been more pronounced.

The order competition proposal, where retail trades would be sent to an open auction before they can be executed internally, is designed to bring greater competition to the marketplace, SEC Chairman Gary Gensler said in December.

Currently, brokers route a far majority of stock orders to a small group of off-exchange dealers, known as wholesalers. Those wholesalers typically execute the orders internally, without any opportunity for other market participants to compete to provide better prices, the SEC said.

"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," Mr. Gensler said at the SEC's December meeting. "For example, individual investors don't necessarily get the best prices that they could get if institutional investors, like pension funds, could systematically and directly compete for their orders."

However, the Council of Institutional Investors in a comment letter said their members are unlikely to expend much effort to participate in a new auction system if the rule were to go into effect.

"In particular, for many institutional investors, the risk of potentially revealing their identities and trade interest to even a single dealer by participating in the proposed new auction mechanisms could materially outweigh any potential benefits of receiving the executions," CII said. "Therefore, we encourage the commission to consider various ways to incentivize the interaction of retail and institutional investors."

Some commenters, including SIFMA, State Street Global Advisors, T. Rowe Price Group Inc. and Cboe Global Markets suggested that the SEC withdraw the proposal entirely.

On the best execution proposal, some commenters said there are already significant regulations in place, including the Financial Industry Regulatory Authority's best execution rule for broker-dealers.

CII in its comment letter said it supports a best execution rule out of the SEC but has concerns with a provision in the proposal that would exempt a broker or dealer when an "institutional customer, exercising independent judgment, executes its order against the broker or dealer's quotation," CII's comment letter said.

CII is worried that the proposed exemption "may result in some institutional investors, particularly smaller institutional investors with less market power, not obtaining the best execution they desire." It suggested the SEC reconsider the exemption and if it's deemed necessary, to narrow its scope or make it conditional.

BlackRock Inc. in its comment letter called on the SEC to eliminate the exemption for institutional customers.

"We believe that this clause is antithetical to the need for best execution in less transparent markets," BlackRock said. "In fixed income markets, where orders are typically traded principally against a broker-dealer's risk or inventory, transacting on a quotation is the dominant style of execution."

Ignacio A. Sandoval, a Washington-based partner at Morgan, Lewis & Bockius LLP and former special counsel in the office of chief counsel in the SEC's trading and markets division, said the four proposals are intended to work in concert, but don't always align.

"We might be looking at these proposals holistically; unfortunately the SEC didn't," he said.

Mr. Sandoval said there are gaps in the way one rule could be implemented vs. how another rule may operate.

For example, there's the best execution proposal, "which the SEC is almost characterizing as best price, but you also have this requirement that retail orders go to an auction even though an auction may actually not represent best execution for a particular order," Mr. Sandoval said.

In a comment letter of its own, the Department of Justice's antitrust division made a similar point and urged the SEC to further consider how the rules could interact with one another, specifically the best execution and order competition proposals.

Should both proposals be adopted, "broker's best execution policies and procedures will have to take into account auctions conducted pursuant to the order competition rule and consider the competitive dynamics of those auctions compared to other ways to execute clients' orders," the DOJ said in its letter.

The proposals were likely separated because the SEC is expecting a legal challenge, Mr. Sandoval said. "If the order competition rule gets struck down you still have three other stand-alone rules that haven't and can still go forward," he said. "That may have played into the strategy. Some are going to be more susceptible to challenges than others so instead of invalidating the entire package you only invalidate part of it."