On December 14, 2022, the SEC issued four proposals to completely rewrite the regulations governing the structure of our equity markets, including how orders are priced, executed and displayed to the public. Taken together, they total over 1,600 pages of proposed rulemaking. What is lacking, in our view, is any evidence of market failure that would necessitate the wholesale revamping of the U.S. equity markets.

Data indicate that U.S. equity markets have never worked better for retail investors who benefit from low- or no-cost trading and efficient execution. Yet without identifying a clear market failure, the SEC is proposing fundamental changes based only on theory. Take the order execution proposal. Academic research strongly suggests that these changes, if enacted as proposed, would harm retail investors by raising trading costs, reducing returns, and making trading less efficient and less competitive.

Historically, agencies promulgate new regulations in response to market failures, or when Congress has directed the agency to act, and with solutions tailored to solve those problems. In this instance, however, there is no market-based driver of change. While the SEC points to the October 2021 SEC staff report on the meme stock event as the impetus for this proposed rulemaking, the report in fact does not recommend equity market structure reforms.

Perhaps more important, Congress has not directed the SEC to undertake such a dramatic rewrite of our equity markets. The U.S. House of Representatives Committee on Financial Services held three hearings in 2021 in response to the “meme” stock trading phenomena. Following those hearings the Committee issued a report on June 24, 2021, proposing several policy recommendations for the SEC, FINRA and DTCC to undertake, but nowhere does the House Committee report recommend any of the changes proposed by the SEC.

Key points:

• SIFMA has long supported a measured, data-driven approach to reviewing U.S. equity market structure, specifically Reg NMS. We support updated disclosure rules, decreased access fees and market data that is accessible to all market participants at a reasonable cost.
• Investor protection is an essential consideration, however. Any changes should be subject to a robust cost benefit analysis, and considered holistically with a view to ensuring there are no negative, unintended consequences for investors.
• The SEC has failed to discuss how each of the four proposals—issued separately—would work with the others. There is little clarity around what the overall changes to market structure would look like, and how they would impact investors.
• Brokers often route retail orders in NMS stocks through wholesalers to achieve better execution and pricing, and where the order handling responsibilities result in an executed order. When orders are routed to an exchange, there is no comparable standard of execution, and the order may go unfilled. While the SEC admits these wholesalers provide price improvement relative to the best publicly quoted prices for round lot sizes on national securities exchanges, it believes moving to order-by-order competition on “open competition venues” could save investors an estimated $1.5 billion annually.
• Regrettably the SEC analysis is based on data that is outdated and not available to the public, which precludes anyone outside the SEC from conducting a sufficient review of its work. The SEC should make it possible for stakeholders to have access, as SIFMA has requested.
• Even so, the recent work of several independent academics undermines the SEC’s analysis and assumptions, while others argue that the changes contemplated in the proposals may well have the opposite effect and cost retail investors far more.
• One study shows that the SEC’s analysis relied on outdated data that fails to capture approximately $3.7 billion per year of financial benefits that our current market structure provides retail investors.^[1]
• Another study found the “majority of retail orders are better off being routed to wholesalers” than to exchanges, and moving retail flow to exchanges “would cost retail investors close to a billion dollars per month in additional trading costs.”^[2]
• A third study found “that order-by-order auctions improve allocative efficiency among market makers, but a winner’s curse problem in the auction can reduce retail investor welfare, particularly at times of limited liquidity.” These findings are supported by an empirical analysis of Retail Liquidity Programs (RLP) currently offered by exchanges, which “behave similarly to order-by-order auctions.”^[3] 

Investor protection is paramount

The U.S. equity markets are the largest in the world, representing around 41% of the $101 trillion in global equity market cap, or $41 trillion. This market is 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—making the U.S. equity markets the best venue for individual investors.

A measured, data driven review of the U.S. equity market structure and specifically Reg NMS has been a SIFMA priority for many years, and SIFMA presented recommendations designed to enhance the current structure to the SEC and Congress in 2013, 2014 and 2017.

We support updated disclosure rules, decreased access fees and market data that is accessible to all market participants at a reasonable cost. We also recognize any changes need to be done thoughtfully with a keen eye towards the impact on investors, starting with an update to Rule 605, which would give the SEC accurate data on which to base its analysis of whether further changes are needed.

The substantial changes proposed individually by the SEC are incredibly complex and interwoven with material impact to all market participants. Any changes being proposed in the name of competition which may tilt the playing field at the expense of investors should be subject to a robust cost benefit analysis, and considered holistically with a view to ensuring there are no negative, unintended consequences for investors.

More questions than answers

The proposals – covering Disclosure of Order Execution Information; Tick Sizes, Access Fees, and Transparency of Better Priced Orders; Enhancing Order Competition; and Regulation Best Execution are significant when viewed alone, and more so when taken in sum. Each proposal is mandated under SEC rulemaking procedures to stand alone, and the SEC has failed to discuss how each would work with the others, leading to more questions than answers about how the proposals interact both with each other and with existing rules. As market participants review the proposals and formulate responses, there is little clarity around what the overall changes to market structure would look like, and how they would impact investors.

Where did the SEC’s $1.5 billion “savings” come from?

The SEC used Rule 605 data for its analysis, even though that Rule would be modernized as part of the rulemaking. SEC Chair Gensler noted, “In the 22 years since Rule 605 was adopted, our equity markets have been transformed by ever-changing technologies and business models. Current Rule 605 disclosures have not kept up with our markets and provide investors with an incomplete picture of execution quality.” This, of course, begs the question of how the SEC can use stale data based on 20-year-old pre-Reg NMS market structure to make valid assumptions about proposed changes to the market.

The SEC’s calculations are based on data that is not transparent, so we need to ask for the data. SIFMA has requested the data and submitted a Freedom of Information Act (FOIA) request for the data the SEC used to support its proposals—in an anonymized format without any personally identifiable or attributable information—and have requested that the comment period be extended to at least 90 days following the Commission’s release of that data. But at the same time, empirical work shows the impact of the proposals would result in the exact opposite of savings—which casts doubt on how the SEC arrived at its figure. One of the studies referenced above^[4] estimates moving retail flow to exchanges “would cost retail investors close to a billion dollars per month in additional trading costs.” The same study concludes “if the current system were to be dismantled, commissions may again be necessary, increasing the overall cost of retail market participation.” Another study^[5] finds the return of $5 commissions could cost investors an estimated $9 billion per year. These numbers dwarf the estimated (and unsubstantiated) savings figure from the SEC.

According to the SEC, broker-dealers currently route more than 90% of marketable orders of individual investors in NMS stocks to several competing broker-dealers, often referred to as wholesalers or wholesale market makers. Order handling rules provide obligations to the broker-dealer who accepts the order, which, critically, means the investor will receive an execution.^[6] The same obligation does not apply when orders are routed to an exchange. While the SEC admits these wholesalers provide price improvement relative to the best publicly quoted prices for round lot sizes on national securities exchanges, it cites its own data analysis showing that moving to order-by-order competition on “open competition venues” could save investors an estimated $1.5 billion annually.

However, the SEC did not disclose the underlying data needed to substantiate their assumptions and conclusions.

And again, independent academic research finds a contrary result when considering order execution. When wholesalers execute orders internally, execution quality is higher compared to what is achieved when wholesalers execute orders externally with respect to both price improvement and size improvement (respectively, 83% and 80% when the wholesaler internalizes orders compared to 60% and 45% provided by external venues). ^[7]

The SEC’s analysis was also done in isolation and does not contemplate the new tick size or best execution regimes – a serious defect of the SEC’s failure to recognize the interrelated nature of the four proposals, which casts doubt on the accuracy of its own figure.

Retail investors have benefited from a highly competitive and efficient market structure. The SEC’s proposed order execution rule could very likely undermine that benefit and raise costs for investors. The better course would be for the SEC to move forward with updating 605 and data transparency, allowing for the Commission, stakeholders and market observers and academics to review the more complete data. Then, and only then, can we determine whether or not a market failure exists and if so, how best to address it.

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Kenneth E. Bentsen, Jr. is President and CEO of SIFMA. Mr. Bentsen is also Chair of the International Council of Securities Associations (ICSA), Co-Chair of the British American Finance Alliance (BAFA) and Chairman of Engage China.

References

^[1] Why do Brokers who do not Charge Payment for Order Flow Route Marketable Orders to Wholesalers?
Authors: Robert Battalio (University of Notre Dame) and Robert Jennings (Indiana University)
Date: December 14, 2022

^[2] The Retail Execution Quality Landscape
Authors: Anne Haubo Dyhrberg and Andriy Shkilko (Wilfrid Laurier University), Ingrid Werner (The Ohio State University)
Date: December 12, 2022

Average execution quality (E/Q, %) = Effective/Quoted Spread. Effective spread = the percentage difference between the transaction price and the bid-ask spread midpoint. Quoted spread = the difference between bid and ask prices at any time in the market.

^[3] Would Order-by-Order Auctions Be Competitive? 
Authors: Thomas Ernst (University of Maryland), Chester Spatt (Carnegie Mellon University), and Jian Sun (Singapore Management University)
Date: December 13, 2022

^[4] The Retail Execution Quality Landscape
Authors: Anne Haubo Dyhrberg and Andriy Shkilko (Wilfrid Laurier University), Ingrid Werner (The Ohio State University)
Date: December 12, 2022

^[5] Commission Savings and Execution Quality for Retail Trades

^[6] https://www.sidley.com/en/insights/newsupdates/2022/12/sec-proposes-rule-to-enhance-competition-for-certain-individual-investor-orders

^[7] Why do Brokers who do not Charge Payment for Order Flow Route Marketable Orders to Wholesalers?
Authors: Robert Battalio (University of Notre Dame) and Robert Jennings (Indiana University)
Date: December 14, 2022

Related Resources

• Press Release & Letters

  SIFMA Comments on the SEC’s Equity Market Structure Proposals

• The SIFMA Podcast

  Creating Risk by Fixing What’s Not Broken

• SIFMA Research

  The ABCs of Equity Market Structure