SEC Equity Market Structure Advisory Committee Meeting
U.S. Securities and Exchange Commission
Equity Market Structure Advisory Committee Meeting
Thursday, May 13, 2015
Key Topics & Takeaways
- HolisticReview: Committee members agreed that issues such as locked/crossed markets, access fees, and the order protection rule need to addressed in a holistic fashion and not in isolation.
- Transparency: Committee members agreed that market participants, in order to make informed decisions, must be provided with increased transparency and disclosure.
- Unintended Consequences: Committee members stated that any possible recommendation or market solution must take into account the possibility of unintended consequences and the associated risks.
Commissioners and Participants
- Mary Jo White, SEC Chairman
- Luis Aguilar, SEC Commissioner
- Daniel Gallagher, SEC Commissioner
- Kara Stein, SEC Commissioner
- Michael Piwowar, SEC Commissioner
- Stephen Luparello, Director, Division of Trading & Markets
- Daniel Gray, Senior Special Counsel, Division of Trading & Markets
- Matthew Andresen, Headlands Technologies LLC
- Reginald Browne, Cantor Fitzgerald & Co.
- Kevin Cronin, Invesco Ltd.
- Brad Katsuyama, IEX Group Inc.’
- Ted Kaufman, Duke University Law School and former U.S. Senator from Delaware
- Richard Ketchum, FINRA
- Manisha Kimmel, Thomson Reuters
- Mehmet Kinak, T. Rowe Price Group
- Andrew Lo, MIT and AlphaSimplex Group
- Joseph Mecane, Barclays PLC
- Jamil Nazarali, Citadel Securities, LLC
- Eric Noll, Convergex Group
- Maureen O’Hara, Cornell University and Investment Technology Group, Inc.
- Joe Ratterman, BATS Global Markets, Inc.
- Nancy Smith, AARP Inc.
- Chester Spatt, Carnegie Mellon University
- Gary Stone, Bloomberg Tradebook LLC
- Jamie Selway, ITG
- Tom Farley, NYSE
- Thomas Wittman, NASDAQ
- Dave Lauer, KOR Trading
- Brandon Becker, TIAA-CREF
- Jeff Brown, Charles Schwab
- Bill Baxter, Fidelity
Opening Statements
Chair Mary Jo White
Chair Mary Jo Whitestated that maintaining and enhancing the high quality of the U.S. equity markets is one of the SEC’s most important responsibilities. She noted that the Equity Market Structure Advisory Committee will assist the Commission in its continuing “efforts to ensure that the equity markets optimally meet the needs of investors and public companies.” She commented that in today’s high-speed electronic markets, “it is not clear that investors and public companies have sufficiently reaped the rewards from improved order handling and trading technologies.”
White identified market complexity as an overarching issue that deserves attention. She explained that market complexity can be useful, but where it is not directed toward producing better markets for investors and issuers, it can lead to “less than optimal” equity market structure, including issues of market instability, a lack of transparency for investors regarding order handling and execution practices, and increased difficulties for regulators in effectively overseeing the markets. She stated that the SEC seeks to optimize market structure “through a careful, data-driven assessment where no issue is off limits or any assumption unquestioned.” With respect to Rule 611, White encouraged the Committee to discuss whether it has contributed to excessive fragmentation, led to increased off-exchange trading, harmed institutional investors, or failed to achieve the objective of enhancing displayed liquidity.
Commissioner Luis Aguilar
Commissioner Luis Aguilar referred to his May 11, 2015 statement in which he recommended a framework for a holistic assessment of our current equity market structure. He stated that the Committee should identify and prioritize market structure changes that would benefit investors and issuers rather than traders who seek to profit from continual trading.
Commissioner Daniel Gallagher
Commissioner Daniel Gallagher described the meeting as a watershed moment in the SEC’s process for conducting a holistic review of our equity market structure. He stated that Regulation NMS is “fundamentally flawed” and cited it as an example of a regulatory distortion of the market. He asked that the Committee focus on the unintended consequences of regulation and the role of regulation in creating market complexity.
Commissioner Kara Stein
Commissioner Kara Stein stated that the Committee should focus on potential market structure changes from the perspectives of investors and issuers. After describing how technology and markets have changed since Regulation NMS was adopted, she asked the Committee to actively think about where things are going in the next ten years.
Commissioner Piwowar
Commissioner Michael Piwowar recommended that the Committee control the agenda for future meetings, rather than the Commission. He asked the Committee to measure the unintended consequences of Regulation NMS as well as any potential changes against the goals and concerns that were articulated at the time it was adopted. Piwowar asked the Committee to consider the dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to the adoption of Regulation NMS. Lastly, he encouraged interested parties who were not members of the Committee to provide feedback on the issues discussed.
Administrative Items
SEC Director of the Division of Trading and Markets Stephen Luparello stated that he expects the staff of his division to issue a series of recommendations to the Commission as the committee progresses, rather than issuing one comprehensive report. He further stated that he expects that the committee will hold meetings on a quarterly basis.
Introductory Remarks of the Committee Members
Each member of the committee provided a brief introduction, including a description of their professional background, current employment, and high-level comments regarding market structure issues. Many members raised concerns about the degree of market fragmentation, conflicts of interest, lack of transparency, and distortions caused by access fees. Additionally, several members stated that the committee should consider these issues from the perspectives of investors and issuers.
Presentation of Rule 611 by Daniel Gray, Division of Trading & Markets
Daniel Gray, Senior Special Counsel of the Division of Trading and Markets, referenced the Division of Trading & Markets staff’s memorandum regarding Rule 611 of Regulation NMS that was published on April 30, 2015. Additionally, he discussed the context of the market at the time that Regulation NMS was adopted. He explained that not all changes in market structure can be attributed to Rule 611. He acknowledged that Rule 611 has been criticized for making lit venues less desirable because of increased complexity and fragmentation.
After concluding his presentation, Gray answered questions from Committee members. Joseph Mecane of Barclays commented that the costs of Rule 611 do not outweigh its benefits in today’s market. He asked Gray how the staff measures the rule’s costs. He also asked how the staff defines the terms “fragmentation” and “complexity.” Luparello stated that he would like the committee to discuss these questions, explaining that these are issues that the SEC has struggled with.
Joe Ratterman of BATS commented that Rule 611 was successful in meeting its goal of increased competition among trading venues, as evidenced by BATS’s existence. He explained that the elimination of the NYSE’s monopoly has resulted in complexity, but some complexity must be accepted.
Brad Katsuyama of IEX commented that complexity is expected with fragmented markets. He stated that the market just needs better transparency and disclosures. He stated further that the lack of transparency causes concerns and hurts confidence in the market.
Matthew Andresen of Headlands stated that Rule 611 increased competition for NYSE, but Nasdaq was already competitive before the rule. He stated that in 2015, Rule 611 may no longer be needed for competition.
Panel 1 – Representatives from NYSE, Nasdaq, and ITG
Jamie Selway of ITG stated that since mid-2004, average trading costs have fallen by 40%. He said that at its core, Rule 611 provides that the “best price wins”. However, he noted the rule comes with difficulties; for instance, it works best in a frictionless market, and since Rule 611 is a prescriptive approach to order routing, it has difficulty accommodating innovations in the marketplace. Selway provided several recommendations for the Commission to consider, specifically: 1) create a de minimis exception, where an exchange’s quotes are not protected if the volume executed falls below a certain level (e.g. 1 percent); 2) create a block exemption to Rule 611; and 3) repeal the prohibition on locked markets. Selway noted that in the absence of Rule 611, improved standards for best execution would be required.
Tom Farley of NYSE stated that Rule 611 had many objectives, including limiting trade-throughs, which was a step forward for equity market structure. Additionally, he provided that an additional objective of Rule 611 was to reward those who make their price and size known on the public markets, but this objective of the rule has fallen short. Farley posed the question of how those who publically display their quotes are rewarded, as it is important that to have deep, liquid, and transparent markets. He noted that there should be a third objective, to contribute to the safety and soundness of the equity markets.
Tom Wittman of NASDAQ stated that the U.S. equity market structure continues to evolve and that regulation needs to evolve with it. He noted the current market structure does not sufficiently serve investors and issuers, and that evaluating Rule 611 as a standalone rule is not the best way to address this concern. Wittman raised his concerns with the one-size-fits-all approach to equity market structure. He noted that exchanges should be free to experiment and evolve, and to take into account issuer size and trading patterns. He stated that he would prefer a principle-based approach to revising Regulation NMS rather than one that is prescriptive.
Question & Answer:
Eric Noll of Convergex asked about the impact of removing the prohibition on locked markets. Selway noted that before Reg NMS, locked markets would occur and it was not necessarily a problem. He indicated that a locked market demonstrates that the trading increment may be too wide.
Jamil Nazarali of Citadel Securities responded that retail clients believe that locked/crossed markets are a failure and that it is hard to explain why a trade does not occur when a buyer and a seller are quoting at the same price and there is not a cross. Nazarali stated that retail clients do not believe locked/crossed market should be permitted.
Gary Stone of Bloomberg Tradebook LLC suggested that if access fees were included within the price of the quote, the likelihood of a locked/crossed market would be significantly reduced. He further stated that with maker/taker, all market participants are aware of incentives. Stone stressed that if maker/taker is no longer permitted, increased transparency for market participants is critical.
Ratterman stated that the market could benefit from a change away from one-size-fits-all, but that reducing market structure to the bare minimum may not be the best for all securities, and that less liquid names could be impacted by a reduction in access fees/rebates. Wittman agreed, noting that with less liquid stocks you could argue for higher rebates.
In response to a question posed by Luperallo regarding a penny tick-size increment, Kevin Cronin of Investco Ltd. stated that if you permit sub-penny pricing, there may less incentive to display liquidity.
Andresen stated that the right answer is tiering in the marketplace, in that some names may be able to support sub-pennies and therefore there should be flexibility in the regulations to allow exchanges to incentivize certain behaviors.
Ratterman, in response to a question of whether permitting locked markets would reduce complexity, stated that a significant amount of time is spent thinking about the interactions of order types and matching engine logic, and therefore permitting locked/crossed markets would reduce complexity from a technological standpoint. However, he noted that complexity is not an issue for technology professionals.
Rick Ketchum, Chairman of the Financial Industry Regulatory Authority, asked Selway what behavior that is currently discouraged he would like to see permitted. Selway stated that Rule 611 is a rough proxy for best execution and therefore market participants would be better off with a more robust best execution. He additionally noted that currently Rule 611 limits the ability of market centers to innovate.
In response to a question regarding the substantial dark activity on exchanges, Farley stated that all order types are disclosed, the percentage of dark liquidity is small, and that lit orders take priority over dark.
Ratterman noted that the answer is not all-lit liquidity or all-dark liquidity due to the fact that market participants have different needs.
Farley stated that NYSE supports dark trading and that block trades off-exchange “make sense.” However, he noted that that those who display their quotes should be “rewarded.”
Nazarali questioned who is harmed with off-exchange/dark trading. He noted that the benefits of off-exchange trading have accrued to retail investors. Nazarali recognized the importance of price discovery, stated that he is also a supporter of lit venues, and that there are benefits that come from competition.
Panel 2 – Representatives from KOR Group, Schwab, TIAA-CREF, and Fidelity
Dave Lauer of KOR Trading stated that the objective of Rule 611 was to protect investors from inferior execution prices and promote limit order display. He noted that Rule 611 sought to provide intermarket price protection and that this was to be supplemented with data from Rules 605 and 606 in order to allow investors to make informed decisions. Lauer stated that criticisms of Rule 611 include that it increases fragmentation and creates unnecessary complexity. He stated that market centers have incredible pricing power over market data feeds and that exchanges should not have been allowed to have become order routers.
Lauer further noted that that the lines between broker-dealers and exchanges have become blurred. He stated that the unnecessary complexity and fragmentation do not help the markets and that market structure reforms should protect investors and incentivize liquidity. Lauer put forth several recommendations for reforms, including updating Rules 605 and 606, modernizing best execution rules, reviewing market data revenue sharing, and that order routing obligations under Rule 611 should be borne by broker-dealers, not exchanges.
Jeff Brown of Charles Schwab stated that one of the biggest unintended consequences of Rule 611 is the growth of off-exchange trading. Brown noted that this growth has been a “tremendous boon” to retail investors, and that competition between off-exchange retail vendors is driving execution quality. He stated that Schwab supports free markets and that the benefits to retail investors cannot be ignored. He stated that any reforms to the markets need to be tested and thoroughly considered, particularly due to the risks of unintended consequences. He added that the Committee should additionally consider NMS governance reform and market data.
Brandon Becker of TIAA-CREF stated that the “rain forest” of order types is “fertilized” by rebates and the prohibition on locked/crossed markets. He said a material reduction of the access fee cap would help change the economics, and that it is a “fool’s errand” to chase order types and best execution reform without addressing the underlying economic incentives. Additionally, Becker suggested materially lowering rebates, permitting locked/crossed markets, and addressing infrastructural issues such as dark pool transparency and upgrading the Securities Information Processors (SIPs). He recommended that the Committee focus on one to three things that the Commission can actually implement.
Bill Baxter of Fidelity noted that the Commission has implemented various reforms over the past several years, including Limit Up-Limit Down and Regulation SCI. Baxter stated that the markets have changed significantly since Rule 611 was adopted, and that as an initial matter, the Committee should first establish the metrics that will facilitate any review. Baxter stated that he welcomes competition and choice in the marketplace, but questioned whether smaller venues add to complexity and market risk. Accordingly, Baxter stated that the definition of “protected quote” should be revised to apply only where a trading venue has a certain market share. He expressed support for addressing the access fee cap under Rule 610, as well as measured reforms to the maker/taker pricing model that takes into account the market capitalization of securities.
Question & Answer:
Commission Gallagher asked Baxter what metrics he had in mind, to which Baxter responded that a clear definition of market quality is needed.
Ratterman stated that retail investors have never had it better, and that this must be the result of the quality of execution retail receives, and therefore it is more about establishing a foundation for reporting such metrics on execution.
Lauer responded by stating that metrics are not well established and that “you cannot trust anecdotes.” He further noted that it is clear to buy-side firms that there needs to be more insight into what the true costs are and more visibility across the industry as to how brokers handle orders. In response, Becker stated that at his former employer, they worked very hard to get best execution right and ensure that customers received very good prices.
In response to Lauer, Brown stated that routing to the highest rebate exchange is not industry practice.
Maureen O’Hara of Cornell University and ITG asked Lauer who should be responsible for providing the information regarding metrics to clients. She noted that her clients are very vocal as to how orders are routed and executed and therefore would like to know the problem with retail.
Lauer stated that he is not singling out retail and meant that there is a lot of work that can be done for institutional clients. He noted that some firms provide data to clients while others do not, and this needs to be codified.
Nazarali stated that with respect to retail investors, there is no question that the data regarding execution quality supports that retail investors are getting a better deal.
In response to a question about how the market would operate if Rule 611 was not in place, Brown indicated that Schwab had previously stated that Rule 611was not needed. He noted however that he is more worried about trade-at, as off-exchange trading was the unintended best part of Reg NMS.
Katsuyama noted that there is a debate within the government over whether they should set rates, and that fees offer perverse incentives. He stated that disclosure will solve a lot of issues and let “businesses stand on their own merit” and that we must allow the market to sort it out given the proper information.
Ketchum asked how removing the low volume exchanges would impact costs, how much money is actually saved, and whether this matters from a broker routing vs. exchange routing perspective.
Lauer answered that moving order routing back to broker-dealers would simplify market structure, as broker-dealers already have routing technology and that it would address the issue of complex order types.
Katsuyama said some brokers do an excellent job of executing customer orders and using their ATS separately. However, he noted that there is punishment in the market for being too transparent, as not all market participants offer the same level of disclosure and therefore those that do disclose open themselves up to scrutiny. He believes that the market needs to reward those market participants that make the “good and right decisions.”
Brown noted that he is wary of changing Rule 611 now due to the unintended consequences. He noted however he is concerned about the recommendation to apply a de minimis level to execution volume in order to have a protected quote, as he does not want to institutionalize an unlevel playing field.
Ratterman stated that Brown reaffirmed his thoughts that with retail investors “you can look them in the eye and no matter what broker you use, day of the week, path you use, you get the best price by law.”
Nazarali stated removing Rule 611 would be a “blow to investor confidence”. He stated that irrespective of Rule 611, you should be monitoring every price in the market and ensuring that your customer gets the best price.
Ratterman noted that if keeping Rule 611 would mean getting the best price by law, whereas with best execution, the investor’s option is to review reports and make an informed choice. He noted that the latter is not a terrible option, but by law is better stance.
Baxter stated that the commercial standard for best execution in the market is more comprehensive than Rule 611. He suggested adopting a more principles-based approach, rather than one that is prescriptive.
Stone asked whether the problem is too many exchanges or too many trading venues. In response, Mecane stated that the issue of whether a quote should be protected is of an economic nature, in that currently they are required to connect to all exchanges and therefore this issue can be addressed in an economic fashion. He noted that complexity and too many venues is a separate issue.
Lauer suggested that the U.S. consider initiatives that Canada has implemented to decrease off-exchange trading. Nazarali in response stated that “Canada is a market we don’t want to emulate”. He noted that it is cheaper for retail investors in Canada to route orders in inter-listed stocks to the U.S., even when taking into account fees, foreign exchange rates, etc. He further noted IIROC is considering a proposal to prevent retail orders from being routed to the United States, even though they are aware of the benefits to retail investors.
Committee members and the staff of the Division of Trading and Markets were in agreement that the Committee should create subcommittees that will address the key issues identified by both the Committee and the Commission. Additionally, Committee members agreed that issues such as locked/crossed markets, access fees, and the order protection rule need to addressed in a holistic fashion and not in isolation.
For more information on this meeting and to view an archived webcast, please click here.
U.S. Securities and Exchange Commission
Equity Market Structure Advisory Committee Meeting
Thursday, May 13, 2015
Key Topics & Takeaways
- HolisticReview: Committee members agreed that issues such as locked/crossed markets, access fees, and the order protection rule need to addressed in a holistic fashion and not in isolation.
- Transparency: Committee members agreed that market participants, in order to make informed decisions, must be provided with increased transparency and disclosure.
- Unintended Consequences: Committee members stated that any possible recommendation or market solution must take into account the possibility of unintended consequences and the associated risks.
Commissioners and Participants
- Mary Jo White, SEC Chairman
- Luis Aguilar, SEC Commissioner
- Daniel Gallagher, SEC Commissioner
- Kara Stein, SEC Commissioner
- Michael Piwowar, SEC Commissioner
- Stephen Luparello, Director, Division of Trading & Markets
- Daniel Gray, Senior Special Counsel, Division of Trading & Markets
- Matthew Andresen, Headlands Technologies LLC
- Reginald Browne, Cantor Fitzgerald & Co.
- Kevin Cronin, Invesco Ltd.
- Brad Katsuyama, IEX Group Inc.’
- Ted Kaufman, Duke University Law School and former U.S. Senator from Delaware
- Richard Ketchum, FINRA
- Manisha Kimmel, Thomson Reuters
- Mehmet Kinak, T. Rowe Price Group
- Andrew Lo, MIT and AlphaSimplex Group
- Joseph Mecane, Barclays PLC
- Jamil Nazarali, Citadel Securities, LLC
- Eric Noll, Convergex Group
- Maureen O’Hara, Cornell University and Investment Technology Group, Inc.
- Joe Ratterman, BATS Global Markets, Inc.
- Nancy Smith, AARP Inc.
- Chester Spatt, Carnegie Mellon University
- Gary Stone, Bloomberg Tradebook LLC
- Jamie Selway, ITG
- Tom Farley, NYSE
- Thomas Wittman, NASDAQ
- Dave Lauer, KOR Trading
- Brandon Becker, TIAA-CREF
- Jeff Brown, Charles Schwab
- Bill Baxter, Fidelity
Opening Statements
Chair Mary Jo White
Chair Mary Jo Whitestated that maintaining and enhancing the high quality of the U.S. equity markets is one of the SEC’s most important responsibilities. She noted that the Equity Market Structure Advisory Committee will assist the Commission in its continuing “efforts to ensure that the equity markets optimally meet the needs of investors and public companies.” She commented that in today’s high-speed electronic markets, “it is not clear that investors and public companies have sufficiently reaped the rewards from improved order handling and trading technologies.”
White identified market complexity as an overarching issue that deserves attention. She explained that market complexity can be useful, but where it is not directed toward producing better markets for investors and issuers, it can lead to “less than optimal” equity market structure, including issues of market instability, a lack of transparency for investors regarding order handling and execution practices, and increased difficulties for regulators in effectively overseeing the markets. She stated that the SEC seeks to optimize market structure “through a careful, data-driven assessment where no issue is off limits or any assumption unquestioned.” With respect to Rule 611, White encouraged the Committee to discuss whether it has contributed to excessive fragmentation, led to increased off-exchange trading, harmed institutional investors, or failed to achieve the objective of enhancing displayed liquidity.
Commissioner Luis Aguilar
Commissioner Luis Aguilar referred to his May 11, 2015 statement in which he recommended a framework for a holistic assessment of our current equity market structure. He stated that the Committee should identify and prioritize market structure changes that would benefit investors and issuers rather than traders who seek to profit from continual trading.
Commissioner Daniel Gallagher
Commissioner Daniel Gallagher described the meeting as a watershed moment in the SEC’s process for conducting a holistic review of our equity market structure. He stated that Regulation NMS is “fundamentally flawed” and cited it as an example of a regulatory distortion of the market. He asked that the Committee focus on the unintended consequences of regulation and the role of regulation in creating market complexity.
Commissioner Kara Stein
Commissioner Kara Stein stated that the Committee should focus on potential market structure changes from the perspectives of investors and issuers. After describing how technology and markets have changed since Regulation NMS was adopted, she asked the Committee to actively think about where things are going in the next ten years.
Commissioner Piwowar
Commissioner Michael Piwowar recommended that the Committee control the agenda for future meetings, rather than the Commission. He asked the Committee to measure the unintended consequences of Regulation NMS as well as any potential changes against the goals and concerns that were articulated at the time it was adopted. Piwowar asked the Committee to consider the dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to the adoption of Regulation NMS. Lastly, he encouraged interested parties who were not members of the Committee to provide feedback on the issues discussed.
Administrative Items
SEC Director of the Division of Trading and Markets Stephen Luparello stated that he expects the staff of his division to issue a series of recommendations to the Commission as the committee progresses, rather than issuing one comprehensive report. He further stated that he expects that the committee will hold meetings on a quarterly basis.
Introductory Remarks of the Committee Members
Each member of the committee provided a brief introduction, including a description of their professional background, current employment, and high-level comments regarding market structure issues. Many members raised concerns about the degree of market fragmentation, conflicts of interest, lack of transparency, and distortions caused by access fees. Additionally, several members stated that the committee should consider these issues from the perspectives of investors and issuers.
Presentation of Rule 611 by Daniel Gray, Division of Trading & Markets
Daniel Gray, Senior Special Counsel of the Division of Trading and Markets, referenced the Division of Trading & Markets staff’s memorandum regarding Rule 611 of Regulation NMS that was published on April 30, 2015. Additionally, he discussed the context of the market at the time that Regulation NMS was adopted. He explained that not all changes in market structure can be attributed to Rule 611. He acknowledged that Rule 611 has been criticized for making lit venues less desirable because of increased complexity and fragmentation.
After concluding his presentation, Gray answered questions from Committee members. Joseph Mecane of Barclays commented that the costs of Rule 611 do not outweigh its benefits in today’s market. He asked Gray how the staff measures the rule’s costs. He also asked how the staff defines the terms “fragmentation” and “complexity.” Luparello stated that he would like the committee to discuss these questions, explaining that these are issues that the SEC has struggled with.
Joe Ratterman of BATS commented that Rule 611 was successful in meeting its goal of increased competition among trading venues, as evidenced by BATS’s existence. He explained that the elimination of the NYSE’s monopoly has resulted in complexity, but some complexity must be accepted.
Brad Katsuyama of IEX commented that complexity is expected with fragmented markets. He stated that the market just needs better transparency and disclosures. He stated further that the lack of transparency causes concerns and hurts confidence in the market.
Matthew Andresen of Headlands stated that Rule 611 increased competition for NYSE, but Nasdaq was already competitive before the rule. He stated that in 2015, Rule 611 may no longer be needed for competition.
Panel 1 – Representatives from NYSE, Nasdaq, and ITG
Jamie Selway of ITG stated that since mid-2004, average trading costs have fallen by 40%. He said that at its core, Rule 611 provides that the “best price wins”. However, he noted the rule comes with difficulties; for instance, it works best in a frictionless market, and since Rule 611 is a prescriptive approach to order routing, it has difficulty accommodating innovations in the marketplace. Selway provided several recommendations for the Commission to consider, specifically: 1) create a de minimis exception, where an exchange’s quotes are not protected if the volume executed falls below a certain level (e.g. 1 percent); 2) create a block exemption to Rule 611; and 3) repeal the prohibition on locked markets. Selway noted that in the absence of Rule 611, improved standards for best execution would be required.
Tom Farley of NYSE stated that Rule 611 had many objectives, including limiting trade-throughs, which was a step forward for equity market structure. Additionally, he provided that an additional objective of Rule 611 was to reward those who make their price and size known on the public markets, but this objective of the rule has fallen short. Farley posed the question of how those who publically display their quotes are rewarded, as it is important that to have deep, liquid, and transparent markets. He noted that there should be a third objective, to contribute to the safety and soundness of the equity markets.
Tom Wittman of NASDAQ stated that the U.S. equity market structure continues to evolve and that regulation needs to evolve with it. He noted the current market structure does not sufficiently serve investors and issuers, and that evaluating Rule 611 as a standalone rule is not the best way to address this concern. Wittman raised his concerns with the one-size-fits-all approach to equity market structure. He noted that exchanges should be free to experiment and evolve, and to take into account issuer size and trading patterns. He stated that he would prefer a principle-based approach to revising Regulation NMS rather than one that is prescriptive.
Question & Answer:
Eric Noll of Convergex asked about the impact of removing the prohibition on locked markets. Selway noted that before Reg NMS, locked markets would occur and it was not necessarily a problem. He indicated that a locked market demonstrates that the trading increment may be too wide.
Jamil Nazarali of Citadel Securities responded that retail clients believe that locked/crossed markets are a failure and that it is hard to explain why a trade does not occur when a buyer and a seller are quoting at the same price and there is not a cross. Nazarali stated that retail clients do not believe locked/crossed market should be permitted.
Gary Stone of Bloomberg Tradebook LLC suggested that if access fees were included within the price of the quote, the likelihood of a locked/crossed market would be significantly reduced. He further stated that with maker/taker, all market participants are aware of incentives. Stone stressed that if maker/taker is no longer permitted, increased transparency for market participants is critical.
Ratterman stated that the market could benefit from a change away from one-size-fits-all, but that reducing market structure to the bare minimum may not be the best for all securities, and that less liquid names could be impacted by a reduction in access fees/rebates. Wittman agreed, noting that with less liquid stocks you could argue for higher rebates.
In response to a question posed by Luperallo regarding a penny tick-size increment, Kevin Cronin of Investco Ltd. stated that if you permit sub-penny pricing, there may less incentive to display liquidity.
Andresen stated that the right answer is tiering in the marketplace, in that some names may be able to support sub-pennies and therefore there should be flexibility in the regulations to allow exchanges to incentivize certain behaviors.
Ratterman, in response to a question of whether permitting locked markets would reduce complexity, stated that a significant amount of time is spent thinking about the interactions of order types and matching engine logic, and therefore permitting locked/crossed markets would reduce complexity from a technological standpoint. However, he noted that complexity is not an issue for technology professionals.
Rick Ketchum, Chairman of the Financial Industry Regulatory Authority, asked Selway what behavior that is currently discouraged he would like to see permitted. Selway stated that Rule 611 is a rough proxy for best execution and therefore market participants would be better off with a more robust best execution. He additionally noted that currently Rule 611 limits the ability of market centers to innovate.
In response to a question regarding the substantial dark activity on exchanges, Farley stated that all order types are disclosed, the percentage of dark liquidity is small, and that lit orders take priority over dark.
Ratterman noted that the answer is not all-lit liquidity or all-dark liquidity due to the fact that market participants have different needs.
Farley stated that NYSE supports dark trading and that block trades off-exchange “make sense.” However, he noted that that those who display their quotes should be “rewarded.”
Nazarali questioned who is harmed with off-exchange/dark trading. He noted that the benefits of off-exchange trading have accrued to retail investors. Nazarali recognized the importance of price discovery, stated that he is also a supporter of lit venues, and that there are benefits that come from competition.
Panel 2 – Representatives from KOR Group, Schwab, TIAA-CREF, and Fidelity
Dave Lauer of KOR Trading stated that the objective of Rule 611 was to protect investors from inferior execution prices and promote limit order display. He noted that Rule 611 sought to provide intermarket price protection and that this was to be supplemented with data from Rules 605 and 606 in order to allow investors to make informed decisions. Lauer stated that criticisms of Rule 611 include that it increases fragmentation and creates unnecessary complexity. He stated that market centers have incredible pricing power over market data feeds and that exchanges should not have been allowed to have become order routers.
Lauer further noted that that the lines between broker-dealers and exchanges have become blurred. He stated that the unnecessary complexity and fragmentation do not help the markets and that market structure reforms should protect investors and incentivize liquidity. Lauer put forth several recommendations for reforms, including updating Rules 605 and 606, modernizing best execution rules, reviewing market data revenue sharing, and that order routing obligations under Rule 611 should be borne by broker-dealers, not exchanges.
Jeff Brown of Charles Schwab stated that one of the biggest unintended consequences of Rule 611 is the growth of off-exchange trading. Brown noted that this growth has been a “tremendous boon” to retail investors, and that competition between off-exchange retail vendors is driving execution quality. He stated that Schwab supports free markets and that the benefits to retail investors cannot be ignored. He stated that any reforms to the markets need to be tested and thoroughly considered, particularly due to the risks of unintended consequences. He added that the Committee should additionally consider NMS governance reform and market data.
Brandon Becker of TIAA-CREF stated that the “rain forest” of order types is “fertilized” by rebates and the prohibition on locked/crossed markets. He said a material reduction of the access fee cap would help change the economics, and that it is a “fool’s errand” to chase order types and best execution reform without addressing the underlying economic incentives. Additionally, Becker suggested materially lowering rebates, permitting locked/crossed markets, and addressing infrastructural issues such as dark pool transparency and upgrading the Securities Information Processors (SIPs). He recommended that the Committee focus on one to three things that the Commission can actually implement.
Bill Baxter of Fidelity noted that the Commission has implemented various reforms over the past several years, including Limit Up-Limit Down and Regulation SCI. Baxter stated that the markets have changed significantly since Rule 611 was adopted, and that as an initial matter, the Committee should first establish the metrics that will facilitate any review. Baxter stated that he welcomes competition and choice in the marketplace, but questioned whether smaller venues add to complexity and market risk. Accordingly, Baxter stated that the definition of “protected quote” should be revised to apply only where a trading venue has a certain market share. He expressed support for addressing the access fee cap under Rule 610, as well as measured reforms to the maker/taker pricing model that takes into account the market capitalization of securities.
Question & Answer:
Commission Gallagher asked Baxter what metrics he had in mind, to which Baxter responded that a clear definition of market quality is needed.
Ratterman stated that retail investors have never had it better, and that this must be the result of the quality of execution retail receives, and therefore it is more about establishing a foundation for reporting such metrics on execution.
Lauer responded by stating that metrics are not well established and that “you cannot trust anecdotes.” He further noted that it is clear to buy-side firms that there needs to be more insight into what the true costs are and more visibility across the industry as to how brokers handle orders. In response, Becker stated that at his former employer, they worked very hard to get best execution right and ensure that customers received very good prices.
In response to Lauer, Brown stated that routing to the highest rebate exchange is not industry practice.
Maureen O’Hara of Cornell University and ITG asked Lauer who should be responsible for providing the information regarding metrics to clients. She noted that her clients are very vocal as to how orders are routed and executed and therefore would like to know the problem with retail.
Lauer stated that he is not singling out retail and meant that there is a lot of work that can be done for institutional clients. He noted that some firms provide data to clients while others do not, and this needs to be codified.
Nazarali stated that with respect to retail investors, there is no question that the data regarding execution quality supports that retail investors are getting a better deal.
In response to a question about how the market would operate if Rule 611 was not in place, Brown indicated that Schwab had previously stated that Rule 611was not needed. He noted however that he is more worried about trade-at, as off-exchange trading was the unintended best part of Reg NMS.
Katsuyama noted that there is a debate within the government over whether they should set rates, and that fees offer perverse incentives. He stated that disclosure will solve a lot of issues and let “businesses stand on their own merit” and that we must allow the market to sort it out given the proper information.
Ketchum asked how removing the low volume exchanges would impact costs, how much money is actually saved, and whether this matters from a broker routing vs. exchange routing perspective.
Lauer answered that moving order routing back to broker-dealers would simplify market structure, as broker-dealers already have routing technology and that it would address the issue of complex order types.
Katsuyama said some brokers do an excellent job of executing customer orders and using their ATS separately. However, he noted that there is punishment in the market for being too transparent, as not all market participants offer the same level of disclosure and therefore those that do disclose open themselves up to scrutiny. He believes that the market needs to reward those market participants that make the “good and right decisions.”
Brown noted that he is wary of changing Rule 611 now due to the unintended consequences. He noted however he is concerned about the recommendation to apply a de minimis level to execution volume in order to have a protected quote, as he does not want to institutionalize an unlevel playing field.
Ratterman stated that Brown reaffirmed his thoughts that with retail investors “you can look them in the eye and no matter what broker you use, day of the week, path you use, you get the best price by law.”
Nazarali stated removing Rule 611 would be a “blow to investor confidence”. He stated that irrespective of Rule 611, you should be monitoring every price in the market and ensuring that your customer gets the best price.
Ratterman noted that if keeping Rule 611 would mean getting the best price by law, whereas with best execution, the investor’s option is to review reports and make an informed choice. He noted that the latter is not a terrible option, but by law is better stance.
Baxter stated that the commercial standard for best execution in the market is more comprehensive than Rule 611. He suggested adopting a more principles-based approach, rather than one that is prescriptive.
Stone asked whether the problem is too many exchanges or too many trading venues. In response, Mecane stated that the issue of whether a quote should be protected is of an economic nature, in that currently they are required to connect to all exchanges and therefore this issue can be addressed in an economic fashion. He noted that complexity and too many venues is a separate issue.
Lauer suggested that the U.S. consider initiatives that Canada has implemented to decrease off-exchange trading. Nazarali in response stated that “Canada is a market we don’t want to emulate”. He noted that it is cheaper for retail investors in Canada to route orders in inter-listed stocks to the U.S., even when taking into account fees, foreign exchange rates, etc. He further noted IIROC is considering a proposal to prevent retail orders from being routed to the United States, even though they are aware of the benefits to retail investors.
Committee members and the staff of the Division of Trading and Markets were in agreement that the Committee should create subcommittees that will address the key issues identified by both the Committee and the Commission. Additionally, Committee members agreed that issues such as locked/crossed markets, access fees, and the order protection rule need to addressed in a holistic fashion and not in isolation.
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