[Federal Register Volume 88, Number 1 (Tuesday, January 3, 2023)]
[Proposed Rules]
[Pages 128-245]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-27617]
[[Page 127]]
Vol. 88
Tuesday,
No. 1
January 3, 2023
Part II
Securities and Exchange Commission
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17 CFR Parts 240 and 242
Order Competition Rule; Proposed Rule
Federal Register / Vol. 88 , No. 1 / Tuesday, January 3, 2023 /
Proposed Rules
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240 and 242
[Release No. 34-96495; File No. S7-31-22]
RIN 3235-AM57
Order Competition Rule
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing to amend the regulation governing the national market system
(``NMS'') under the Securities Exchange Act of 1934 (``Exchange Act'')
to add a new rule designed to promote competition as a means to protect
the interests of individual investors and to further the objectives of
an NMS. The proposed rule would prohibit a restricted competition
trading center from internally executing certain orders of individual
investors at a price unless the orders are first exposed to competition
at that price in a qualified auction operated by an open competition
trading center. The proposed rule would also include limited exceptions
to this general prohibition. In addition, the Commission is proposing
to amend the regulation governing the NMS to add new defined terms
included in the proposed rule.
DATES: Comments should be received on or before March 31, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.htm); or
Send an email to [email protected]. Please include
File Number S7-31-22 on the subject line.
Paper Comments
Send paper comments to Secretary, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-1090.
All submissions should refer to File Number S7-31-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's website (http://www.sec.gov/rules/proposed.shtml).
Comments are also available for website viewing and printing in the
Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. Operating conditions may limit access to the Commission's Public
Reference Room. All comments received will be posted without change.
Persons submitting comments are cautioned that the Commission does not
redact or edit personal identifying information from comment
submissions. You should submit only information that you wish to make
available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any materials will
be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Dan Gray, Senior Special Counsel,
Jennifer Dodd, Special Counsel, or Stacia Sowerby, Special Counsel, at
(202) 551-5500, Office of Market Supervision, Division of Trading and
Markets, Securities and Exchange Commission, 100 F Street NE,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment amendments to Regulation NMS [17 CFR 242.600 through 242.614]
(``Regulation NMS'') that would add new 17 CFR 242.615 (``Proposed Rule
615''), add new defined terms to 17 CFR 242.600 (``Rule 600'') that are
used in Proposed Rule 615, and make conforming amendments to defined
terms in 17 CFR 242.602, 17 CFR 242.611, and 17 CFR 242.614; and
conforming amendments to defined terms in 17 CFR 240.3a51-1, 17 CFR
240.13h-1, 17 CFR 242.105, 17 CFR 242.201, 17 CFR 242.204, and 17 CFR
242.1000.
Table of Contents
I. Introduction
II. Overview of Market Structure for NMS Stocks
A. Investors
B. Trading Centers
C. Order Types and Trading Costs
D. Quantitative Measures of Order Execution Quality and Trading
Costs
1. Description of Quantitative Measures
2. Examples of Calculating Measures of Order Execution Quality
and Trading Costs
III. Statutory and Regulatory Background
A. Statutory Framework for an NMS
B. Current Regulatory Components of the NMS for NMS Stocks
1. Rules Addressing Consolidated Market Data
2. Rules Addressing Order Handling and Execution
3. Rules Addressing Access to Trading Centers
4. Disclosure of Order Routing Practices and Order Execution
Statistics
IV. Description of Proposed Rule 615
A. Overview of Order Competition Requirement
B. Coverage of Proposed Rule 615
1. Definition of Segmented Order
2. Definition of Open Competition Trading Center
3. Definition of Restricted Competition Trading Center
4. Definition of Originating Broker
5. Exceptions
C. Qualified Auction Requirements
1. Auction Messages
2. Auction Responses
3. Pricing Increment
4. Fees and Rebates
5. Auction Execution Priority
D. Open Competition Trading Center Requirements
E. Originating Broker Requirements
F. Broker-Dealer Requirements
G. National Securities Exchange Requirements
V. Request for Comment
VI. Paperwork Reduction Act Analysis
A. Summary of Collection of Information
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
B. Proposed Use of Information
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
C. Respondents
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
D. Burdens
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures for Excluding
Subscribers
E. Collection of Information Is Mandatory
F. Confidentiality of Information Collected
1. Auction Messages
2. Identifying and Marking Segmented Orders
3. Originating Broker Certification
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
G. Retention Period for Recordkeeping Requirements
H. Request for Comments
VII. Economic Analysis
A. Introduction
B. Baseline
1. Competition for Liquidity Provision in NMS Stocks
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2. Segmentation of Individual Investor Order Flow
3. Institutional Investor Interactions With Retail Orders
4. Execution Quality of Individual Investor Marketable Orders in
NMS Stocks
5. Variation in Wholesaler Execution Quality
6. Retail Broker Services
7. Rules Addressing Consolidated Market Data
C. Economic Effects
1. Benefits
2. Costs
3. Competition
4. Efficiency
5. Capital Formation
D. Reasonable Alternatives
1. Variation in Provisions Regarding Segmentation and Routing
2. Alternate Definitions of Segmented Orders
3. Variation in Auction Design
4. Variation in Exceptions to the Order Competition Requirement
5. Variation in the Definition of Open Competition Trading
Centers
6. Wholesaler Information Barriers
7. Display Quotes in Retail Liquidity Programs
8. Creation of a Retail Best Bid and Offer
9. Disclosure of Execution Quality of Individual Investor Orders
E. Request for Comments
VIII. Regulatory Flexibility Act Certification
IX. Consideration of Impact on the Economy
Statutory Authority
I. Introduction
The Commission is proposing a new rule, Proposed Rule 615 of
Regulation NMS, entitled the ``Order Competition Rule,'' to promote a
more competitive, transparent, and efficient market structure for NMS
stocks, with resulting benefits to investors. Proposed Rule 615 would
require that certain orders of individual investors be exposed to
competition in fair and open auctions, before such orders could be
executed internally by trading centers that restrict order-by-order
competition.\1\ The Commission believes that the proposal would better
advance each of the five Congressional objectives for an NMS set forth
in section 11A of the Exchange Act.\2\ In particular, Proposed Rule 615
is designed to benefit individual investors by promoting competition
and transparency as means to enhance the opportunity for their orders
to receive more favorable prices than they receive in the current
market structure, as well as to benefit investors generally by giving
them an opportunity to interact directly with a large volume of
individual investor orders that are mostly inaccessible to them in the
current market structure. This section provides an overview of that
market structure and how that market structure may impact investors.
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\1\ ``Order-by-order'' competition in this context means an
opportunity to compete to trade with individual investor orders by
offering the most favorable price for each order based on the
particular characteristics of the order, including the nature of the
NMS stock, the size of the order, and market conditions at the time
the order is submitted. Section II below provides an overview of the
current market structure for NMS stocks, including descriptions of
key terms used in this release that readers may find useful to
assess and comment on the Commission's proposal. Among many others,
these terms include ``individual investors,'' ``trading centers,''
and ``wholesalers.''
\2\ 15 U.S.C. 78k-1 (``section 11A''). These objectives are: (1)
economically efficient execution of securities transactions; (2)
fair competition among brokers and dealers, among exchange markets,
and between exchange markets and markets other than exchange
markets; (3) the availability to brokers, dealers, and investors of
information with respect to quotations for and transactions in
securities; (4) the practicability of brokers executing investors'
orders in the best market; and (5) an opportunity, consistent with
objectives 1 and 4, for investors' orders to be executed without the
participation of a dealer. 15 U.S.C. 78k-1(a)(1)(C).
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As discussed in sections II and VII below, individual investors
primarily use market orders and marketable limit orders (collectively
known as ``marketable orders'') to trade in NMS stocks. Market
participants who use these orders seek to trade immediately at the best
available prices in the market. Broker-dealers route more than 90% of
marketable orders of individual investors in NMS stocks to a small
group of six off-exchange dealers, often referred to as
``wholesalers.'' \3\ The wholesaling business is highly concentrated,
with two firms capturing approximately 66% of the executed share volume
of wholesalers as of the first quarter of 2022.\4\ The practice of
separately identifying and routing the marketable orders of individual
investors to wholesalers is a form of ``segmentation.'' The term
``segmentation'' can refer to any practice by which a certain category
of orders is identified and treated differently for execution than
other categories of orders.
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\3\ Table 3, infra, section VII.B.2.a.
\4\ See infra note 372.
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As discussed in the economic analysis in section VII.B.2 below,
individual investor orders are segmented because they are ``low-cost''
flow--they impose lower adverse selection costs on liquidity providers
than the unsegmented order flow routed to national securities
exchanges. ``Adverse selection'' involves situations where buyers and
sellers have different information, and specifically for a liquidity
provider, refers to the extent to which prices move against it after a
trade. For example, if the price of a stock drops right after a
liquidity provider buys it, the liquidity provider has suffered from
adverse selection. Generally, the more severe the adverse selection,
the larger the ``effective spread'' that would be expected for a trade
because liquidity providers require a wider effective spread to
compensate them for the higher cost of adverse selection.\5\ In this
respect, the size of effective spreads can be interpreted as a measure
of the average adverse selection that liquidity providers expect to
suffer when trading with incoming orders. Data analysis conducted for
this proposal reveals that the average adverse selection costs of
orders routed to wholesalers are far lower than the average adverse
selection costs of orders routed to national securities exchanges.\6\
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\5\ As explained in more detail in section II.D below, the
``effective spread'' of a trade is measured as double the difference
between the trade's execution price and the midpoint of the national
best bid and offer at the time of order receipt. Adverse selection
reflects the ``price impact'' of a trade, which is measured as the
difference between the midpoint of the national best bid and offer
at the time of the trade and the midpoint of the national best bid
and offer at a specified time (e.g., one minute or five minutes)
after the time of the trade.
\6\ Table 7, infra, section VII.B.4 (adverse selection costs, as
measured by price impact, of marketable orders of individual
investors in all NMS stocks are 71% lower at wholesalers (1.26 basis
points) than on exchanges (4.40 basis points)).
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The primary benefit of segmentation for individual investors is
that it can provide an opportunity for their low-cost orders to be
executed at better prices than those generally available on national
securities exchanges, a practice known as ``price improvement.'' \7\ As
discussed in section VII below, wholesalers often provide some price
improvement relative to the best publicly quoted prices for round lot
sizes on national securities exchanges.\8\
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\7\ Section VII.B.4 below discusses an analysis of wholesaler
trading data indicating the relationship between segmentation,
adverse selection costs, and order execution quality.
\8\ Table 5, infra, section VII.B.4 (83.17% of marketable orders
routed to wholesalers receive price improvement when compared to the
best publicly quoted prices for round lot sizes on national
securities exchanges, and 8.78% of marketable orders routed to
national securities exchanges receive such price improvement). These
better prices are due in large part to the ability of wholesalers to
offer sub-penny prices that are not permitted on national securities
exchanges and other trading centers. The current rules that govern
sub-penny trading are discussed in section III.B.2.c below.
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Price improvement, however, is not the same as competitive order
execution. Today, the primary business model of wholesalers is to trade
bilaterally as principal with individual investor orders (a form of
``internalization''). Typically, the way broker-dealers choose a
wholesaler for any particular order is not based on the
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price the wholesaler is willing to provide for that order, as
wholesalers do not display or otherwise indicate in real-time the
prices at which they are willing to trade with individual investor
orders. Instead, a wholesaler is often chosen by a formula that depends
on past execution quality of the wholesaler, its relationship with the
broker-dealer, and other factors. In addition, the bilateral nature of
the wholesaler business model not only restricts contemporaneous
competition among wholesalers, it also restricts opportunities for
other market participants to trade with the low-cost flow. Once a
wholesaler receives an individual investor's marketable order, the
wholesaler's execution of the order does not face competition at all--
the wholesaler typically executes the order internally without
providing any opportunity for other market participants, including
institutional investors, to compete to provide more favorable prices
for the order.\9\ This lack of order-by-order competition among market
participants is particularly significant in the market for NMS stocks,
which is an order-driven market in which a wide range of market
participants, including institutional investors, seek to provide
liquidity on national securities exchanges by posting orders for the
approximately 12,000 NMS stocks. In contrast, the listed options market
is a quote-driven market in which professional market makers dominate
liquidity provision by displaying quotes in the more than 1,000,000
different options series. In sum, in the current market structure for
NMS stocks, individual investor orders are not merely segmented; they
also are isolated from order-by-order competition by a wide range of
market participants, which, as discussed below, can affect the prices
that individual investors receive for their orders.
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\9\ As shown in Table 7, infra, section VII.B.4, wholesalers
execute internally (in ``principal transactions'') 90.44% of the
dollar volume of executed marketable orders routed to them. As
discussed in section VII.B.2.b below, wholesalers primarily obtain
external executions of the remaining volume of the marketable orders
in ``riskless principal'' transactions.
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Data analysis suggests that opening up individual investor orders
to order-by-order competition would lead to significantly better prices
for those investors. In a fully competitive market, competition among
liquidity providers would be expected to drive the amount of price
improvement that an order receives to a level commensurate with its
adverse selection cost (setting aside other relevant costs). All else
equal, the lower an order's expected adverse selection cost, the
greater would be the order's expected price improvement. However, as
discussed in section VII.C.1.b below, the current isolation of
individual investor orders from order-by-order competition results in
suboptimal price improvement for such orders. The Commission labels
this forgone price improvement ``competitive shortfall.'' Based on an
analysis of trading data from the wholesalers and national securities
exchanges in the first quarter of 2022, the competitive shortfall is
estimated to be approximately 1.08 basis points per dollar traded by
wholesalers or 1.08 cents for every $100 traded, with an estimated
total annual competitive shortfall of $1.5 billion.\10\
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\10\ Table 18 and Table 19, infra, section VII.C.1.b (figures in
text are for the CAT rebate base competitive shortfall estimates).
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In addition to this competitive shortfall, the isolation of
individual investor orders at wholesalers prevents other investors from
having an opportunity to trade with this low-cost flow. Institutional
investors that currently submit their own marketable orders on national
securities exchanges and other trading centers potentially could trade
at better prices if given an opportunity to interact with the
marketable orders of individual investors in fair and open
auctions.\11\ For example, data analysis indicates that undisplayed
liquidity often is available at trading centers other than wholesalers
when a wholesaler executes marketable orders of individual investors at
prices less favorable for the individual investor than the prices of
the undisplayed liquidity.\12\ Moreover, if institutional investors
that currently pay a full ``spread'' (that is, the difference between
the highest price bid and the lowest price offer) to access liquidity
were able instead to interact in auctions with the marketable orders of
individual investors that currently are mostly inaccessible to them,
these institutional investors could benefit from lower spread
costs.\13\
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\11\ See, e.g., section VII.B.3, infra, discussing institutional
investor interactions with retail orders.
\12\ Table 20, infra, section VII.C.1.b.
\13\ See, e.g., Section VII.C.1.c, infra, discussing potential
improved execution quality for institutional investor orders.
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The Commission is proposing Rule 615 to encourage greater
competition for individual investor order execution. Proposed Rule 615
generally would require that individual investor orders be exposed to
order-by-order competition in fair and open auctions designed to obtain
the best prices before such orders could be internalized by wholesalers
or any other type of trading center that restricts order-by-order
competition. As a result, individual investor orders could continue to
receive the benefits of segmentation (i.e., better prices that reflect
the low adverse selection costs of those orders), but without the
negative effects of those orders being isolated from order-by-order
competition (i.e., such better prices not fully reflecting the low
adverse selection costs of those orders; and a substantial percentage
of those orders seldom being accessible to institutional investors and
other market participants). In sum, the auctions required by Proposed
Rule 615 are intended to enhance competitive forces as a means to
protect the interests of investors in the NMS.
In developing the specific elements of Proposed Rule 615, the
Commission has been guided by this goal of benefiting investors by
enhancing competition. The overriding objective of these elements of
Proposed Rule 615 is to maximize the opportunity for a wide range of
market participants to participate in auctions on terms that will
promote the best possible prices for the orders of individual
investors. In this respect, the Commission has drawn from its
experience with the operation of existing auctions for orders in listed
options and tailored Proposed Rule 615 to promote fair and open
auctions that reflect the particular nature of the market for NMS
stocks. As discussed in section IV below, these elements would include
the wide dissemination of auction messages in consolidated market data,
requirements that any fees and rebates be capped at a low level
($0.0005 per share for auction prices of $1 or more) and be flat across
all market participants, and requirements for execution priority of
auction responses that give no advantage to the broker-dealer that
routed the marketable order of an individual investor to the auction.
In addition, the Commission has limited the scope of Proposed Rule
615 to contexts in which an auction could be most beneficial for
individual investors. For example, individual investors that trade many
times per day tend to use marketable orders that pose higher adverse
selection risk for liquidity providers; hence, their orders would be
outside the scope of the rule.\14\ In addition, proposed exceptions are
provided for orders with a market value of $200,000 or more and for
orders with execution prices (including prices constrained by non-
marketable limit prices) that are very favorable for individual
investors (i.e., the midpoint of the best displayed round lot
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quotations or better).\15\ These exceptions would not be mandatory,
however, which means that broker-dealers could choose whether or not to
route orders with these characteristics to an auction.
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\14\ See infra section IV.B.1; section VII.D.2.c.
\15\ As discussed in section IV.B.1 below, a subset of non-
marketable limit orders with prices not as favorable for individual
investors (i.e., beyond the midpoint of the best displayed round lot
quotations) would not qualify for the proposed exceptions.
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As discussed in section VII.D, the Commission assessed several
alternatives to Proposed Rule 615, both to the design of the required
auctions and to the auction approach itself. The Commission
preliminarily considers Proposed Rule 615 to be the best approach for
investors. As described throughout this release, and in more detail in
section IV, Proposed Rule 615 is designed to maintain the price
improvement benefits of the segmentation of individual investor orders
and to enhance those benefits through the introduction of order-by-
order competition with a wide range of market participants, including
institutional investors, through an auction mechanism that is fast,
low-cost, transparent, and fair.
The next two sections of this release are intended to provide
background information on the current structure and regulation of the
market for NMS stocks that will help promote understanding of the
details of the Commission's proposal. Section II provides a general
overview of the current market structure for NMS stocks, and section
III provides background on the statutory and regulatory framework for
NMS stocks. Section IV then describes the proposal in detail, and
section V consolidates all Commission requests for comment on the
proposal.
II. Overview of Market Structure for NMS Stocks
This section provides an overview of the market structure for NMS
stocks,\16\ particularly focusing on the types of market participants,
order types, and trading costs that will be referred to throughout this
release.\17\ An understanding of the current market structure,
particularly the trading costs of different types of market
participants, including liquidity takers and liquidity providers, is
critically important when assessing the rationale and objectives of
Proposed Rule 615.
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\16\ NMS stocks generally include equity securities other than
options that are listed on a national securities exchange. Rule
600(b)(55) of Regulation NMS defines ``NMS stock'' as any NMS
security other than an option, and Rule 600(b)(54) defines ``NMS
security'' to mean any security or class of securities for which
transaction reports are collected, processed, and made available
pursuant to an effective transaction reporting plan, or an effective
NMS plan for reporting transactions in listed options. The
definition of NMS stock does not include securities that are not
listed on a national securities exchange, sometimes referred to as
``over-the-counter'' or ``OTC'' securities.
\17\ A much more extensive discussion of the ``market
microstructure'' of securities markets is provided by treatises on
the subject. See, e.g., Larry Harris, Trading and Exchanges: Market
Microstructure for Practitioners (Oxford University Press 2003)
(``Harris Treatise''); Joel Hasbrouck, Empirical Market
Microstructure: The Institutions, Economics, and Econometrics of
Securities Trading (Oxford University Press 2007) (``Hasbrouck
Treatise'').
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A. Investors
Section 11A(a)(2) of the Exchange Act \18\ provides that the
Commission should have due regard for the protection of ``investors''
when facilitating the establishment of an NMS. As used in this release,
the term ``individual investor'' will refer to natural persons that
trade relatively infrequently for their own or closely related
accounts.\19\ Individual investors generally trade in relatively small
sizes that can be executed against immediately available liquidity.
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\18\ 15 U.S.C. 78k-1(a)(2).
\19\ For a discussion of the specific orders covered by Proposed
Rule 615, see Proposed Rule 600(b)(91) (defining the term
``segmented order'') and section IV.B.1 below (discussing the
proposed definition of ``segmented order''). As discussed in section
IV.B, the Commission is proposing to add definitions to Rule 600(b)
of Regulation NMS and adjust the numbering of current definitions
accordingly. Throughout this release, unless otherwise noted,
references to existing Rule 600(b) definitions are to the
definitions as they are currently numbered. References to proposed
new definitions are designated with ``Proposed Rule 600(b)'' and
reflect the proposed adjusted numbering.
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The term ``institutional investor'' as used in this release refers
to investors that trade in much larger sizes and much more frequently
than individual investors. Many institutional investors, such as
pension funds and mutual funds, operate on behalf of a large number of
individuals. Because institutional investors need to trade in large
sizes that can exceed immediately available liquidity, their large
``parent'' orders typically will be broken into smaller ``child''
orders. Institutional investors typically are focused primarily on
obtaining the best price for their large parent orders as a whole.\20\
The child orders will be fed into the market gradually so as to
minimize the extent to which market prices move away before the full
size of a parent order is executed, which is known as ``slippage.'' One
means for institutional investors to minimize slippage is to limit
``information leakage'' concerning the unexecuted portions of their
large parent orders by closely controlling the impact of the execution
of their child orders on market prices.
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\20\ See, e.g., Securities Exchange Act Release No. 61358 (Jan.
14, 2010), 75 FR 3594, 3604-3605 (Jan. 21, 2010) (``Equity Market
Structure Concept Release'') (measuring the transaction costs of
institutional investors ``can be extremely complex'' because their
``large orders often are broken up into smaller child orders and
executed in a series of transactions'' and ``[m]etrics that apply to
small order executions may miss how well or poorly the large order
traded overall.'').
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B. Trading Centers
Trades in NMS stocks are executed at a number of different types of
trading centers.\21\ As discussed below, trading centers that currently
trade NMS stocks can be divided into five categories: (1) national
securities exchanges operating SRO trading facilities; \22\ (2)
alternative trading systems (``ATSs'') that trade NMS stocks (``NMS
Stock ATSs''); (3) exchange market makers; (4) wholesalers; and (5) any
other broker-dealer that executes orders internally by trading as
principal or crossing orders as agent.\23\
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\21\ Rule 600(b)(95) of Regulation NMS defines ``trading
center'' as a national securities exchange or national securities
association that operates a self-regulatory organization (``SRO'')
trading facility, an alternative trading system, an exchange market
maker, an OTC market maker, or any other broker or dealer that
executes orders internally by trading as principal or crossing
orders as agent.
\22\ Rule 600(b)(89) of Regulation NMS defines ``SRO trading
facility'' as, among other things, a facility operated by a national
securities exchange that executes orders in a security.
\23\ ``Broker'' is generally defined in section 3(a)(4)(A) of
the Exchange Act as any person engaged in the business of effecting
transactions in securities for the account of others. 15 U.S.C.
78c(a)(4)(A). ``Dealer,'' in turn, is generally defined in section
3(a)(5)(A) of the Exchange Act as any person engaged in the business
of buying and selling securities for such person's own account
through a broker or otherwise. 15 U.S.C. 78c(a)(5)(A). The term
``broker-dealer'' is used in this release to encompass all brokers,
all dealers, and firms that are both brokers and dealers.
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National securities exchanges, among other things, operate SRO
trading facilities that bring together purchasers and sellers of NMS
stocks and execute their trades, fall within the definition of an
exchange in section 3(a)(1) of the Exchange Act,\24\ and are required
to register under section 6 of the Exchange Act.\25\ As discussed
further in section III.A below, national securities exchanges are
subject to a comprehensive regulatory regime that, among other things,
requires that their rules not impose any burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act and not be designed to permit unfair discrimination between
customers,
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issuers, and broker-dealers. All national securities exchanges publicly
display quotations for NMS stocks in consolidated market data and are
known as ``lit'' trading centers. As discussed in section III.B.1
below, the best-priced quotations of round lots of national securities
exchanges (highest priced bids to buy and lowest priced offers to sell)
are included in the consolidated market data feeds currently
disseminated by centralized securities information processors
(``SIPs''). In the first quarter of 2022, 16 national securities
exchanges executed 59.7% of share volume in NMS stocks.\26\
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\24\ Section 3(a)(1) of the Exchange Act defines ``exchange''
as, among other things, any organization that provides facilities
for bringing together purchasers and sellers of securities. 15
U.S.C. 78c(1).
\25\ 15 U.S.C. 78f.
\26\ Table 1, infra, section VII.B.1.
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NMS Stock ATSs operate facilities that fall within the definition
of an exchange in section 3(a)(1) of the Exchange Act, but, as
discussed in section III.B.3.b below, they are exempted from that
definition if they register as broker-dealers and otherwise comply with
Regulation ATS under the Exchange Act.\27\ No NMS Stock ATS currently
displays quotations in NMS stocks in consolidated market data. The
trading centers that do not display quotations are known as ``dark''
trading centers or ``dark pools.'' An NMS Stock ATS is required to
provide fair access to its services if it had 5% or more of the average
daily volume with respect to an NMS stock during four of the preceding
six calendar months,\28\ and as of November 30, 2022, one NMS Stock ATS
discloses on its Form ATS-N that it is subject to these fair access
requirements for securities that are available for trading on its
platform.\29\ In the first quarter of 2022, 32 ATSs executed 10.2% of
volume in NMS stocks.\30\
---------------------------------------------------------------------------
\27\ 17 CFR 240.3a1-1(a)(2); see also Securities Exchange Act
Release No. 40760 (Dec. 8, 1998), 63 FR 70844, 70858 (Dec. 22, 1998)
(``Regulation ATS Adopting Release'') (stating that the Commission
would not consider making an assessment whether a particular system
should register as an exchange unless such system exceeded the
volume thresholds specified in 17 CFR 240.3a1-1(b): during three of
preceding four calendar quarters, the system had (1) 50% or more of
the average daily dollar trading volume in any security and 5% or
more of the average daily dollar trading volume in any class of
security; or (2) 40% or more of the average daily dollar trading
volume in any class of securities).
\28\ See Rule 301(b)(5); infra section III.B.3.b (discussing
fair access requirements for NMS Stock ATSs).
\29\ See Dealerweb Inc., Form ATS-N/OFA, Part III, Items 11
(Trading Services, Facilities and Rules) and Item 25 (Fair Access)
(filed Oct. 24, 2022), https://www.sec.gov/Archives/edgar/data/817462/000081746222000015/0000817462-22-000015-index.htm (disclosing
that the NMS Stock ATS is subject to the fair access requirements in
symbols SPY and QQQ). This NMS Stock ATS generally limits its
eligible subscribers to market makers, banks, broker-dealers, and
asset managers with at least $10 under management. See id. at Part
III, Item 1 (Types of Subscribers) and Item 2 (Eligibility for ATS
Services). Access to Form ATS-Ns filed by NMS Stock ATSs are
available on the Commission's website at https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm.
\30\ Table 1, infra, section VII.B.1.
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An exchange market maker is defined in Rule 600(b)(32) of
Regulation NMS as any member of a national securities exchange that is
registered as a specialist or market maker pursuant to the rules of
such exchange. Exchange rules typically require exchange market makers
to provide liquidity by displaying quotations at which they are willing
to buy and sell NMS stocks for their own account.\31\ In this respect,
exchange market makers fall within the definition of a ``dealer'' in
section 3(a)(5) of the Exchange Act as buying and selling NMS stocks
for their own accounts as part of a regular business. The on-exchange
volume of exchange market makers in NMS stocks is included in the
volume for national securities exchanges referenced above because it is
reported by such exchanges.
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\31\ See, e.g., New York Stock Exchange LLC (``NYSE'') Rule 104
(Dealing and Responsibilities of DMMs) (requiring the exchange's
Designated Market Makers (``DMMs'') to maintain a continuous two-
sided quote for securities in which the DMM unit is registered with
the exchange) available at https://nyseguide.srorules.com/rules.
---------------------------------------------------------------------------
Wholesalers fall within the definition of an OTC market maker in
Rule 600(b)(64) of Regulation NMS--any dealer that holds itself out as
being willing to buy from and sell to its customers, or others, in the
United States, an NMS stock for its own account on a regular or
continuous basis otherwise than on a national securities exchange in
amounts of less than block size. The term ``wholesaler'' is not defined
in Regulation NMS, but commonly refers to an OTC market maker that
seeks to attract orders from broker-dealers that service the accounts
of individual investors,\32\ referred to in this release as ``retail
brokers.'' \33\ The public order-routing reports required by 17 CFR
242.606 (``Rule 606'') \34\ show that the six largest wholesalers
collectively paid retail brokers $235 million in payment for order flow
(``PFOF'') in the first quarter of 2022 for orders in NMS stocks.\35\
Many retail brokers do not accept PFOF for marketable orders in NMS
stocks routed to wholesalers, though the retail brokers that do accept
PFOF represent 73.88% of the dollar volume of marketable orders of
retail brokers routed to wholesalers.\36\
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\32\ Another type of business operated by some OTC market makers
is known as a ``single dealer platform,'' which primarily seeks to
attract the orders of institutional investors for internal
execution. Infra section VII.B.3.
\33\ As discussed in section VII.B.1.a below, the Commission has
identified six firms as wholesalers based on the public order
routing disclosures of retail brokers. Retail broker services are
discussed in section VII.B.6 below.
\34\ Rule 606 is discussed in section III.B.4 below.
\35\ See infra section VII.B.6.a.
\36\ See Table 14, infra section VII.B.5.c.
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Wholesalers do not display or otherwise reveal the prices at which
they are willing to execute individual investor orders internally.
Moreover, as discussed in section III.B.3 below, while they are subject
to Commission and SRO requirements as broker-dealers, wholesalers are
not subject to a statutory or regulatory requirement to provide fair
access. They are not required to provide an opportunity for other
market participants, including institutional investors and other
exchange market makers, to compete on an order-by-order basis to
provide the best prices for the individual investor orders that the
wholesalers internalize. Some institutional investors, for example,
consider this order flow to be ``inaccessible.'' \37\ In the first
quarter of 2022, six large wholesalers internally executed 23.9% of
share volume in NMS stocks.\38\
---------------------------------------------------------------------------
\37\ See, e.g., Cowen, Inc., ``Cowen Market Structure: Retail
Trading--What's going on, what may change, and what can you do about
it?'' (Mar. 23, 2021), available at https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/ (``Market makers print most of
these shares internally at their firm, so they trade off-exchange.
One way we have for isolating retail volume is to look at the share
of volume that trades off-exchange, but not in a dark pool. We refer
to this as `inaccessible liquidity.' This is because most
institutional orders--whether they are executed via algos directly
or by high touch desks--primarily go to exchanges and dark
pools.'').
\38\ Table 1, infra, section VII.B.1.
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The fifth and final category of trading center that executes trades
in NMS stocks is a catchall category encompassing broker-dealers that
execute orders internally by trading as principal or crossing orders as
agent. In the first quarter of 2022, over 230 broker-dealers (other
than NMS Stock ATSs and OTC market makers) reported trades in NMS
stocks, which accounted for the remaining 6.3% of share volume in NMS
stocks.\39\
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\39\ Table 1, infra, section VII.B.1.
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C. Order Types and Trading Costs
When seeking to buy and sell NMS stocks, investors submit orders
through the broker-dealers that service their accounts. The order type
most frequently used to trade by individual investors is a ``market''
order, which simply instructs a broker-dealer to seek an execution of
the order at the best available price in the market. In contrast to
market orders, a ``limit order'' specifies a ``limit price''--a price
[[Page 133]]
beyond which the investor is not willing to trade. Limit prices reflect
an intention to ``buy low and sell high.'' For example, a buy order
with a limit price of $20 means the investor would like to buy as soon
as possible, but only at a price that is $20 or less. Conversely, a
sell order with a limit price of $20 means the investor would like to
sell as soon as possible, but only at a price that is $20 or more.
In practice, the likelihood and speed of execution of limit orders
can vary greatly depending primarily on the relation between their
limit prices and the best-priced quotations that are displayed by
national securities exchanges in the consolidated market data feeds. As
discussed in section III.B.1 below, these quotations are in ``round
lot'' sizes, which currently are 100 shares or more for nearly all NMS
stocks. The highest price bid for an NMS stock is known as the national
best bid (``NBB''), and the lowest price offer for an NMS stock is
known as the national best offer (``NBO''). Collectively, the NBB and
NBO are known as the national best bid and offer (``NBBO''). When a
limit order to buy has a limit price that is equal to or greater than
the NBO, it is known as a ``marketable'' limit order because it can be
executed immediately at the best displayed quote to sell. Similarly, a
limit order to sell is marketable when it has a limit price that is
equal to or less than the NBB.\40\
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\40\ Rule 600(b)(47) of Regulation NMS defines a ``marketable
limit order'' as any buy order with a limit price equal to or
greater than the NBO at the time of order receipt, or any sell order
with a limit price equal to or less than the NBB at the time of
order receipt.
---------------------------------------------------------------------------
For example, assume the NBB is $20.00 and the NBO is $20.10. A buy
limit order with a price of $20.10 or higher is marketable, and a sell
limit order with $20.00 or lower is marketable. Marketable limit orders
are similar to market orders with respect to their willingness to trade
immediately at the best displayed prices or better and will be referred
to collectively in this release as ``marketable orders.''
Investors that use marketable orders to trade immediately at the
best available prices are known as ``liquidity takers'' and generally
incur a trading cost for the service, known as a ``spread.'' In the
example above, when the NBBO is $20.00 and $20.10, the quoted spread is
10 cents. An investor that wished to avoid paying a spread could use a
``non-marketable'' limit order in an attempt to become a ``liquidity
provider.'' A non-marketable limit order to buy has a limit price that
is less than the NBO, and a non-marketable limit order to sell has a
limit price that is greater than the NBB.\41\ For example, again using
the example when the NBBO is $20.00 and $20.10, an investor could
submit a buy limit order with a limit price of $20.00. This buy order
is not marketable because it is priced less than the NBO of $20.10 and
therefore cannot be executed immediately against the best displayed
offer. A non-marketable limit order generally will ``rest'' on the
continuous order book of a trading center awaiting the arrival of a
contra-side marketable order against which it can execute. In the
example, if the resting non-marketable limit order to buy were able to
obtain an execution at its limit price of $20.00 (e.g., by interacting
with a contra-side marketable order to sell), the investor would have
succeeded in trading at a price that was 10 cents lower than if the
investor had used a marketable order and traded at the NBO of $20.10.
The risk, however, of using a non-marketable limit order is that it may
not execute at all if market prices move away from the order (i.e.,
prices increase for buy orders and decrease for sell orders). If this
happens, the investor will incur an opportunity cost by missing a
trade.
---------------------------------------------------------------------------
\41\ Rule 600(b)(57) of Regulation NMS defines ``non-marketable
limit order'' as any limit order other than a marketable limit
order.
---------------------------------------------------------------------------
Using the example of an NBBO of $20.00 and $20.10, assume the
investor submitted a non-marketable order to buy with a limit price of
$20.00, but did not obtain an execution and the NBBO then rose to
$20.15 and $20.25. Seeing that the market was moving away, the investor
decided to cancel the unexecuted non-marketable order and replace it
with a marketable order to buy, which then was executed at the new NBO
price of $20.25. In this case, the investor incurred an opportunity
cost of 15 cents--the difference between (1) the original NBO price of
$20.10 that the investor likely could have obtained if the investor
first had used a marketable order to buy at $20.10 rather than using
the non-marketable order in an unsuccessful attempt to buy at $20.00,
and (2) the price of $20.25 at which the investor actually obtained an
execution.
In sum, an investor's decision of whether to use marketable orders
or non-marketable orders to trade can depend on an often complex
judgment of whether prices are likely to move in the short-term future.
Individual investors, who typically do not follow market prices closely
throughout a trading day, often will not feel in the best position to
make this judgment and generally choose to be liquidity takers by using
marketable orders to obtain the certainty of an immediate execution at
a displayed price or better.\42\ Accordingly, a key source of trading
costs for individual investors are the spreads they pay when using
marketable orders. The narrower the spreads, the lower the prices at
which they will buy and the higher the prices at which they will sell,
which translate into lower trading costs and higher investment returns.
Conversely, wider spreads mean higher trading costs and lower
investment returns.
---------------------------------------------------------------------------
\42\ Rule 606 order-routing reports reveal that customers of
retail brokers used marketable orders for approximately 39-40% of
their trades and used ``other'' orders for approximately 26-27% of
their trades. Table 3, infra, section VII.B.2.a. As presented in
Table 2 in section VII.B.2.a below, however, the PFOF rates received
from wholesalers for these ``other'' orders almost exactly matched
the rates received from wholesalers for marketable limit orders.
Accordingly, it is likely that most of these other orders were
marketable (i.e., immediately executable at the best available
prices), although the orders may have had particular characteristics
that led them to be classified as other orders.
---------------------------------------------------------------------------
The spread costs of individual investors highlight the role played
by liquidity providers in determining spreads. Liquidity providers
determine spreads by setting the prices at which they are willing to
trade with marketable orders as such orders are submitted by liquidity
takers. Liquidity providers can include professional market
intermediaries, such as exchange market makers and OTC market makers
(including wholesalers), as well as investors that use non-marketable
limit orders. For example, national securities exchanges, which display
the quotations that determine the NBBO, all operate continuous order
books. Unexecuted non-marketable orders that have been routed to an
exchange rest on its continuous order book awaiting an opportunity for
interaction with incoming contra-side orders. Using the NBBO example of
$20.00 and $20.10, assume a national securities exchange has displayed
limit orders resting on its continuous order book with limit prices
that equal the NBBO, but then an institutional investor submits a buy
order with a limit price of $20.02 for display on the continuous order
book. At this point, there will be a new NBB of $20.02 and the NBBO
spread will have been reduced from 10 cents to 8 cents. If an
individual investor's market order to sell was routed to the exchange,
the order would execute at the new NBB of $20.02, saving the individual
investor two cents per share compared to the old NBB of $20.00.
For liquidity providers, the adverse selection costs of trading
with a given
[[Page 134]]
marketable order flow are a key factor for determining the prices at
which they are willing to trade with such flow, particularly for
professional market intermediaries. These market intermediaries
generally seek to generate short-term trading profits by buying and
selling on a continuous basis and capturing a spread between their buys
and sells. Adverse selection costs reflect the extent to which prices
move against the liquidity provider in the seconds and minutes after a
trade, which increases the difficulty faced by the liquidity provider
in successfully capturing a spread between buys and sells.
For example, assume an NBBO of $20.00 and $20.10, and a market
maker provides liquidity by trading with a contra-side marketable sell
order at the $20.00 NBB. The market maker may hope to profit by quickly
providing liquidity to a contra-side marketable buy order at the $20.10
NBO and thereby earning a 10 cent spread. Seconds later, however, and
before the market maker is able to liquidate the buy position, the NBBO
declines to $19.85 and $19.95. In this case, the market maker has
bought immediately prior to a 15 cent decline in the NBBO. This
subsequent move in the NBBO is known as ``price impact.'' Instead of
earning a 10 cent spread as it hoped by providing liquidity when the
NBBO was $20.00 and $20.10, the market maker would realize a loss of 5
cents on its position if it then provided liquidity to a contra-side
marketable buy order by selling at the new NBO of $19.95. Therefore,
the market maker had an adverse selection cost of 15 cents.
Accordingly, market makers assess the potential adverse selection costs
of the liquidity-taking order flow with which they are likely to
interact when setting the spreads at which they are willing to provide
liquidity to such flow. Segmentation of marketable orders with low
adverse selection costs is a means for liquidity providers to control
such costs. As discussed in section VII,\43\ the marketable orders of
individual investors routed to wholesalers have adverse selection costs
(as measured by price impact) that are approximately 71% lower than the
adverse selection costs of orders routed to national securities
exchanges. The low adverse selection costs of the segmented marketable
orders of individual investors generally enable wholesalers to offer
better prices for such orders than would be available for unsegmented
orders routed to national securities exchanges.
---------------------------------------------------------------------------
\43\ See Table 7, infra, section VII.B.4.
---------------------------------------------------------------------------
The trading examples thus far have assumed that trades occur at the
NBBO prices, which are determined by round lot quotations displayed on
national securities exchanges. In fact, however, trades can be executed
on national securities exchanges at prices that are better than NBBO
prices (``NBBO price improvement''). Marketable orders routed to access
the NBBO at a national securities exchange can obtain NBBO price
improvement in two primary contexts. First, a national securities
exchange may have displayed orders on its continuous order book with
sizes less than round lots, known as ``odd lot quotations,'' that are
priced better than the NBBO. If a contra-side marketable order is
routed to a national securities exchange with such an odd lot
quotation, the contra-side marketable order will interact with the odd-
lot quotation and receive a better price than the NBBO. Second, there
may be undisplayed non-marketable limit orders resting on the
continuous order book of a national securities exchange with prices
that are better than such exchange's displayed quotations. One common
example is an NBBO midpoint order. An NBBO midpoint order has an
execution price that is pegged to, and accordingly fluctuates with, the
midpoint of the NBBO. If the NBBO is $20.00 and $20.10, and an NBBO
midpoint order to sell is resting on the continuous order book of a
national securities exchange, a marketable order to buy that is routed
to such exchange will execute at the NBBO midpoint price of $20.05
rather than the NBO of $20.10. By trading at the NBBO midpoint, the
incoming marketable buy order has obtained an immediate execution
without paying any spread, and the resting NBBO midpoint order to sell
has not earned any spread. Institutional investors may use undisplayed
NBBO midpoint orders because they provide an opportunity to trade with
contra-sided marketable flow, but without the information leakage (and
potential slippage) that could occur if their orders were displayed.
D. Quantitative Measures of Order Execution Quality and Trading Costs
A variety of quantitative measures can be used to assess the
quality of order executions that broker-dealers obtain for their
individual investor customers, as well as more generally the trading
costs of liquidity takers and liquidity providers. 17 CFR 242.605
(``Rule 605'') of Regulation NMS,\44\ for example, requires many
trading centers, including national securities exchanges and
wholesalers, to make data files publicly available on a monthly basis
that include detailed measures of execution quality for marketable and
non-marketable orders in NMS stocks. This section will describe some of
the quantitative measures included in Rule 605 data, as well as provide
concrete examples illustrating specifically how the measures are
calculated. These quantitative measures are referenced extensively
throughout this release to explain the rationale for and the potential
economic effects of Proposed Rule 615.
---------------------------------------------------------------------------
\44\ Rule 605 is discussed in section III.B.4 below.
---------------------------------------------------------------------------
1. Description of Quantitative Measures
The following is a list, with brief descriptions, of quantitative
measures of order execution quality and trading costs in NMS stocks
that are included in, or can be derived from, Rule 605 data files.
Specific examples of how the measures are calculated will be provided
in section II.D.2 below.
As stated above, NBBO price improvement is the amount by which the
execution price of a marketable order is better than the relevant NBBO
quotation at the time a marketable order is received by a trading
center.\45\ For marketable buy orders, it is the amount by which the
buy order received a price lower than the NBO at the time of order
receipt. For marketable sell orders, it is the amount by which the sell
order received a price higher than the NBB at the time of order
receipt.
---------------------------------------------------------------------------
\45\ Rule 600(b)(36) of Regulation NMS defines ``executed with
price improvement'' as, for buy orders, execution at a price lower
than the NBO at the time of order receipt and, for sell orders,
execution at a price higher than the NBB at the time of order
receipt.
---------------------------------------------------------------------------
``NBBO quoted half-spread'' is one-half of the difference between
the NBO and NBB, as measured at the time when a marketable order is
received by a trading center. The full quoted spread is halved to
reflect the spread cost for establishing or liquidating a position
(long or short). For example, if an investor uses a marketable order to
buy at the NBO (incurring a half-spread to establish a long position),
but then is able to use a non-marketable order to sell at the NBO
(earning a half-spread to liquidate the long position), the investor
would have paid a net spread of 0 cents on the ``round-trip''
transaction.
``Effective half-spread'' is the half-spread actually paid by a
marketable order. It is calculated by comparing execution prices with
the NBBO midpoint, rather than the relevant NBB or NBO, at the time of
order receipt.\46\
[[Page 135]]
Accordingly, a trading center's average effective half-spread for
marketable orders may be narrower or wider than the NBBO quoted half-
spread, depending on the extent to which execution prices at a trading
center are inside, at, or outside NBBO prices.
---------------------------------------------------------------------------
\46\ Rule 600(b)(8) of Regulation NMS defines ``average
effective spread'' as the share-weighted average of effective
spreads for order executions calculated, for buy orders, as double
the amount of difference between the execution price and the
midpoint of the NBB and NBO at the time of order receipt and, for
sell orders, as double the amount of difference between the midpoint
of the NBB and NBO at the time of order receipt and the execution
price.
---------------------------------------------------------------------------
``Price impact'' is the extent to which the NBBO midpoint moves
against the liquidity provider for a marketable order in a short time
period after the order execution. For Rule 605 reporting, the time
period is five minutes after the time of order execution. For the
analyses of CAT data provided in section VII.B.4 below, the time period
is one minute after the time of order execution.\47\ Price impact
measures the extent of adverse selection costs faced by a liquidity
provider and is closely related to realized half-spread (described
next). When price impact and realized half-spread are calculated using
the same post-trade time period, the difference between the effective
half-spread and the realized half-spread on a trade will equal the
price impact of the trade.\48\
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\47\ The analysis in section VII.B.4 below uses one minute to
reflect the increase in trading speed in the years since Rule 605
was adopted.
\48\ See, e.g., Hasbrouck Treatise at 147 (``The execution cost
based on the pretrade bid-ask midpoint (BAM) is also known as the
effective cost. Since 2001, the U.S. SEC has required U.S. equity
markets to compute effective costs and make summary statistics
available on the Web . . . . The rule . . . also requires
computation of the realized cost . . . . The difference between
effective and realized costs is sometimes used as an estimate of the
price impact of the trade. The realized cost can also be interpreted
as the revenue of the dealer who sold to the customer . . . and then
covered his position at the subsequent BAM.'').
---------------------------------------------------------------------------
``Realized half-spread'' is calculated similarly to the effective
half-spread, but, instead of using the NBBO midpoint at the time of
order receipt, the realized spread calculation uses the NBBO midpoint a
short time period after the execution of a marketable order.\49\ For
Rule 605 reporting, the time period is five minutes after the time of
order execution. For the analyses of CAT data provided in section
VII.B.4 below, the time period is one minute after the time of order
execution.\50\ When deciding to include realized spread statistics in
Rule 605 reports, the Commission stated that the smaller the average
realized spread, ``the more market prices have moved adversely to the
market center's liquidity providers after the order was executed,''
which shrinks the spread ``realized'' by the liquidity providers.\51\
The Commission further stated that the average realized spread
statistic for market and marketable limit orders potentially could help
``to spur more vigorous competition to provide the best prices to these
orders to the benefit of many retail investors.'' \52\ In sum, by
capturing the extent of adverse selection costs faced by liquidity
providers, realized spreads are designed to provide a more accurate
measure of the potential profitability of trading for liquidity
providers than do effective spreads.\53\
---------------------------------------------------------------------------
\49\ Rule 600(b)(9) of Regulation NMS generally defines
``average realized spread'' as the share-weighted average of
realized spreads for order executions calculated, for buy orders, as
double the amount of difference between the execution price and the
midpoint of the NBB and NBO five minutes after the time of order
execution and, for sell orders, as double the amount of difference
between the midpoint of the NBB and NBO five minutes after the time
of order execution and the execution price.
\50\ The analysis in section VII.B.4 below uses a one-minute
period to reflect the increase in trading speed in the years since
Rule 605 was adopted.
\51\ Securities Exchange Act Release No. 43590 (Nov. 17, 2000),
65 FR 75414, 75424 (Dec. 1, 2000).
\52\ Id.
\53\ See, e.g., Harris Treatise at 286 (``Informed traders buy
when they think that prices will rise and sell otherwise. If they
are correct, they profit, and whoever is on the other side of their
trade loses. When dealers trade with informed traders, prices tend
to fall after the dealer buys and rise after the dealer sells. These
price changes make it difficult for dealers to complete profitable
round-trip trades. When dealers trade with informed traders, their
realized spreads are often small or negative. Dealers therefore must
be very careful when trading with traders they suspect are well
informed.'').
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2. Examples of Calculating Measures of Order Execution Quality and
Trading Costs
When the execution quality and trading cost measures described
above are calculated and averaged for a large volume of orders at
different trading centers, the results can reveal important information
about the nature of the order execution quality and trading costs
across different trading centers. Section VII below, which provides an
economic analysis of Proposed Rule 615, makes extensive use of data
analyses using these measures.
The following two examples are patterned on those analyses,
particularly the empirical finding that the marketable orders of
individual investors routed to wholesalers have adverse selection costs
(as measured by price impact) that, on average, are approximately 71%
lower than the marketable orders routed to national securities
exchanges. The examples are intended to illustrate how quantitative
measures of order execution quality and trading costs are calculated in
these two contexts that are most relevant for understanding the
empirical basis for Proposed Rule 615. The examples show how a
difference in the adverse selection costs of order flow routed to two
different trading centers can result in more price improvement and
narrower effective spreads at the trading center with lower adverse
selection costs (the wholesaler) than at the trading center with higher
adverse selection costs (the exchange), yet still result in wider
realized spreads (i.e., spreads realized by the liquidity provider
after estimating for adverse selection costs) at the wholesaler than at
the exchange.
The first example below (``Exchange Example'') presents the
execution of an unsegmented marketable order to buy at a national
securities exchange at a price that matches the NBBO, and the second
example below (``Wholesaler Example'') presents the execution of a
segmented marketable order to buy of an individual investor at a
wholesaler at a price better than the NBBO. The examples use the
calculation methodology prescribed by Rule 605 of Regulation NMS,
except that statistics are presented for the half-spread associated
with a single buy or sell order rather than the full spread statistics
prescribed for Rule 605, which are doubled to reflect estimates of
round-trip (offsetting buy and sell) trading costs.\54\ Half-spreads
are used to more clearly present the calculations for the single order
in each of the examples.
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\54\ The definitions of ``average effective spread'' and
``average realized spread'' provided in Rule 600(b)(8) and (9) of
Regulation NMS, which are incorporated in Rule 605, prescribe
doubling of the amounts by which an order execution price differs
from the NBBO midpoint at the time of order receipt (for effective
spreads) and five minutes after the time of order execution (for
realized spreads).
---------------------------------------------------------------------------
The data used for the two examples are labeled as follows:
execution price of marketable order (``ExP''), NBB at time of order
receipt (``NBBt0''), NBO at time of order receipt
(``NBOt0''), NBBO midpoint at time of order receipt
(``MPt0''), and NBBO midpoint 5 minutes after time of order
execution (``MPt5'').
The execution quality and trading cost measures for the two
examples of marketable orders to buy are calculated as follows:
NBBO quoted half-spread: \1/2\ x (NBOt0-NBBt0)
NBBO price improvement: NBOt0-ExP
Effective half-spread: ExP-MPt0
Price impact: MPt5-MPt0
Realized half-spread: ExP-MPt5
The data and calculations for the two examples are as follows:
[[Page 136]]
------------------------------------------------------------------------
Exchange example Wholesaler example
------------------------------------------------------------------------
EXP............................. $110.05........... $110.04.
NBBT0........................... $110.00........... $110.00.
NBOT0........................... $110.05........... $110.05.
MPT0............................ $110.025.......... $110.025.
MPT5............................ $110.055.......... $110.035.
NBBO PRICE IMPROVEMENT.......... 0 cents........... 1 cent.
NBBO QUOTED HALF-SPREAD......... 2.5 cents......... 2.5 cents.
EFFECTIVE HALF-SPREAD........... 2.5 cents......... 1.5 cents.
PRICE IMPACT.................... 3 cents........... 1 cent.
REALIZED HALF-SPREAD............ <0.5 cents>....... 0.5 cents.
------------------------------------------------------------------------
In the Exchange Example and Wholesaler Example, the NBBO is the
same at the time of order receipt for both marketable buy orders, but
the national securities exchange in the Exchange Example executes the
order at the NBO with no NBBO price improvement, while the wholesaler
in the Wholesaler Example executes the marketable buy order with NBBO
price improvement of one cent. Consequently, the NBBO quoted half-
spread is the same for both trades (2.5 cents), but the effective half-
spread is wider for the liquidity provider on the national securities
exchange (2.5 cents) than for the wholesaler (1.5 cents) because of the
1 cent NBBO price improvement provided by the wholesaler. The price
impact of the order routed to the national securities exchange is 3
cents, while the price impact of the order routed to the wholesaler is
only 1 cent. Accordingly, the adverse selection cost for the liquidity
provider on the national securities exchange was 3 cents, while the
adverse selection cost for the wholesaler was 1 cent.
The difference in adverse selection costs leaves the liquidity
provider on the national securities exchange in the Exchange Example
with a narrower realized half-spread of negative 0.5 cents, while the
wholesaler in the Wholesaler Example preserves a positive realized
half-spread of 0.5 cents. Stated another way, the wholesaler provided
some NBBO price improvement (1 cent), but its adverse selection cost
savings compared to the liquidity provider on the national securities
exchange was 2 cents, and as a result the wholesaler was able to
capture a realized half-spread that was one cent wider than the
liquidity provider on the national securities exchange. If, however,
the wholesaler had provided NBBO price improvement that matched its
cost savings, the individual investor would have received NBBO price
improvement of 2 cents rather than 1 cent. In this case, the realized
half-spread for both the wholesaler and the liquidity provider on the
national securities exchange would have been the same--negative 0.5
cents.
In this respect, the Exchange Example and Wholesaler Example
highlight the key order-by-order competition objective of Proposed Rule
615. As discussed in section VII.C.2.b below, competition among a wide
range of liquidity providers on national securities exchanges is
intense and results in realized spreads for unsegmented orders that are
narrower than the realized spreads captured by wholesalers for the
segmented orders of individual investors. Another way of stating the
same point is that wholesalers do not provide average NBBO price
improvement that matches their savings in average adverse selection
costs from securing the opportunity to trade first with the segmented
orders of individual investors. Proposed Rule 615 would enable order-
by-order competition to provide the best prices to the segmented
marketable orders of individual investors. By providing an opportunity
for a wide variety of liquidity providers to compete to provide the
best prices for the segmented marketable orders of individual
investors, Proposed Rule 615 is designed to expand the level of NBBO
price improvement currently provided by wholesalers to match the low
adverse selection costs of such orders.
III. Statutory and Regulatory Background
The development of today's market structure for NMS stocks has been
guided by the Congressional determination set forth in section 11A of
the Exchange Act that the United States should have an NMS in which
multiple competing markets are linked together through communications
and data processing facilities. This section III first will discuss the
Exchange Act framework for an NMS. It then will summarize the rules
that the Commission has adopted over the years to facilitate the
development of an NMS, with particular focus on rules that address the
handling and execution of investor orders in NMS stocks. Many aspects
of Proposed Rule 615, as described in section IV below, are designed to
build on the existing statutory framework and Commission rules
discussed in this section III.
A. Statutory Framework for an NMS
Section 11A of the Exchange Act, enacted as part of the Securities
Acts Amendments of 1975,\55\ sets forth the statutory framework for an
NMS. Section 11A(a)(2) directs the Commission, having due regard for
the public interest, the protection of investors, and the maintenance
of fair and orderly markets, to use its authority under the Exchange
Act to facilitate the establishment of an NMS for securities in
accordance with the Congressional findings and objectives set forth in
section 11A(a)(1) of the Exchange Act.\56\ Section 11A(a)(1)(C) sets
forth the finding of Congress that it is in the public interest and
appropriate for the protection of investors and the maintenance of fair
and orderly markets to assure five objectives:
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\55\ Public Law 94-29, 89 Stat. 97 (1975).
\56\ Section 11A(a)(3)(B) also provides the Commission the
authority to require the SROs, by rule or order, ``to act jointly .
. . in planning, developing, operating, or regulating [an NMS] (or a
subsystem thereof).''
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(1) economically efficient execution of securities transactions;
(2) fair competition among brokers and dealers, among exchange
markets, and between exchange markets and markets other than exchange
markets;
(3) the availability to brokers, dealers, and investors of
information with respect to quotations for and transactions in
securities;
(4) the practicability of brokers executing investors' orders in
the best market; and
(5) an opportunity, consistent with the foregoing objectives of
efficient execution of securities transactions and practicability of
brokers executing investors' orders in the best market, for investors'
orders to be executed without the participation of a dealer.\57\
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\57\ Section 11A(a)(1) of the Exchange Act.
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A variety of Exchange Act provisions grant the Commission specific
[[Page 137]]
rulemaking authority in different contexts to fulfill its
responsibility to facilitate the establishment of an NMS that assures
the five objectives. Three of these Exchange Act authorizations are
particularly relevant in the context of rules to address the handling
and execution of investor orders in NMS stocks.
First, section 11A(c)(1)(E) addresses the routing of orders by
broker-dealers. It authorizes the Commission to prescribe rules, as
necessary or appropriate in the public interest, for the protection of
investors, or otherwise in furtherance of the Exchange Act to assure
that all exchange members and brokers-dealers transmit and direct
orders for the purchase or sale of NMS stocks in a manner consistent
with the establishment and operation of an NMS.\58\
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\58\ 15 U.S.C. 78k-1(c)(1)(E).
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Second, section 11A(c)(1)(F) grants rulemaking authority to assure
equal regulation of all markets for NMS stocks, as well as of all
exchange members and broker-dealers effecting transactions in NMS
stocks.\59\ The meaning of the term ``equal regulation'' is specified
in section 3(b)(36), which provides that a class of persons or markets
is subject to equal regulation if no member of the class has a
competitive advantage over any other member thereof resulting from a
disparity in their regulation under the Exchange Act which the
Commission determines is unfair and not necessary or appropriate in
furtherance of the purposes of the Exchange Act.
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\59\ 15 U.S.C. 78k-1(c)(1)(F).
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Third, section 15(c)(5) addresses the practices of dealers, such as
wholesalers. It authorizes the Commission to prescribe rules setting
forth specified and appropriate standards with respect to dealing for
dealers (other than specialists registered on a national securities
exchange) acting in the capacity of a market maker or otherwise that
are necessary or appropriate in the public interest and for the
protection of investors, to maintain fair and orderly markets, or to
remove impediments to and perfect the mechanism of an NMS.\60\
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\60\ 15 U.S.C. 78o(c)(5).
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In addition to these grants of rulemaking authority to facilitate
the development of an NMS, section 6 of the Exchange Act \61\
specifically addresses the types of access to trading services that one
type of market--a national securities exchange--is required to provide
to broker-dealers and market participants. Access to the trading
services of a market is essential for that market to be linked together
with other markets in an NMS.
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\61\ 15 U.S.C. 78f.
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First, section 6(b)(2) requires that, subject to the provisions of
section 6(c) relating to statutory disqualification and other concerns,
the rules of the exchange must provide that any registered broker-
dealer may become a member of such exchange.\62\ Broker-dealers
generally need to become exchange members, as an initial matter, to
obtain access to many of the trading services of an exchange.
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\62\ 15 U.S.C. 78f(b)(2).
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Second, section 6(b)(4) requires that the rules of the exchange
provide for the equitable allocation of reasonable dues, fees, and
other charges among its members and issuers and other persons using its
facilities.\63\ This provision recognizes that the opportunity for
different market participants to access trading services at a market
can be greatly affected by the charges for those services.
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\63\ 15 U.S.C. 78f(b)(4).
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Third, section 6(b)(5) requires that the rules of the exchange are
designed to, among other things, ``remove impediments to and perfect
the mechanism of a free and open market and [an NMS], and, in general,
to protect investors and the public interest.'' \64\ Section 6(b)(5)
further requires that the rules of the exchange are not designed ``to
permit unfair discrimination between customers, issuers, brokers, or
dealers.'' \65\ These provisions broadly help ensure fair and efficient
access to the trading services of national securities exchanges, both
by requiring them to act affirmatively to promote high quality markets
and by prohibiting them from acting negatively by unfairly
discriminating between customers, issuers, or broker-dealers.
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\64\ 15 U.S.C. 78f(b)(5).
\65\ Id.
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Finally, section 6(b)(8) requires that ``the rules of the exchange
do not impose any burden on competition not necessary or appropriate in
furtherance of the purposes'' of the Exchange Act.\66\ This provision
further restricts a national securities exchange's ability to limit
access to its trading services in an anti-competitive manner.
---------------------------------------------------------------------------
\66\ 15 U.S.C. 78f(b)(8).
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To help ensure that national securities exchanges operate according
to rules consistent with their statutory obligations, section 19(b)(1)
of the Exchange Act \67\ requires SROs,\68\ including national
securities exchanges, to file with the Commission any proposed rule
change.\69\ The Commission publishes for public comment all SRO
proposed rule changes.\70\ For new or materially modified trading
services, a proposed rule change generally cannot become effective, and
the national securities exchange cannot implement such rule change,
until the Commission has approved it as consistent with the
requirements of the Exchange Act.\71\
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\67\ 15 U.S.C. 78s(b)(1).
\68\ See 15 U.S.C. 78c(b)(26) (defining ``self-regulatory
organization'' to include, among other things, any national
securities exchange or registered securities association).
\69\ Section 19(b)(1) of the Exchange Act defines a ``proposed
rule change'' to be any proposed change in, addition to, or deletion
from the rules of an SRO. 15 U.S.C. 78s(b)(1). Section 3(a)(27) of
the Exchange Act generally defines ``rules'' to include the
constitution, articles of incorporation, bylaws, and rules, or
instruments corresponding to the foregoing and the stated policies,
practices, and interpretations of an exchange, association, or
clearing agency as the Commission, by rule, may determine to be
necessary or appropriate in the public interest or for the
protection of investors to be deemed to be rules of such exchange,
association, or clearing agency. 15 U.S.C. 78c(a)(27). Rule 19b-4(b)
under the Exchange Act defines ``stated policy, practice, or
interpretation'' to mean, in part, any material aspect of the
operation of the facilities of the SRO or any statement made
generally available that establishes or changes any standard, limit,
or guideline with respect to the rights, obligations, or privileges
of persons or the meaning, administration, or enforcement of an
existing rule. 17 CFR 240.19b-4(b).
\70\ See 15 U.S.C. 78s(b)(1).
\71\ If the Commission does not approve or disapprove a proposed
rule change within the required timeframe prescribed by section 19
of the Exchange Act, it is ``deemed to have been approved.'' 15
U.S.C. 78s(b)(2)(D).
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Section 15A of the Exchange Act \72\ includes many requirements for
the rules of a national securities association that are analogous to
those prescribed for national securities exchanges. FINRA is currently
the only registered national securities association. Broker-dealers
that handle customer orders in NMS stocks or trade NMS stocks in the
off-exchange market generally must become FINRA members.\73\ Section
15A does not, however, impose fair access requirements on the broker-
dealer members of FINRA. Accordingly, broker-dealers that trade
internally are not subject to the statutory access requirements that
apply to national securities exchanges under section 6 of the Exchange
Act.
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\72\ 15 U.S.C. 78o-3.
\73\ See 15 U.S.C. 78o(b)(8). The Commission has proposed to
amend 17 CFR 240.15b9-1, which provides an exemption from
association membership for certain exchange members. Securities
Exchange Act Release No. 95388 (July 29, 2022), 87 FR 49930 (Aug.
12, 2022) (proposing to replace a de minimis allowance with narrower
exemptions from association membership).
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B. Current Regulatory Components of the NMS for NMS Stocks
Over the years since 1975, the Commission has used its Exchange Act
[[Page 138]]
authority to adopt a series of rules to fulfill its regulatory
responsibility to facilitate the establishment of an NMS. In doing so,
it particularly has emphasized the importance of promoting competition
as a means to protect investors and to achieve the five statutory
objectives for an NMS. In its request for comment on issues relating to
market fragmentation in 2000,\74\ for example, the Commission stated
that the section 11A findings and objectives can be summed up in two
fundamental principles. First, the interests of investors (both large
and small) are preeminent, ``especially the efficient execution of
their securities transactions at prices established by vigorous
competition.'' \75\ Second, investor interests are best served by a
market structure that, to the greatest extent possible, maintains the
benefits of ``both an opportunity for interaction of all buying and
selling interest'' in individual securities and ``fair competition
among all types of market centers'' seeking to provide a forum for the
execution of securities transactions.\76\ The Commission further stated
that competition among multiple competing markets can isolate investor
orders and that this ``may reduce competition on price, which is one of
the most important benefits of greater interaction of buying and
selling interest in an individual security.'' \77\
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\74\ Securities Exchange Act Release No. 42450 (Feb. 23, 2000),
65 FR 10577 (Feb. 28, 2000) (``Market Fragmentation Concept
Release'').
\75\ Id. at 10580.
\76\ Id. (emphasis in original).
\77\ Id. (emphasis in original).
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In 2005, the Commission adopted Regulation NMS to consolidate the
NMS rules it had previously adopted under section 11A and to include
new rules designed to modernize and strengthen equity market
structure.\78\ It again emphasized the importance of competition among
orders to obtain the best prices for investors, stating that this basic
principle was recognized in the legislative history of section 11A:
``Investors must be assured that they are participants in a system
which maximizes the opportunities for the most willing seller to meet
the most willing buyer.'' \79\ The Commission summed up its approach to
achieving an NMS as resisting suggestions that it adopt an approach
focusing on a single form of competition that, while perhaps easier to
administer, ``would forfeit the distinct, but equally vital, benefits
associated with both competition among markets and competition among
orders.'' \80\
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\78\ Securities Exchange Act Release No. 51808 (June 9, 2005),
70 FR 37496 (June 29, 2005) (``Regulation NMS Adopting Release'').
\79\ Id. at 37499 (quoting H.R. Rep. 94-123, 94th Cong., 1st
Sess. 50 (1975)). The Commission further quoted this legislative
history for section 11A of the Exchange Act to emphasize the
importance of ensuring that investor orders are able to be executed
in a market with the best price: ```market fragmentation becomes of
increasing concern in the absence of mechanisms designed to assure
that public investors are able to obtain the best price for
securities regardless of the type or physical location of the market
upon which his transaction may be executed.''' Id. at 37499 n.13.
\80\ Id.
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Four categories of the Regulation NMS rules are particularly
important in the context of Proposed Rule 615: (1) consolidated market
data; (2) order handling and execution; (3) access to trading centers;
and (4) disclosure of order routing practices and order execution
statistics.
1. Rules Addressing Consolidated Market Data
Several rules under Regulation NMS set forth requirements for
consolidated market data, which, as defined in Rule 600(b)(19) and (21)
of Regulation NMS, includes information concerning quotations and
transactions in NMS stocks. 17 CFR 242.601 (``Rule 601'') provides for
the dissemination of transaction information; 17 CFR 242.602 (``Rule
602'') provides for the dissemination of quotation information; 17 CFR
242.603 (``Rule 603'') requires, among other things, the national
securities exchanges and national securities associations to act
jointly for disseminating consolidated market data; and 17 CFR 242.608
(``Rule 608'') addresses the joint-NMS plans that currently are
responsible for operating the facilities for collecting and
disseminating consolidated market data in NMS stocks.
In 2020, the Commission adopted a new rule and amended existing
rules to establish a new infrastructure for consolidated market data
and to update and significantly expand the content of consolidated
market data (``MDI Rules'').\81\ The MDI Rules have not yet been
implemented and, as discussed below, given their unimplemented status,
the description of Proposed Rule 615 in section IV below reflects the
regulatory structure currently in place for consolidated market data.
Section VII below addresses the economic effects of Proposed Rule 615,
taking into account both the regulatory structure currently in place
and the unimplemented MDI Rules. This section III.B.1 first will
briefly summarize the currently implemented regulatory structure for
consolidated market data. It then will discuss the status of the
implementation of MDI Rules and how it would not affect the operation
of and need for Proposed Rule 615.
---------------------------------------------------------------------------
\81\ Securities Exchange Act Release No. 90610 (Dec. 9, 2020),
86 FR 18596 (Apr. 9, 2021) (``MDI Adopting Release''); see also The
Nasdaq Stock Market LLC, et al v. SEC, No. 21-1100 (D.C. Cir. May
24, 2022) (upholding these Commission amendments to market data
rules adopted in the MDI Adopting Release). The MDI Adopting Release
provides a comprehensive discussion of the current arrangements for
consolidated market data, as well as the adopted but unimplemented
rules to change these current arrangements.
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a. Current Regulatory Structure for Consolidated Market Data
As stated in section II.B above, consolidated market data currently
is collected and disseminated by the centralized SIPs. For quotation
information, only the 16 exchanges that currently trade NMS stocks
provide quotation information to the SIPs for dissemination in
consolidated market data.\82\ FINRA has the only SRO display-only
facility (the ADF) for quotations. No broker-dealer, however, currently
uses the ADF to display quotations in NMS stocks in consolidated market
data. For transaction information, all of the national securities
exchanges that trade NMS stocks and FINRA provide real-time transaction
information to the SIPs for dissemination in consolidated market data.
Such information includes the symbol, price, and size of the
transaction. A notable difference, however, between the transaction
information provided by the national securities exchanges and the
transaction information provided by FINRA is that the identity of the
particular exchange that executed a trade is included in consolidated
market data, while the
[[Page 139]]
identity of the particular FINRA member responsible for reporting a
trade, such as a wholesaler or other type of broker-dealer, is not
included in consolidated market data.\83\
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\82\ Currently, these national securities exchanges are: Cboe
BYX Exchange, Inc. (``Cboe BYX''); Cboe BZX Exchange, Inc. (``Cboe
BZX''); Cboe EDGA Exchange, Inc. (``Cboe EDGA''); Cboe EDGX
Exchange, Inc. (``Cboe EDGX''); Investors Exchange LLC (``IEX'');
Long-Term Stock Exchange, Inc. (``LTSE''); MEMX LLC (``MEMX''); MIAX
Pearl, LLC (``MIAX PEARL''); Nasdaq BX, Inc. (``Nasdaq BX''); Nasdaq
PHLX LLC (``Nasdaq Phlx''); The Nasdaq Stock Market LLC
(``Nasdaq''); NYSE; NYSE American LLC (``NYSE American''); NYSE
Arca, Inc. (``NYSE Arca''); NYSE Chicago, Inc. (``NYSE CHX''); and
NYSE National, Inc. (``NYSE National''). The Commission approved
rules proposed by BOX Exchange LLC (``BOX'') for the listing and
trading of certain equity securities that would be NMS stocks on a
facility of BOX known as BSTX LLC (``BSTX''), but BSTX is not yet
operational. See Securities Exchange Act Release Nos. 94092 (Jan.
27, 2022), 87 FR 5881 (Feb. 2, 2022) (SR-BOX-2021-06) (approving the
trading of equity securities on the exchange through a facility of
the exchange known as BSTX); 94278 (Feb. 17, 2022), 87 FR 10401
(Feb. 24, 2022) (SR-BOX-2021-14) (approving the establishment of
BSTX as a facility of BOX). BSTX cannot commence operations as a
facility of BOX until, among other things, the BSTX Third Amended
and Restated Limited Liability Company Agreement approved by the
Commission as rules of BOX is adopted. Id. at 10407.
\83\ Separate from the dissemination of real-time transaction
information in consolidated market data, FINRA publishes statistics
on trading volume at member firms, including ATSs and wholesalers,
that are aggregated on a weekly basis. Publication of the aggregate
volume statistics is delayed by two weeks for some NMS stocks and by
four weeks for others. The statistics are available at https://www.finra.org/filing-reporting/otc-transparency.
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b. Unimplemented MDI Rules
When implemented, the MDI Rules will modify the current regulatory
structure for consolidated market data in two respects. First, they
will enhance the content of consolidated market data by defining three
new data elements as ``core data'' \84\--(1) information about better
priced quotations in higher priced stocks (to be implemented through a
new definition of ``round lot'' \85\ and the inclusion of certain
``odd-lot information''),\86\ (2) information about quotations that are
outside of the best-priced quotations (to be implemented through a new
``depth of book data'' definition),\87\ and (3) information about
orders that are participating in auctions (to be implemented through a
new definition of ``auction information'').\88\ As discussed below in
section III.B.1.b.ii, the MDI Rules will enhance the content of
consolidated market data, but the enhanced content of consolidated
market data still will not include all of the quotation information
currently available to market participants that purchase proprietary
data feeds that are disseminated individually by national securities
exchanges. Second, the MDI Rules will enhance the provision of
consolidated market data by adopting a new decentralized model that
replaces the SIPs with ``competing consolidators'' \89\ and ``self-
aggregators.'' \90\ Under the decentralized model, the relevant SROs
(national securities exchanges that trade NMS stocks and FINRA) will be
required to provide their data directly to multiple competing
consolidators and self-aggregators rather than to a centralized
SIP.\91\
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\84\ The term ``core data'' is defined in section 600(b)(21) of
Regulation NMS.
\85\ The term ``round lot'' is defined in section 600(b)(82) of
Regulation NMS.
\86\ The term ``odd lot information'' is defined in section
600(b)(59) of Regulation NMS.
\87\ The term ``depth of book data'' is defined in section
600(b)(26) of Regulation NMS.
\88\ The term ``auction information'' is defined in section
600(b)(5) of Regulation NMS.
\89\ The term ``competing consolidator'' is defined in section
600(b)(16) of Regulation NMS.
\90\ The term ``self-aggregator'' is defined in section
600(b)(83) of Regulation NMS.
\91\ Rule 603(b) of Regulation NMS requires, among other things,
every national securities exchange on which an NMS stock is traded
and national securities association to make available to all
competing consolidators and self-aggregators its information with
respect to quotations for and transactions in NMS stocks.
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i. Implementation of the MDI Rules
In the MDI Adopting Release in 2020, the Commission outlined a
phased transition plan for the implementation of the MDI Rules.\92\ The
first step was the filing of amendments to the effective NMS market
data plan(s) as required under Rule 614(e) of Regulation NMS.\93\ The
Commission's approval of such amendments will be the starting point for
the rest of the implementation schedule. While the Commission can
approve NMS plan amendments within 90 days of the date of their
publication in the Federal Register if the Commission finds them to be
consistent with the standards set forth in Rule 608 of Regulation
NMS,\94\ the Commission may, under rule 608(b)(2)(i), institute
proceedings to determine whether to approve or disapprove proposed
amendments, which proceedings must conclude within 180 days of notice
publication of the proposed amendments but can be extended by an
additional 120 days.\95\ Therefore, the maximum time permitted under
rule 608 for Commission action is 300 days.
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\92\ MDI Adopting Release, supra note 81, 86 FR at 18698-18701.
\93\ 17 CFR 242.614(e). The participants of the effective NMS
market data plan(s) filed proposed amendments on Nov. 5, 2021, which
were published for comment in the Federal Register. Securities
Exchange Act Release Nos. 93615 (Nov. 19, 2021), 86 FR 67800 (Nov.
29, 2021); 93625 (Nov. 19, 2021), 86 FR 67517 (Nov. 26, 2021); 93620
(Nov. 19, 2021), 86 FR 67541 (Nov. 26, 2021); 93618 (Nov. 19, 2021),
86 FR 67562 (Nov. 26, 2021) (``MDI Plan Amendments'').
\94\ 17 CFR 242.608(b)(2).
\95\ 17 CFR 242.608(b)(2). The Commission instituted proceedings
to determine whether to approve or disapprove the MDI Plan
Amendments. Securities Exchange Act Release Nos. 94310 (Feb. 24,
2022), 87 FR 11748 (Mar. 2, 2022); 94309 (Feb. 24, 2022), 87 FR
11763 (Mar. 2, 2022); 94308 (Feb. 24, 2022), 87 FR 11755 (Mar. 2,
2022); 94307 (Feb. 24, 2022), 87 FR 11787 (Mar. 2, 2022).
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After the Commission finds that the plan amendments required under
Rule 614(e) are consistent with the Rule 608 standards and approves
such amendments, the next step will be a 180-day development period,
during which competing consolidators can register with the Commission.
The development period is followed by a 90-day testing period.\96\ Once
the testing period concludes, a 180-day parallel operation period will
begin during which the SIPs and the decentralized consolidation model
will operate in parallel.\97\
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\96\ MDI Adopting Release, supra note 81, 86 FR at 18699-700.
\97\ During the parallel operation period, the SIPs will
continue to disseminate the data that they currently disseminate and
competing consolidators will be permitted to offer consolidated
market data products, including odd-lot information. Because the
round lot definition will be implemented during a later phase
consistent with the MDI Adopting Release, the SIPs and competing
consolidators will collect, consolidate and disseminate NMS data
that will be based on the current national securities exchange
definitions of round lot. Id. at 18699-18701.
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Within 90 days of the end of the parallel operation period, the
operating committee(s) of the effective NMS plan(s), in consultation
with relevant market participants, will make a recommendation to the
Commission as to whether the SIPs should be decommissioned. The SIPs
will only cease operations to the extent that the Commission approves
an amendment pursuant to Rule 608 to the effective NMS plan(s) to
effectuate such a cessation.\98\
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\98\ Id. at 18701. Following the cessation of the operations of
the SIPs, the changes necessary to implement the new round lot sizes
will be tested for 90 days and then implemented. Id. The Commission
also is proposing to accelerate implementation of the round lot
sizes. See Securities Exchange Act Release No. 96494 (Dec. 14, 2022)
(File No. S7-30-22) (Regulation NMS: Minimum Pricing Increments,
Access Fees, and Transparency of Better Priced Orders) (``Minimum
Pricing Increments Proposal''). The Commission encourages commenters
to review that proposal to determine whether it might affect their
comments on this proposing release.
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The plan participants of two effective NMS plans filed the MDI Plan
Amendments on November 5, 2021.\99\ On September 21, 2022, the
Commission disapproved the proposed amendments.\100\ As a result, new
proposed amendments pursuant to Rule 608 will need to be developed and
filed for implementation of the MDI Rules.
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\99\ See supra note 93.
\100\ Securities Exchange Act Release Nos. 95848 (Sept. 21,
2022), 87 FR 58544 (Sept. 27, 2022); 95849 (Sept. 21, 2022), 87 FR
58592 (Sept. 27, 2022); 95850 (Sept. 21, 2022), 87 FR 58560 (Sept.
27, 2022); 95851 (Sept. 21, 2022), 87 FR 58613 (Sept. 27, 2022).
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The Commission does not believe that the subsequent implementation
of the MDI Rules would substantially affect the operation of Proposed
Rule 615. In the existing regulatory structure, the national securities
exchanges and FINRA would be required to provide the SIPs with the
necessary data (including the auction messages specified in Proposed
Rule 615(c)(1)) and the quotation and transaction information specified
in the proposed definition of ``open competition trading center'' in
Proposed Rule 600(b)(64) of Regulation NMS). When the MDI Rules are
subsequently implemented, a
[[Page 140]]
decentralized model would replace the SIPs, and the national securities
exchanges and FINRA would provide this information directly to the
competing consolidators and self-aggregators pursuant to Rule 603(b) of
Regulation NMS.\101\
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\101\ The MDI Adopting Release states that the benefits of a
decentralized model for consolidated market data are gains in
efficiency and innovation for delivering consolidated market data,
reduced content and latency differentials between consolidated
market data and proprietary market data, and increased market
resiliency. MDI Adopting Release, supra note 81, 86 FR at 18778. As
discussed in section III.B.1.b.ii below, the Commission does not
believe that these benefits of the MDI Rules substantially reduce
the need to propose Rule 615 to address the goals stated herein.
---------------------------------------------------------------------------
As noted above, auction information is to be included in the
expanded content of consolidated market data that can be disseminated
by competing consolidators under the MDI Rules. Market participants in
the decentralized model will have a choice of whether to purchase
consolidated market data products that include auction information, as
well as any of the other components of consolidated market data.\102\
The fees that ultimately are approved for the different components of
consolidated market data will affect the extent to which market
participants choose to purchase auction information,\103\ but, as
discussed above, the fees are not known at this time. Any fees for
auction information will be required to be fair, reasonable, and not
unreasonably discriminatory,\104\ and, as such, the Commission does not
anticipate that such fees would be so high as to deter a substantial
number of market participants interested in participating in auctions
under Proposed Rule 615 from purchasing consolidated data products that
include auction information.
---------------------------------------------------------------------------
\102\ See, e.g., id. at 18751 (competing consolidators will not
be required to offer consolidated market products that ``include all
of the content of expanded core data'' and market participants ``may
choose not to take in all of the new core data elements in every
instance.'').
\103\ See, e.g., id. at 18764 (because fees will depend on
future action by the effective NMS system plans, the Commission
``cannot be certain of the level of those fees or whether such fees
would provide discounts'' for those end users who wish to receive
subsets of consolidated market data).
\104\ See, e.g., id. at 18773 (the fees for the data content
underlying consolidated market data must be ``fair, reasonable and
not unreasonably discriminatory'').
---------------------------------------------------------------------------
ii. Implementation of the MDI Rules Will Not Substantially Reduce the
Need To Propose Rule 615 To Address the Goals Stated Herein
As stated in section I above, Proposed Rule 615 is designed to
promote order-by-order competition and thereby achieve two primary
goals for the benefit of investors--(1) obtain better prices for the
execution of the marketable orders of individual investors that
currently are segmented at wholesalers, and (2) expand opportunities
for such individual investor orders to meet directly with other
investor orders without the participation of a dealer (such as a
wholesaler). The MDI Rules would not substantially reduce the need to
propose Rule 615 to address the goals stated herein.
The MDI Rules will enhance the content of consolidated market data
and thereby benefit those market participants that currently use SIP
data and decide to purchase the enhanced elements of consolidated
market data. As the MDI Adopting Release stated, however,
implementation of the MDI Rules will not expand the content of data
already available to sophisticated market participants that purchase
the proprietary data feeds that are individually disseminated by the
national securities exchanges.\105\ The Commission stated its
understanding that ``approximately 50 to 100 firms purchase all of the
proprietary [depth-of-book] feeds from the exchanges and do not rely on
the SIP data for their trading.'' \106\ Moreover, these 50 to100 firms
that currently use proprietary data feeds play a significant role in
the current market structure.\107\ For example, the MDI Adopting
Release stated that ``nearly all orders entered in the [NMS], including
retail orders, touch a component (typically the order router of the
executing broker) that uses proprietary data in order to reduce
execution costs and improve execution quality.'' \108\ Furthermore, the
Commission understands that the wholesalers, as six of the highest
volume trading firms in the U.S. equity markets, currently pay for and
use the proprietary data feeds. One wholesaler submitted a comment on
the MDI Rules stating that it would be unable to remain competitive,
even after the MDI Rules were implemented, without continuing to
purchase proprietary data feeds.\109\
---------------------------------------------------------------------------
\105\ See, e.g., id. at 18752 (``[a]lthough expanded core data
will not contain all of the data contained in proprietary [depth of
book] feeds, the Commission believes that it will contain data that
will be useful for market participants''); id. at 18754 (the
potentially lower cost of consolidated market data ``will come at
the expense of losing the full set of data currently available via
proprietary feeds,'' because the consolidated market data definition
``does not include all data elements currently available via
proprietary data feeds.'').
\106\ Id. at 18728.
\107\ See, e.g., id. at 18734 n. 1724 (Commission analysis
showed that 91.6% of the message volume on exchanges in a sample
week came from just 50 firms that use proprietary data feeds).
\108\ Id. at 18734.
\109\ Id. at 18793 n. 2386 (commenters agreed that ``switching
to new consolidated market data would come with this expense of
losing some data compared to the proprietary data feeds,'' with one
stating that it would be ``unable to remain competitive even after
the final amendments are in place without continuing to purchase
proprietary data feeds.''); see also id. at 18795 (stating
possibility that potential participants in automated market making
and other latency sensitive trading businesses could not ``compete
effectively without using the data that would remain exclusive to
proprietary feeds'').
---------------------------------------------------------------------------
Statements in the MDI Adopting Release addressing the benefits of
the MDI Rules are consistent with a conclusion that the MDI Rules can
benefit SIP data users that currently do not purchase the proprietary
data feeds, but will not substantially reduce the need to propose Rule
615 to address the goals stated herein. For example, the MDI Adopting
Release stated that the ``odd-lot aggregation methodology'' of the MDI
Rules ``would benefit market participants by promoting tighter spreads
in all stocks, especially high priced ones.'' \110\ All of the odd lot
quotations that will be aggregated, however, were already included in
an order-by-order basis in the proprietary data feeds that the
Commission understands the wholesalers use. As the MDI Adopting Release
stated, the inclusion of odd-lot quote information in core data will
improve transparency and ``reduce information asymmetry between market
participants who already receive this information through proprietary
[depth-of-book] feeds and market participants who choose to subscribe
to this aspect of core data and previously did not receive this
information.\111\
---------------------------------------------------------------------------
\110\ MDI Adopting Release, supra note 81, 86 FR at 18615.
\111\ Id. at 18753.
---------------------------------------------------------------------------
In addition, the MDI Adopting Release states that ``because richer,
more timely consolidated market data may enhance the ability of broker-
dealers to obtain the most favorable terms reasonably available under
the circumstances, including the best reasonably available price and
other factors, for their customer orders, broker-dealers should
consider the availability of consolidated market data for purposes of
evaluating best execution.'' \112\ The availability of additional
quotation information in consolidated market data, however, is unlikely
to affect the wholesalers' and retail brokers' evaluation of best
execution because the Commission understands that wholesalers already
would be expected, under FINRA
[[Page 141]]
guidance,\113\ to use a more complete set of quotation information
(i.e., proprietary data feeds) than will be available in the expanded
MDI data when evaluating best execution today, and retail brokers use
wholesalers as executing brokers to obtain the best terms reasonably
available.
---------------------------------------------------------------------------
\112\ Id. at 18605 (footnotes omitted).
\113\ The MDI Adopting Release referred to this FINRA guidance
concerning the relevance of proprietary data feeds to a broker-
dealer's best execution efforts under FINRA rules. Id. at 18605 n.
94 (quoting FINRA Notice to Members 15-46, Guidance on Best
Execution Obligations in Equity, Options and Fixed Income Markets at
3 n. 12 (Nov. 2015), available at https://www.finra.org/rules-guidance/notices/15-46 (``FINRA Notice 15-46''). The relevant
portion of FINRA Notice 15-46 provides the following guidance on
compliance with FINRA Rule 5310: ``[A] firm that regularly accesses
proprietary data feeds, in addition to the consolidated SIP feed,
for its proprietary trading, would be expected to also be using
these data feeds to determine the best market under prevailing
market conditions when handling customer orders to meet its best
execution obligations.''
---------------------------------------------------------------------------
The MDI Adopting Release also stated that ``as a result of the new
round lot definition and the inclusion of odd-lot quotations in core
data, retail investors will be able to see, and more readily access,
better-priced quotations.'' \114\ Such information will, depending on
the fees yet to be determined for such information (as stated above),
enable those retail investors that purchase such information (or for
those retail investors whose broker-dealers purchase it for them) to
see and more readily access better-priced quotations than the current
NBBO disseminated by the SIPs. To do so, retail investors will need to
direct their own orders to the particular trading center that is
displaying a better-priced quotation. As stated in the MDI Adopting
Release, however, most retail investors rely on their broker-dealers
for execution of their orders, and the additional quotation information
will likely be used by more sophisticated retail investors that are
able to process quotation information and self-direct their
orders.\115\
---------------------------------------------------------------------------
\114\ Id. at 18601.
\115\ See, e.g., id. at 18753 (``the Commission believes, as
suggested by commenters, that retail brokers may allow some
sophisticated retail investors to directly utilize the expanded
content of core data and realize the benefits discussed below'').
---------------------------------------------------------------------------
The MDI Adopting Release also stated that ``through the addition of
depth of book data and auction information in core data, the scope of
NMS information will, to a greater extent, allow some market
participants to trade in a more informed, competitive, and efficient
manner.'' \116\ The phrase ``some market participants'' as discussed
above, refers to those market participants that currently rely on SIP
data for trading and not the proprietary data feeds. For the marketable
orders of individual investors that currently are routed to
wholesalers, the expansion of depth of book data in consolidated market
data will not affect the information used for their execution because
the Commission understands that wholesalers currently use proprietary
data feeds for evaluating the best execution of their orders, which
include more information than the expanded consolidated market data of
the MDI Rules.
---------------------------------------------------------------------------
\116\ Id. at 18601.
---------------------------------------------------------------------------
An aspect of the MDI Rules that will affect the public evaluation
of wholesaler order execution quality is smaller round lot sizes for
quotations in NMS stocks with prices greater than $250 per share. These
quotations determine the NBBO, and smaller round lot sizes can lead to
narrower NBBO spreads. As discussed in section II above, the NBBO is a
benchmark used to assess the market for an NMS stock, as well as to
retrospectively assess the level of execution quality for an order.
Accordingly, although implementation of the MDI Rules will not increase
the information available to wholesalers in proprietary data feeds,
changes in the round lot definition could narrow the NBBO as a public
benchmark for the execution quality of the marketable orders of
individual investors.
The Commission does not believe, however, the smaller round lot
sizes for NMS stocks with prices that exceed $250 per share will
substantially affect the need for Proposed Rule 615 in terms of
improved order execution quality for the marketable orders of
individual investors. In particular, Proposed Rule 615 would encompass
all NMS stocks, while the new round lot definition will encompass a
much smaller range of NMS stocks and trading volume. In the MDI
Adopting Release, for example, Table 3 and Table 4 set out the range of
stocks and volume estimated to be affected by the new round lot
definition. This information is summarized below:
----------------------------------------------------------------------------------------------------------------
% Average % Average
Round lot tier Number of NMS daily share daily dollar % Instances of
stocks volume volume smaller NBBO
----------------------------------------------------------------------------------------------------------------
$0-$250......................................... 9,023 97.12 71.93 n/a
$250.01-$1,000.................................. 117 2.79 23.24 26.6
$1,000.01-$10,000............................... 16 0.09 4.82 47.7
$10,000+........................................ 1 0.00 0.02 n/a
----------------------------------------------------------------------------------------------------------------
First, as stated in the MDI Adopting Release, ``most stocks,
approximately 98.5%, will remain unaffected'' by the new round lot
definition.\117\ The 98.5% of unaffected NMS stocks with prices of $250
or less represented 97.12% of total NMS stock share volume and 71.93%
of total NMS stock dollar volume. Thus, the great majority of NMS
stocks and their volume would not be affected by the narrowing of the
NBBO benchmark that will result from the new round lot definition in
the MDI Rules.\118\
---------------------------------------------------------------------------
\117\ MDI Adopting Release, supra note 81, 86 FR at 18743 (Table
4).
\118\ Id. at 18753 (``Even though the new round lot definition
would expand information on odd-lots that may be priced better than
the current NBBO in some stocks, most stocks would not be affected
by the new round lot definition.'') (footnotes omitted).
---------------------------------------------------------------------------
Second, for the estimated 1.5% of high-priced NMS stocks (over
$250) that will be affected by the reduction in round lot sizes, the
Commission estimated that most of the dollar volume (23.24% of total
NMS stock dollar volume) will occur within the $250.01-$1,000 tier, but
in this tier, the NBBO spread will be reduced for only 26.6% of the
trading day.\119\ For the remaining 73.4% of the trading day in these
NMS stocks, the NBBO spread in these NMS stocks will be
unaffected.\120\ Accordingly, even for the 1.5% of NMS stocks that will
be affected by the revised round lot definition, NBBO spreads were
estimated to remain unaffected for the most of the trading day.
---------------------------------------------------------------------------
\119\ Id. at 18743 (Table 3).
\120\ Id. (Table 4). For NMS stocks with prices of $1000.01 to
$10,000, which represented 4.82% of trading volume, the Commission
estimated that, taking into account the new round lot definition,
the NBBO spread would be reduced to some extent for 47.7% of the
trading day. Id. (Tables 3-4).
---------------------------------------------------------------------------
This conclusion is consistent with statements in the MDI Adopting
Release. For example, the MDI Adopting Release states that ``the size
of the change in the NBBO spread, conditional
[[Page 142]]
on the NBBO being smaller, will also be substantial.'' \121\ The phrase
``conditional on the NBBO being smaller'' \122\ means that the
reduction in size of the half spread is limited to the 1.5% of stocks
and their volume that, as discussed above, will be affected by the new
odd lot definition. As a result, there will be a significant reduction
in half spread of the NBBO for those stocks, but this reduction is
conditional on the minority of the trading day for 1.5% of NMS stocks
when NBBO spreads actually will be affected by the new round lot
definition.
---------------------------------------------------------------------------
\121\ Id. at 18744.
\122\ Similarly, the following statement in the MDI Adopting
Release is conditional on those instances where the NBBO spread is
smaller: ``The Commission believes that, in particular, for
securities with a significant amount of dollar trading volume, there
will be significant changes to (tightening of) the quoted spread
displayed under the new round lot definition.'' Id. at 18743.
---------------------------------------------------------------------------
Third and finally, the NBBO as a benchmark for order execution
quality does not, as discussed in section II.C above, reflect the
availability of prices better than round lot displayed quotations. Such
better prices include displayed odd lot quotations and undisplayed
orders at national securities exchanges, as well as the availability of
NBBO price improvement at wholesalers that is enabled by the low
adverse selection costs of the marketable orders of individual
investors. In the MDI Adopting Release, the Commission considered
whether a narrowing of the NBBO spread would affect the order execution
quality of retail investors.\123\ While it stated that a narrowing of
the NBBO spread would, by definition, reduce the level of NBBO price
improvement if execution prices for retail investors remained the
same,\124\ the Commission stated that ``retail investors might or might
not'' experience an improvement in execution quality, ``as measured by
execution prices,'' from wholesalers.\125\ The Commission stated that a
retail broker commented that retail investors would not receive better
execution prices under the new round lot sizes because wholesalers
already offer price improvement to retail investors that exceeds the
potential improvements in the NBBO from the new round lot size.\126\
Another commenter stated that all investors, including retail
investors, would experience reduced execution costs from a tighter NBBO
no matter where the execution took place.\127\ The Commission concluded
that it was ``uncertain'' whether the execution quality that retail
investors receive from wholesalers would change if the NBBO spread
narrows because the effect ``would depend on how the change in the NBBO
compared to the current price improvement offered by wholesalers,'' as
well as on ``changes in the degree of price improvement wholesalers
will offer in stocks with tighter NBBOs, which is uncertain.'' \128\
---------------------------------------------------------------------------
\123\ Id. at 18747 (section addressing ``effects of
internalization on retail order flow'').
\124\ Id. (``it may become more difficult for the retail
execution business of wholesalers to provide price improvement and
other execution quality metrics at levels similar to those provided
under the 100 share round lot definition today'').
\125\ Id.
\126\ Id.
\127\ Id.
\128\ Id.
---------------------------------------------------------------------------
As stated above, the Commission understands that wholesalers
already would be expected, under FINRA guidance, to use proprietary
data feeds, which contain a fuller set of quotations than will be
included in the new round lot definition, when, among other things,
evaluating best execution. Consequently, the new round lot definition
will not change the quotation data used by wholesalers to determine
prices for executing the orders of individual investors, but rather
will change the NBBO as benchmark for analysis of order execution
quality at wholesalers.\129\ Moreover, narrowing the NBBO as a
benchmark for execution quality of wholesalers will affect all
wholesalers equally. For example, if the average NBO for an NMS stock
declined by two cents, the NBO as a benchmark would reduce the
calculation of NBBO price improvement by two cents for all wholesalers
and therefore leave them in the same relative position when compared to
each other. The Commission does not believe that implementation of the
new round lot definition in the MDI Rules will substantially affect the
need for Proposed Rule 615 in terms of an improvement in the order
execution quality of the marketable orders of individual investors.
---------------------------------------------------------------------------
\129\ Id. at 18745 (``the new round lot definition will also
improve transaction cost analysis and best execution analysis in
higher priced stocks, which are benchmarked against the NBBO'').
---------------------------------------------------------------------------
2. Rules Addressing Order Handling and Execution
Broker-dealers owe their customers a duty of best execution when
handling and executing customer orders.\130\ This duty of best
execution derives from common law agency principles and fiduciary
obligations, and is incorporated in SRO rules and enforced through the
antifraud provisions of the Federal securities laws.\131\ The
Commission has stated that ``the duty of best execution generally
requires broker-dealers to execute customers' trades at the most
favorable terms reasonably available under the circumstances, i.e., at
the best reasonably available price.'' \132\ Broker-dealers should
periodically assess the quality of competing markets to assure that
order flow is directed to the markets providing the most beneficial
terms for their customer orders.\133\ In doing so, broker-dealers must
take into account price improvement opportunities, and whether
different markets may be more suitable for different types of orders or
particular securities.\134\
---------------------------------------------------------------------------
\130\ The Commission also is proposing a new rule addressing the
best execution obligations of broker-dealers. See Securities
Exchange Act Release No. 96496 (Dec. 14, 2022) (File No. S7-32-22)
(Regulation Best Execution) (``Regulation Best Execution
Proposal''). The Commission encourages commenters to review that
proposal to determine whether it might affect their comments on this
proposal.
\131\ See MDI Adopting Release, supra note 81, 86 FR at 18605.
In addition, FINRA has codified a duty of best execution in its
rules, requiring a broker-dealer to ``use reasonable diligence to
ascertain the best market for the subject 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.'' FINRA
Rule 5310, ``Best Execution and Interpositioning.''
\132\ See MDI Adopting Release, supra note 81, 86 FR at 18605
(quoting Regulation NMS Adopting Release, supra note 78, 70 FR at
37538); see also Geman v. SEC, 334 F.3d 1183, 1186 (10th Cir. 2003)
(quoting Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135
F.3d 266, 270 (3d Cir. 1998)) (``[T]he duty of best execution
requires that a broker-dealer seek to obtain for its customer orders
the most favorable terms reasonably available under the
circumstances.''); and Kurz v. Fidelity Management & Research Co.,
556 F.3d 639, 640 (7th Cir. 2009) (describing the ``duty of best
execution'' as ``getting the optimal combination of price, speed,
and liquidity for a securities trade'').
\133\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37538.
\134\ See id.
---------------------------------------------------------------------------
After the enactment of section 11A in 1975, which included as an
objective the practicability of brokers' executing investor orders in
the best market,\135\ the Commission adopted rules that prescribe
requirements for the handling and execution of orders in NMS stocks in
certain contexts. These rules were often designed, at least in part, to
promote best execution of investors' orders. Three rules in Regulation
NMS, discussed below, specifically address the handling and execution
of orders in NMS stocks--17 CFR 242.604 (``Rule 604,'' also known as
the ``Limit Order Display Rule''), 17 CFR 242.611 (``Rule 611,'' also
known as the ``Order Protection Rule''), and 17 CFR 242.612 (``Rule
612,'' also known as the ``Sub-Penny Rule'').
---------------------------------------------------------------------------
\135\ Section 11A(a)(1)(C)(iv) of the Exchange Act; see also
supra note 57 and accompanying text.
---------------------------------------------------------------------------
[[Page 143]]
a. Limit Order Display Rule
The Limit Order Display Rule was originally adopted in 1996 as Rule
11Ac1-4 and redesignated as Rule 604 with the adoption of Regulation
NMS in 2005.\136\ It establishes minimum display requirements for
customer limit orders that are not executed immediately, which, as
discussed in section II.C above, can be referred to as ``non-
marketable'' limit orders. In contrast to marketable limit orders, non-
marketable limit orders cannot be executed immediately at the NBBO.
Rule 604 requires specialists and OTC market makers to display the
price and full size of customer limit orders when these orders
represent buying and selling interest that is at a better price than a
specialist's or OTC market maker's public quotation.\137\ Specialists
and OTC market makers also must increase the size of their quotation
for a particular security to reflect a limit order of greater than de
minimis size when the limit order is priced equal to the specialist's
or OTC market maker's disseminated quotation and that quotation is
equal to the NBBO.\138\
---------------------------------------------------------------------------
\136\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37570. Modifications included conforming terms to those adopted with
Regulation NMS, such as changing references from ``covered
security'' to ``NMS stock.'' Id. at 37572.
\137\ Rule 604(b)(1) provides exceptions for, among other
things, orders executed immediately upon receipt and odd lot orders.
\138\ See Securities Exchange Act Release No. 37619A (Sep. 6,
1996), 61 FR 48290, 48290 (Sep. 12, 1996) (Order Execution
Obligations) (adopting final rules to require the display of
customer limit orders and amending a rule governing publication of
quotations) (``1996 Order Handling Release''); Rule 604(a).
---------------------------------------------------------------------------
In adopting Rule 604, the Commission observed that the enhanced
transparency of such orders would increase the likelihood that customer
limit orders would be executed because contra-side market participants
would have a more accurate picture of trading interest in a given
security, and that the increased visibility would enable market
participants to interact directly with limit orders, rather than rely
on the participation of a dealer for execution.\139\ The Commission
also stated that the display requirement (together with other
amendments being made at the time) would help ensure the disclosure of
customer and market maker buying and selling interest that had, prior
to adoption of Rule 604, been hidden from many market
participants.\140\
---------------------------------------------------------------------------
\139\ See 1996 Order Handling Release, supra note 138, 61 FR at
48293.
\140\ Id. at 48292. The Commission also adopted amendments to
require a market maker to publish quotations for any listed security
when it is responsible for more than 1% of the aggregate trading
volume for that security and to make publicly available any superior
prices that a market maker privately quotes through certain
electronic communications networks (``ECNs''). Id. at 48292. Also,
at the same time it adopted the Limit Order Display Rule in 1996,
the Commission deferred action on a proposed rule to address the
handling of customer market orders of less than block size, referred
to as the ``Price Improvement Rule.'' Id. at 48322. This proposed
rule would have required specialists and OTC market makers to
provide their customer market orders an opportunity for price
improvement. The proposal included a non-exclusive safe harbor to
satisfy the price improvement obligation that included exposing the
customer order for 30 seconds at an improved price in a published
quotation. The proposal sought to improve opportunities in auction
and dealer markets for market orders to interact directly with other
market orders and public limit orders, consistent with the goals of
an NMS. Id.
---------------------------------------------------------------------------
b. Order Protection Rule
In 2005, the Commission adopted the Order Protection Rule as Rule
611 of Regulation NMS. Rule 611(a) applies to ``trading centers,''
which is defined broadly in Rule 600(b)(95) as a national securities
exchange or national securities association that operates an SRO
trading facility, an ATS, an exchange market maker, an OTC market
maker, or any other broker or dealer that executes orders internally by
trading as principal or crossing orders as agent.
Rule 611(a)(1) requires trading centers to implement written
policies and procedures reasonably designed to prevent trade-throughs--
the execution of an order at a price that is inferior to the price of a
``protected quotation.'' \141\ To be protected, a quotation must be
immediately and automatically accessible up to its full displayed size,
must be the best-priced quotation (highest bid to buy and lowest offer
to sell) in round lot sizes of an exchange or FINRA, and must be
disseminated in consolidated market data.\142\ Accordingly, Rule 611
provides for intermarket price protection only of an exchange's or
FINRA's best bid and offer (``BBO''). It does not establish time
priority among the same-priced quotations at different trading centers,
nor does it protect ``depth-of-book'' quotations (quotations with
prices outside an exchange's or FINRA's BBO) or odd lot quotations
(quotations with sizes of less than one round lot).
---------------------------------------------------------------------------
\141\ Rule 600(b)(70) defines ``protected bid'' or ``protected
offer'' as a quotation in an NMS stock that: (i) is displayed by an
automated trading center; (ii) is disseminated pursuant to an
effective NMS plan; and (iii) is an automated quotation that is the
best bid or best offer of a national securities exchange, or the
best bid or best offer of a national securities association.
\142\ Rule 600(b)(71) defines ``protected quotation'' as a
protected bid or a protected offer. As stated in section II.B.1
above, no FINRA member currently uses the ADF, its facility for
displaying quotations, to disseminate quotations in consolidated
market data. Today, only exchanges display protected quotations
under Rule 611.
---------------------------------------------------------------------------
In adopting Rule 611, the Commission stated that strong intermarket
price protection offers greater assurance, on an order-by-order basis,
to investors who submit market orders that their orders in fact will be
executed at the best readily available prices, which can be difficult
for investors, particularly individual investors, to monitor.\143\ One
of the Commission's concerns when adopting Rule 611 was the
internalization of individual investor orders by broker-dealers. The
Commission observed that the great majority of internalized trades are
the small trades of individual investors, and that, in 2003, nearly 1
out of every 30 of these trades, of which there are millions, appears
to have been executed at a price inferior to an automated and
accessible quotation.\144\ The Commission stated that Nasdaq's data
submitted in response to the Rule 611 proposal appeared to indicate a
need for regulatory action to reinforce the fundamental principle of
best price for all NMS stocks.\145\
---------------------------------------------------------------------------
\143\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37505.
\144\ Id. at 37508.
\145\ Id. In response to the Commission's proposal to adopt
Regulation NMS, The Nasdaq Stock Market, Inc. (n.k.a. Nasdaq)
submitted data to show that the trade-through rates for Nasdaq
stocks in some trading centers had dropped from the Fall of 2003 to
the Fall of 2004, and that the reduction during that time was a
result of fewer independently operating ECNs. The Commission stated
``[i]t is unlikely that ECN consolidation could have caused such a
major reduction in trade-through rates at securities dealers when
they execute their customer orders internally.'' Id. (footnote
omitted).
---------------------------------------------------------------------------
c. Sub-Penny Rule
Also in 2005, the Commission adopted the Sub-Penny Rule as Rule 612
of Regulation NMS to establish a minimum pricing increment for NMS
stocks. Specifically, paragraph (a) of Rule 612 provides that no
national securities exchange, national securities association, ATS,
vendor, or broker or dealer shall display, rank, or accept from any
person a bid or offer, an order, or an indication of interest in any
NMS stock priced in an increment smaller than $0.01 if that bid or
offer, order, or indication of interest is priced equal to or greater
than $1.00 per share.\146\ Rule 612 does not, however, prohibit a sub-
penny trade by a wholesaler or other internalizing broker-dealer, as
long as the trade did not result from an impermissible sub-penny
quotation,
[[Page 144]]
order, or indication of interest.\147\ For example, Rule 612 does not
prevent wholesalers, after they receive an order from a broker, from
choosing to execute that order in a transaction at a sub-penny price.
This includes a trade executed at a price that is a sub-penny increment
better than the best displayed quotation in consolidated market
data.\148\ This sub-penny trading exception is not available to market
participants on exchanges and ATSs,\149\ in contrast, because those
trading centers operate by accepting, matching, and executing orders
from market participants. Exchanges and ATSs, with limited exceptions,
may only execute orders at a sub-penny price if the price is the NBBO
midpoint.\150\ Also, exchanges with retail liquidity programs
(``RLPs'') have been granted an exemption from Rule 612 to provide
executions in tenths of a penny.\151\ The Commission has granted
exemptions for these programs to promote competition between exchanges
and OTC market makers (which, as discussed above, includes
wholesalers).\152\ As discussed in section VII below, however, the
great majority of marketable orders of individual investors continue to
be routed first to wholesalers.
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\146\ 17 CFR 242.612(a). Paragraph (b) of Rule 612 sets forth a
minimum increment of $0.0001 for prices less than $1.00 per share.
\147\ The Commission also is proposing to amend Rule 612
regarding sub-penny trading. See Minimum Pricing Increments
Proposal, supra note 98. The Commission encourages commenters to
review that proposal to determine whether it might affect their
comments on this proposing release.
\148\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37556 (the Commission stated that sub-penny executions due to price
improvement are generally beneficial to retail investors).
\149\ The regulatory framework for ATSs is discussed in section
III.B.3 below.
\150\ Neither Rule 612 nor any other Commission rule or
interpretation states that exchanges and ATSs may execute midpoint
orders at a sub-penny amount (e.g., if the NBBO is 10.00-10.01 to
execute at the mid-point price of 10.005). However, the Commission
has stated that Rule 612 will not prohibit a sub-penny execution
resulting from a midpoint or volume-weighted algorithm or from price
improvement, so long as the execution did not result from an
impermissible sub-penny order or quotation. Regulation NMS Adopting
Release, supra note 78, 70 FR at 37556. Undisplayed ``floating''
midpoint orders (i.e., orders that re-price when the exchange BBO
changes), for example, are permissible under Rule 612, and the
Commission has approved numerous rule proposals by national
securities exchanges for their use. See, e.g., Securities Exchange
Act Release Nos. 89563 (Aug. 14, 2020), 85 FR 51510 (Aug. 20, 2020)
(SR-PEARL-2020-03) (order approving proposed rule change by MIAX
PEARL to establish rules governing the trading of equity securities,
including a midpoint peg order type); and 78101 (June 17, 2016), 81
FR 41142 (June 23, 2016) (File No. 10-222) (order approving IEX's
registration as a national securities exchange, including the
exchange's inclusion of a midpoint pegged order type in its
rulebook).
\151\ Several exchanges operate RLPs. These are programs for
retail orders seeking liquidity that allow market participants to
supply liquidity to such retail orders by submitting undisplayed
orders priced at least $0.001 better than the exchange's protected
best bid or offer. Each program results from a Commission approval
of a proposed rule change made on Form 19b-4 combined with a
conditional exemption, pursuant to section 36 of the Exchange Act,
from Rule 612 to enable the exchange to accept and rank (but not
display) the sub-penny orders. See, e.g., Securities Exchange Act
Release Nos. 85160 (Feb. 15, 2019), 84 FR 5754 (Feb. 22, 2019) (SR-
NYSE-2018-28) (approving the NYSE RLP on a permanent basis and
granting the exchange a limited exemption from the Sub-Penny Rule to
operate the program); 86194 (June 25, 2019), 84 FR 31385 (July 1,
2019) (SR-BX-2019-011) (approving Nasdaq BX's retail price
improvement program on a permanent basis and granting the exchange a
limited exemption from the Sub-Penny Rule to operate the program).
\152\ Id. See also Securities Exchange Act Release No. 73702
(Nov. 28, 2014), 79 FR 72049 (Dec. 4, 2014) (SR-BX-2014-048)
(approving Nasdaq BX's (f/k/a NASDAQ OMX BX Inc.) establishment of
its retail price improvement program on a pilot basis). In granting
the original exemption from Rule 612, the Commission stated that the
vast majority of ``marketable retail orders'' are internalized by
OTC market makers, and that retail investors can benefit from such
arrangements to the extent that OTC market makers offer them price
improvement over the NBBO. This price improvement is typically
offered in sub-penny amounts. The Commission explained that OTC
market makers typically select a sub-penny price for a trade without
quoting at that exact amount or accepting orders from retail
customers seeking that exact price; and that exchanges--and exchange
member firms that submit orders and quotations to exchanges--cannot
compete for ``marketable retail order flow'' on the same basis,
because it would be impractical for exchange electronic systems to
generate sub-penny executions without exchange liquidity providers
or retail brokerage firms having first submitted sub-penny orders or
quotations, which the Sub-Penny Rule expressly prohibits. The
Commission explained that the limited exemption granted to operate
the retail price improvement program should promote competition
between exchanges and OTC market makers in a manner reasonably
designed to minimize the problems that the Commission identified
when adopting the Sub-Penny Rule. Id. at 72053.
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3. Rules Addressing Access to Trading Centers
As stated above, access to trading centers and their services is a
critically important component of the NMS as a means to link trading
centers together in a unified system. For example, the Regulation NMS
rules addressing the display of quotations, the display of customer
limit orders, and protection of customer orders cannot achieve their
objectives if market participants do not have fair and efficient means
to access those trading centers that display quotations and execute
orders.\153\
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\153\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37538. The rules discussed in this section address requirements
that apply to trading centers providing access to their services.
Exchange Act Rule 15c3-5, in contrast, addresses access, but in the
context of risk management controls for broker-dealers with market
access.
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For purposes of assessing access requirements in today's NMS,
trading centers for NMS stocks can be divided into three distinct
regulatory categories: national securities exchanges, NMS Stock ATSs,
and internalizing broker-dealers (including wholesalers). As discussed
below, the statutory access requirements and the Commission's access
rules currently apply to exchanges and ATSs, as well as to FINRA
members that display quotations in consolidated market data through
FINRA's ADF (of which there currently are none). In contrast, broker-
dealers that do not display quotations in consolidated market data and
that trade outside of an ATS, such as wholesalers, are not subject to
any fair access requirements under the Exchange Act or Commission
rules. While subject to Commission and SRO rules for broker-dealers,
internalizing broker-dealers are not prohibited from restricting access
to their trading mechanisms and the investor orders that they
internalize. An internalizing broker-dealer is not required, for
example, to provide other market participants, including institutional
investors and liquidity providers on exchanges, with any opportunity to
compete to provide the best prices to the individual investor orders
that the broker-dealer executes internally.
a. Access Rules for National Securities Exchanges
As stated in section III.A above, the Exchange Act directly
requires national securities exchanges to provide fair access in four
contexts.\154\ Section 6(b)(2) specifies that exchange rules must allow
``any'' broker-dealer registered with the Commission, unless subject to
a specified disqualification, to become a member of the exchange.
Section 6(b)(4) requires that exchange rules provide for the
``equitable'' allocation of ``reasonable'' dues, fees, and other
charges among members, issuers, and other persons using exchange
facilities. Section 6(b)(5) broadly requires that exchange rules be
designed, among other things, to remove impediments to and perfect the
mechanism of a free and open market and an NMS, and that exchange rules
are not designed to permit unfair discrimination between customers,
issuers, brokers, or dealers. And section 6(b)(8) requires that
exchange rules do not impose any burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
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\154\ See supra notes 61-66 and accompanying text.
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In addition to these broad statutory requirements for all national
securities exchanges, the Commission has adopted 17 CFR 242.610 (``Rule
610'') of Regulation NMS, which addresses access to displayed
quotations.
[[Page 145]]
Specifically, Rule 610(a) prohibits any national securities exchange
that operates an SRO trading facility \155\ from imposing unfairly
discriminatory terms that would prevent or inhibit any person from
obtaining efficient access through a member of the national securities
exchange to the quotations in an NMS stock displayed through its SRO
trading facility. This provision is designed to prohibit national
securities exchanges from limiting ``piggyback access'' as a means by
which non-members obtain access to exchange quotations through the
services of an exchange member.\156\ Piggyback access, for example,
allows non-members to obtain access to a national securities exchange's
quotations without the need to obtain (and pay for) direct connectivity
to the exchange.
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\155\ Rule 600(b)(89) defines an ``SRO trading facility'' as a
facility operated by or on behalf of a national securities exchange
or a national securities association that executes orders in a
security or presents orders to members for execution.
\156\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37539. Rule 610(c) also limits the fees that can be charged for
accessing an exchange's best-priced displayed quotations, and Rule
610(d) addresses locking and crossing quotations.
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b. Access Rules for NMS Stock ATSs
In 1998, the Commission initiated a new regulatory regime for ATSs
with the adoption of Regulation ATS.\157\ An ATS is a trading system
that falls within the definition of exchange in Section 3(b)(1) of the
Exchange Act, but is exempted from such definition by Rule 3a1-1 under
the Exchange Act if the trading system complies with Regulation
ATS.\158\ For an NMS Stock ATS,\159\ Regulation ATS requires, among
other things, that the NMS Stock ATS must register with the Commission
as a broker-dealer and must file a Form ATS-N, a publicly available
document that includes detailed disclosures about the NMS Stock ATS's
operations.
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\157\ See Regulation ATS Adopting Release, 63 FR 70844, supra
note 27. ``Regulation ATS'' consists of 17 CFR 242.300 through
242.304 (``Rule 300'' through ``Rule 304'' under the Exchange Act).
\158\ 17 CFR 240.3a1-1.
\159\ In 2018, the Commission amended Regulation ATS with
respect to the requirements that apply to NMS Stock ATSs. Securities
Exchange Act Release No. 83663 (July 18, 2018), 83 FR 38768 (Aug. 7,
2018) (``ATS-N Adopting Release'').
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In addition, Regulation ATS includes two separate types of access
requirements that potentially can apply to an NMS Stock ATS. First,
Rule 301(b)(3) imposes order display and execution access requirements
on an NMS Stock ATS that displays orders to any person and had 5% or
more of average daily volume reported in an NMS stock during four of
the preceding six calendar months. Similar to Rule 610, the ``execution
access'' requirement of Rule 301(b)(3) is limited to access to
displayed quotations in consolidated market data. As stated above in
section III.B.1, FINRA's ADF is a facility for broker-dealers
(including ATSs) to display quotations in consolidated market data.
Currently, no NMS Stock ATS that displays quotations uses the ADF to
display its quotations in consolidated market data, and no NMS Stock
ATS is subject to the execution access requirement of Rule 301(b)(3).
Second, Rule 301(b)(5) imposes ``fair access'' requirements with
respect to an NMS stock in which the NMS Stock ATS had 5% or more of
the average daily volume reported during four of the preceding six
calendar months. This fair access requirement requires an NMS Stock ATS
(1) to establish written standards for granting access to trading on
its systems, (2) to not unreasonably prohibit or limit any person in
respect to access to services offered by such ATS by applying the
written access standards in an unfair or discriminatory manner, (3) to
maintain records of grants, denials, and limitations of access, and (4)
to report the information required by Form ATS-R on grants, denials,
and limitations of access. When it adopted Regulation ATS, the
Commission emphasized that the fair access requirements of Rule
301(b)(5) apply to a far broader range of services than the ``execution
access'' requirements of Rule 301(b)(3), which are limited to access to
quotations. Specifically, the Commission stated that although it was
adopting rules to require ATSs with significant trading volume to
publicly display their best bid and offer and provide equal access to
those orders, direct participation in ATSs offers benefits in addition
to execution against the best bid and offer. The Commission gave as an
example that direct participants could enter limit orders into the
system, rather than just execute against existing orders on a fill-or-
kill basis,\160\ and that direct participants could view all orders,
not just the best bid or offer, which provides important information
about the depth of interest in a particular security. The Commission
further observed that some ATSs also allowed direct participants to
enter ``reserve'' orders which hide the full size of an order from
view. Because of these advantages to direct participants in an ATS,
access to the best bid and offer through an SRO provided an incomplete
substitute. Therefore, the Commission adopted rules to require most
ATSs that have a significant percentage of overall trading volume in a
particular security to comply with fair access standards.\161\
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\160\ A fill-or-kill order is an order with instructions to
cancel the order if it cannot be executed in its full size.
\161\ Regulation ATS Adopting Release, supra note 27, 63 FR at
70872 (footnote omitted).
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In sum, the fair access requirements of Rule 301(b)(5) encompass
all of the trading services of an NMS Stock ATS. When adopting these
requirements, the Commission emphasized that an ``alternative trading
system must apply [fair access] standards fairly and is prohibited from
unreasonably prohibiting or limiting any person with respect to trading
in any equity securities.'' \162\
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\162\ See id. at 70873.
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Currently, only a single NMS Stock ATS discloses on its Form ATS-N
that it is subject to these fair access requirements for securities
that are available for trading on its platform.\163\ NMS Stock ATSs
that are not subject to fair access requirements are not prohibited
from unfairly discriminating with respect to the trading services they
offer broker-dealers and other market participants.
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\163\ See supra note 29 and accompanying text.
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c. Access Rules for ADF Participants
As stated in section III.B.2 above, Rule 611 protects the best-
priced displayed quotations of FINRA members that use the ADF to
display quotations in consolidated market data (though no FINRA member
currently uses the ADF to do so). In adopting Rule 611, the Commission
recognized that assuring fair and efficient access to FINRA members
displaying quotations in the ADF would be essential, given that other
market participants were required by rule to not trade through such
quotations.\164\ The ADF falls within the definition of an ``SRO
display-only facility'' in Rule 600(b)(88) because it merely displays
the quotations of its participants and neither executes orders itself
nor presents orders to ADF participants for execution. Instead, market
participants must obtain their own means of access to ADF participants
to trade with ADF protected quotations. Accordingly, the Commission
adopted Rule 610(b) to promote such access to ADF participants.\165\
Rule 610(b)(2) imposes
[[Page 146]]
the same piggyback access requirement that applies to exchanges under
Rule 610(a), thereby assuring that market participants can obtain
indirect access to an ATS's or broker-dealer's quotations in the ADF.
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\164\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37540 (discussing Rule 610, which addresses means of access to
quotations). The Regulation NMS Adopting Release refers to National
Association of Securities Dealers (``NASD'') members. NASD was the
predecessor association to what today is FINRA.
\165\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37502-03; see also id. at 37539-43.
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In addition, however, Rule 610(b)(1) imposes an access requirement
that is particularly tailored to address concerns presented by FINRA
members (including NMS Stock ATSs) displaying quotations in the ADF.
Specifically, Rule 610(b)(1) requires that any trading center that
displays quotations in NMS stocks through an SRO display-only facility
must provide a level and cost of access to such quotations that is
substantially equivalent to the level and cost of access to quotations
displayed by SRO trading facilities (such as national securities
exchanges). The Commission emphasized that the phrase ``level and cost
of access'' would encompass both (1) the policies, procedures, and
standards that govern access to quotations of the trading center, and
(2) the connectivity through which market participants can obtain
access and the cost of such connectivity.\166\ The Commission further
stated that trading centers that choose to display quotations in an SRO
display-only facility would be required to bear the responsibility of
establishing the necessary connections to afford fair and efficient
access to their quotations, and the nature and cost of these
connections for market participants seeking to access the trading
center's quotations would need to be substantially equivalent to the
nature and cost of connections to SRO trading facilities.\167\
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\166\ Regulation NMS Adopting Release, supra note 78, 70 FR at
37549.
\167\ Id.
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In addition to these heightened access requirements for FINRA
members (including NMS Stock ATSs) that display quotations in the ADF,
the Commission stated that FINRA, as the self-regulatory authority
responsible for enforcing compliance by ADF participants with the
requirements of the Exchange Act, would need to evaluate the
connectivity of ADF participants to determine whether they meet the
requirements of Rule 610(b)(1).\168\ The Commission also stated that
the addition of a new ADF participant would constitute a material
aspect of the operation of FINRA's facilities, and thus require the
filing of a proposed rule change pursuant to section 19(b) of the
Exchange Act that would offer an opportunity for public notice and
comment.\169\
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\168\ Id.
\169\ Id.
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4. Disclosure of Order Routing Practices and Order Execution Statistics
Rule 606 of Regulation NMS requires broker-dealers to publish
quarterly reports on their routing of customer orders in NMS stocks,
and Rule 605 of Regulation NMS requires market centers to make data
files publicly available on a monthly basis that include a variety of
statistics on their execution of orders in NMS stocks.\170\ When it
originally adopted the two rules in 2000, the Commission stated that,
by increasing the visibility of order execution and routing practices,
the rules were ``intended to empower market forces with the means to
achieve a more competitive and efficient [NMS] for public investors.''
\171\
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\170\ The rules that the Commission originally adopted were
designated as Rule 11Ac1-6 and Rule 11Ac1-5. The Commission re-
designated Rule 11Ac1-6 as Rule 606 and Rule 11Ac1-5 as Rule 605
when it adopted Regulation NMS in 2005. Regulation NMS Adopting
Release, supra note 78, 70 FR at 37538. The term ``market center,''
as defined in Rule 600(b)(46) of Regulation NMS, is somewhat
narrower than trading center. Market centers include, for example,
national securities exchanges, ATSs, and OTC market makers
(including wholesalers), but do not include the broad catch-all
category of trading center that encompasses any broker-dealer that
executes orders internally as principal or agent.
\171\ Securities Exchange Act Release No. 43590 (Nov. 17, 2000),
65 FR 75414, 75427 (Dec. 1, 2000). The Commission enhanced the order
routing disclosure requirements of Rule 606 when it amended the rule
in 2018. Securities Exchange Act Release No. 84528 (Nov. 2, 2018),
83 FR 58338 (Nov. 19, 2018).
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Rule 606 requires broker-dealers to disclose, among other things,
the percentage of non-directed customer orders routed to different
trading centers, as well as the financial inducements offered by these
trading centers to attract order flow.\172\ Information must be
provided for four types of orders--market orders, marketable limit
orders, non-marketable limit orders, and other orders. The enhanced
disclosures include a requirement to disclose net aggregate amounts of
PFOF received from trading centers or amounts paid to them (such as
transaction fees on exchanges), both as a total dollar amount and an
amount per 100 shares.
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\172\ A ``non-directed order'' is defined in Rule 600(b)(56) of
Regulation NMS to mean any order from a customer other than a
directed order, and a ``directed order'' is defined in Rule
600(b)(27) of Regulation NMS to mean an order from a customer that
the customer specifically instructed the broker-dealer to route to a
particular venue for execution.
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Rule 605 requires market centers to disclose standardized
statistics about the execution quality they achieve for ``covered
orders,'' as defined in Rule 600(b)(22) of Regulation NMS.\173\ In
general, the definition of covered orders excludes order types for
which the customer requests special handling that could detract from
the goal of achieving comparable statistics for similar order types
across different market centers. Unlike the Rule 606 disclosures, the
Rule 605 data files are not designed to be human-readable and instead
consist of a large volume of detailed statistics for each of the NMS
stocks in which a market center receives covered orders. The data files
are published in a format that is designed to be downloaded and
processed with analysis software, such as a spreadsheet program, which
then can be used to generate summary reports for viewing.
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\173\ Rule 605(a)(1). The Commission also is proposing to amend
the order execution quality disclosures required by Rule 605. See
Securities Exchange Act Release No. 96493 (Dec. 14, 2022) (File No.
S7-29-22) (Disclosure of Order Execution Information). The
Commission encourages commenters to review that proposal to
determine whether it might affect their comments on this proposing
release.
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IV. Description of Proposed Rule 615
A. Overview of Order Competition Requirement
Paragraph (a) of Proposed Rule 615 sets forth the rule's core
competition requirement. It states that a restricted competition
trading center shall not execute a segmented order internally \174\
until after a broker-dealer has exposed such order to competition at a
specified limit price in a qualified auction operated by an open
competition trading center. As discussed below in this section IV: (1)
segmented order, open competition trading center, restricted
competition trading center, and qualified auction are new terms
proposed to be defined in Rule 600(b) of Regulation NMS; (2) certain
exceptions to the order competition requirement are set forth in
paragraph (b) of Proposed Rule 615; (3) the requirements for a
qualified auction are specified in paragraph (c) of Proposed Rule 615;
and (4) the requirements with respect to segmented orders that would be
imposed on open competition trading centers, originating brokers, all
broker-dealers, and national securities exchanges are set forth in
paragraphs (d) through (g) of Proposed Rule 615.
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\174\ The applicability of paragraph (a) of Proposed Rule 615 to
``internally'' executed transactions is designed to accommodate the
practice of some trading centers that both execute orders internally
and obtain executions of orders externally by seeking liquidity at
other trading centers. Cf. Rule 600(b)(95) of Regulation NMS
(definition of ``trading center'' includes ``any other broker or
dealer that executes orders internally by trading as principal or
crossing orders as agent'').
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The term ``segmented order,'' as proposed to be defined in Proposed
Rule 600(b)(91) of Regulation NMS, is a
[[Page 147]]
key term determining the scope of Proposed Rule 615 and is designed to
encompass those orders of individual investors with relatively low
adverse selection costs.\175\ In addition, paragraphs (b)(2) and (b)(3)
of Proposed Rule 615 would provide exceptions for larger orders
($200,000 or more) and orders that are executed at favorable prices for
individual investors (orders executed at the NBBO midpoint or better);
paragraph (b)(4) would provide an exception for limit orders that have
a limit price that is equal to or more favorable for the segmented
order than the NBBO midpoint (i.e., non-marketable segmented orders
with a limit price that is equal to or lower than the midpoint for buy
orders and equal to or higher than the NBBO midpoint for sell orders);
and paragraph (b)(5) would provide an exception for orders sized less
than one share and for the fractional component, if any, of a segmented
order if no qualified auction is available to execute the fractional
share or fractional component.\176\
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\175\ As discussed in IV.B.1 below, the proposed definition of
``segmented order'' would exclude very active traders whose orders
are likely to impose a much higher level of adverse selection costs
on liquidity providers than the less-active accounts that are more
typical of individual investors. This is done by limiting the
proposed definition of ``segmented orders'' to orders for accounts
in which the average daily number of trades executed in NMS stocks
was less than 40 in each of the six preceding calendar months.
\176\ As discussed in section IV.B.1 below, the proposed
definition of ``segmented order'' does not include a limit price
component. Compliance with the order competition requirement for
limit orders would vary depending on the relation of any limit price
and an execution price to the NBBO. For example, segmented orders
that have a limit price, or are executed at a price, equal to or
more favorable for the segmented order than the NBBO midpoint or
better, would have an exception under paragraph (b)(3) or (b)(4) of
Proposed Rule 615(b). Segmented orders with a limit price beyond the
NBBO midpoint (higher for segmented orders to buy and lower for
segmented orders to sell) could still qualify for the exception in
Proposed Rule 615(b)(3) if they were executed at the NBBO midpoint
or better (i.e., such an order would have been executed at a more
favorable price for the segmented order than its limit price).
---------------------------------------------------------------------------
The purpose of the order competition requirement is to expose
segmented orders to competition to provide the best prices on an order-
by-order basis and thereby minimize the transaction costs incurred by
individual investors when they use marketable orders. Proposed Rule 615
would allow flexibility for broker-dealers, wholesalers, and other
restricted competition trading centers in how they comply with the
rule. A broker-dealer could choose, subject to its best execution
responsibilities as discussed further below, to route a segmented order
directly to a qualified auction, to an open competition trading center,
or to a national securities exchange. Alternatively, a broker-dealer
could route such segmented order to another destination, such as a
routing broker-dealer, a wholesaler, or other restricted competition
trading center, which, in turn, could route the segmented order to a
qualified auction, to an open competition trading center, or to a
national securities exchange.
For illustrative purposes, the following is one example of how a
segmented order could be handled and executed in compliance with
Proposed Rule 615. Assume that a broker-dealer routed a customer's
segmented order to a wholesaler. The wholesaler that received the
segmented order could select a price at which it was willing to execute
a segmented order internally. Before executing internally, however, the
wholesaler would be required to submit the segmented order to a
qualified auction with a specified limit price. As discussed further
below, the specified limit price is not a price at which the wholesaler
is guaranteeing to execute (i.e., it is not a ``reserve'' price or a
``backstop'' of the segmented order).\177\ Rather, the specified limit
price would inform auction responders on how to price their orders and
also, if the segmented order did not receive an execution in the
qualified auction, would be the price (or better) at which the
wholesaler or other restricted competition trading center subsequently
could execute the segmented order as soon as reasonably possible.
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\177\ If the segmented order is not executed in the qualified
auction, however, the wholesaler could choose to execute the
segmented order internally at the specified limit price or better.
---------------------------------------------------------------------------
The wholesaler that submitted the segmented order to a qualified
auction would have a choice of whether to participate in the qualified
auction by submitting its own auction response. The wholesaler could,
for example, use its selected price for execution of the segmented
order as the specified limit price in the qualified auction or,
alternatively, the wholesaler could pick a less aggressive price as the
specified limit price for the qualified auction and participate in the
qualified auction by submitting an auction response with its more
aggressive selected price. The open competition trading center
operating the qualified auction would widely disseminate an auction
message, which would include the specified limit price, in consolidated
market data that would invite auction responses. During the qualified
auction, the full range of market participants with the technological
capability of responding to a fast (sub-second) auction, such as
exchange market makers and institutional investors through their
broker-dealers' smart order routers (``SORs''), would have an
opportunity to compete to provide the best price for the segmented
order by submitting auction responses. If all or part of the segmented
order could be executed in the qualified auction at the specified limit
price or better, the open competition trading center operating the
qualified auction would execute the segmented order pursuant to the
execution priority rules set by the open competition trading center
running the qualified auction, consistent with the execution priority
requirements of Proposed Rule 615(c)(5). If the segmented order did not
receive a full execution in the qualified auction, the unexecuted
order, or unexecuted portion thereof, would be canceled back to the
wholesaler, who could, as soon as reasonably possible, execute the
segmented order, or unexecuted portion thereof, internally at a price
that was equal to or better for the segmented order than the specified
limit price. As discussed below, the wholesaler would not, however, be
required to execute the unexecuted segmented order or unexecuted
portion of the segmented order at the specified limit price. Any
unexecuted segmented order, or any unexecuted portion thereof, would
continue to be subject to the order competition requirements of
Proposed Rule 615(a).
Given the absence of a ``reserve price'' or ``backstop''
requirement, a segmented order would not have certainty of an execution
in a qualified auction at a price equal to the NBBO or better, but the
marketable orders of individual investors orders today also do not have
certainty of execution for orders routed to wholesalers. As shown in
Table 7 in section VII.B.4 below, 1.67% of marketable order shares in
NMS stocks (and 3.61% of marketable order shares in non-S&P 500 stocks)
receive executions at prices that are outside the NBBO at the time the
wholesaler received the order. This low percentage of orders executed
outside the NBBO when routed to wholesalers is consistent with the low
probability that the NBBO will move away from individual investor
orders in the very short time period of a qualified auction.\178\ For
the reasons discussed in section VII.C.2.b.i below, the Commission does
not believe that
[[Page 148]]
segmented orders would have significantly greater risk of inferior
execution prices under Proposed Rule 615 than currently provided by
wholesalers, but the variability of execution prices could increase.
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\178\ See infra section VII.C.2.b.i (the fade probability of the
NBBO prices goes from an average of 1.8% at 25 milliseconds after an
internalized individual investor order, to 2.8% at 100 milliseconds,
and to 4.6% at 300 milliseconds).
---------------------------------------------------------------------------
In sum, Proposed Rule 615 would allow segmented orders to continue
to be executed internally by a wholesaler or other restricted
competition trading center, but not until after the execution price had
been exposed to order-by-order competition in a fair and open qualified
auction. In addition, qualified auctions would give the trading
interest of other investors, particularly institutional investors, an
opportunity to interact directly (without the participation of a
dealer) with, and thus execute against, the marketable orders of
individual investors. When investor orders are able to interact
directly at a fully competitive price without the intermediation of a
wholesaler or other dealer, two investors (both the buyer and the
seller) are able to benefit mutually from a single trade, thereby
promoting the NMS objective that, consistent with the objectives of
economically efficient execution of securities transactions and the
practicability of brokers executing investors' orders in the best
market, investors' orders have an opportunity to be executed without
the participation of a dealer.\179\
---------------------------------------------------------------------------
\179\ See Section 11A(a)(1)(C)(v) of the Exchange Act.
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Proposed Rule 615 does not limit the types of broker-dealers that
would be permitted to submit segmented orders for execution in a
qualified auction. For example, a retail broker that currently routes
segmented orders directly to a wholesaler could instead route such
orders directly to a qualified auction with a specified limit price
selected by the retail broker. Such specified limit price would need to
be consistent with its best execution responsibilities and the terms of
the order as set by the customer. If the segmented order did not
receive an execution in the auction at the specified limit price, the
retail broker could, as soon as reasonably possible, route the
segmented order to a wholesaler with a representation that the
segmented order had cleared (i.e., not received an execution in) a
qualified auction at that price. The wholesaler then could, in
compliance with Proposed Rule 615, as soon as reasonably possible,
execute the segmented order internally at the specified limit price or
better.
If a segmented order did not receive an execution in a qualified
auction (regardless of whether submitted to the auction by a retail
broker, a wholesaler, or other broker-dealer), a wholesaler that
received such order following the conclusion of a qualified auction
would not be required by Proposed Rule 615 to execute the order
internally. If a wholesaler chose not to execute the order internally
following the conclusion of a qualified auction, the segmented order,
as with all segmented orders, would need to be further handled in
compliance with Proposed Rule 615. For example, (1) the wholesaler
could return the order to the retail broker or other broker-dealer for
further handling (such as resubmission to a qualified auction with a
revised specified limit price); (2) the wholesaler itself could
resubmit the segmented order to a qualified auction with a revised
specified limit price; \180\ or (3) the wholesaler could route the
order directly to an open competition trading center or national
securities exchange (as national securities exchanges are not
restricted competition trading centers subject to Proposed Rule 615(a))
for an immediate execution on its continuous order book. The decision
on how to handle segmented orders that clear qualified auctions without
executions also would be governed by the relevant best execution
responsibilities of retail brokers and wholesalers.
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\180\ The revised specified limit price set by the wholesaler
would have to be consistent with the terms of the order, such as the
limit price set by the customer, if any, as well as with the
wholesaler's best execution responsibilities.
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As indicated in the above example and subject to relevant best
execution responsibilities, a broker-dealer responsible for obtaining
the execution of a segmented order has the option of routing the order
directly to the continuous order book \181\ of an open competition
trading center or national securities exchange for execution, without
exposure in a qualified auction. The definition of restricted
competition trading center would exclude all open competition trading
centers and all national securities exchanges.\182\ They would be
excluded because both of these types of trading centers either are not
permitted by the Exchange Act currently, or would not be permitted by
Proposed Rule 615, to unfairly restrict access to their continuous
order books.\183\ Consequently, segmented orders routed directly to the
continuous order books of open competition trading centers and national
securities exchanges would be subject to competition to provide the
best prices on an order-by-order basis, and thus would not be
isolated.\184\
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\181\ See infra section IV.B.2 (discussing the proposed
definition of ``continuous order book'').
\182\ See Proposed Rule 600(b)(87) and discussion in section
IV.B.3 below.
\183\ Section III.B.2 above discusses the Exchange Act
provisions that currently prohibit a national securities exchange
from unfairly restricting access. Section IV.B.2 below discusses the
proposed access requirement for any open competition trading center
that is not a national securities exchange (i.e., an NMS Stock ATS).
In many cases, an open competition trading center also would be a
national securities exchange. As discussed in section IV.B.2 below,
however, some national securities exchanges would not meet the
definition of an open competition trading center.
\184\ As discussed in sections IV.D and IV.G below, open
competition trading centers and national securities exchanges would
not be allowed to operate a mechanism limited, in whole or in part,
to segmented orders, including RLPs, barring an exception from
Proposed Rule 615. See infra notes 258, 259 and accompanying text.
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Importantly, however, all relevant broker-dealer best execution
responsibilities would govern the extent to which segmented orders
could be routed to an open competition trading center or national
securities exchange without first clearing a qualified auction. As
discussed in section III.B.2 above, best execution generally requires a
broker-dealer to obtain the best terms reasonably available for
customer orders. Because liquidity providers can profitably offer
better prices to segmented orders of individual investors with low
adverse selection costs as compared to the prices they can offer other
types of order flow, trading mechanisms that offer such segmentation,
as would a qualified auction, are quite likely to obtain better prices
for segmented orders than other trading mechanisms, such as the
continuous order book of an open competition trading center or national
securities exchange, that commingle all types of order flow.\185\ A
broker-dealer would need to consider the opportunity for better prices
in its best execution analysis.
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\185\ See, e.g., infra section VII.C.1.b (discussing anticipated
benefits of improved execution quality for retail orders exposed in
qualified auctions).
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There may be market conditions when a best execution analysis could
indicate that a broker-dealer should route segmented orders directly to
the continuous order book of an open competition trading center or
national securities exchange. One example could be a ``fast market''--
when publicly quoted prices are moving rapidly away when a broker-
dealer receives a marketable order (that is, rapidly up in price for
orders to buy or rapidly down in price for orders to sell). In these
market conditions, the broker-dealer could determine that best prices
could be obtained by immediately attempting to execute segmented orders
against the NBBO on an open competition trading center or national
securities exchange,
[[Page 149]]
rather than first submitting segmented orders to qualified auctions
when market conditions suggest that auction would be unlikely to
generate better prices than the NBBO. Proposed Rule 615 is designed to
give broker-dealers sufficient flexibility to obtain best execution of
individual investor orders in the full range of market conditions.
B. Coverage of Proposed Rule 615
1. Definition of Segmented Order
The term ``segmented order,'' as proposed to be defined in Proposed
Rule 600(b)(91) \186\ of Regulation NMS, would have two parts. First,
the order for an NMS stock must be for an account of a natural person,
or an account held in legal form on behalf of a natural person or group
of related family members. Second, for such an account, the average
daily number of trades executed in NMS stocks must be less than 40 in
each of the preceding six calendar months. The intent of the proposed
definition is to encompass the marketable orders of individual
investors with expected low adverse selection costs that retail brokers
currently route to wholesalers for handling and execution. These orders
already are segmented in practice.
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\186\ Rule 600(b) of Regulation NMS sets forth defined terms.
Rule 600(b) would be amended to insert new defined terms used in
Proposed Rule 615, and existing defined terms would be renumbered
accordingly. Cross references to Rule 600(b) throughout the rules
and regulations under the Exchange Act would also be amended to
reflect the new numbering.
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The proposed definition's limitation to ``natural persons'' draws
on the approach in existing rules designed to identify the orders of
individual investors. For example, the definition of ``retail
customer'' in the Commission's Regulation Best Interest (``Regulation
BI'') is limited to a ``natural person.'' \187\ Moreover, several
national securities exchanges operate programs for trading ``retail''
orders that are limited to accounts of natural persons or certain
accounts on behalf of natural persons.\188\ The proposed definition of
segmented order is closely related to these rules,\189\ as well as to
FINRA's fee schedule for Nasdaq's Trade Repository Facility.\190\
Patterning the definition of segmented order on existing SRO rules is
designed to leverage market knowledge and to facilitate compliance with
Proposed Rule 615. This would help reduce the costs of compliance
because broker-dealers would already be familiar with identifying
orders as for the accounts of natural persons, or for related accounts,
in these other contexts. In addition to the accounts of natural persons
themselves, the definition would, again consistent with SRO rules,
cover accounts held in legal form on behalf of natural persons or
groups of related family members.
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\187\ 17 CFR 240.15l 1(b)(1) (defining ``retail customer'' as,
among other things, as a natural person who receives a
recommendation of any securities transaction from a broker-dealer
and uses the recommendation primarily for personal, family, or
household purposes). Proposed Rule 615 does not incorporate all of
the definition of ``retail customer'' in Regulation BI, because that
definition is limited to when there is a recommendation to a retail
customer. Proposed Rule 615, in contrast, is designed to promote
competition for individual investor orders, regardless of whether
such investor is self-directed. Moreover, Proposed Rule 615 is
focused on limiting the extent to which an account may generate
orders with a high level of adverse selection costs. As discussed
below, Proposed Rule 615 includes a trading activity threshold
designed to address this policy concern. The definition of ``retail
investor'' for purposes of 17 CFR 249.641 (``Form CRS'')
(Relationship Summary for Brokers and Dealers Providing Services to
Retail Investors) is also limited to ``natural persons'' and defines
``retail investor'' as a natural person, or the legal representative
of such natural person, who seeks to receive or receives services
primarily for personal, family or household purposes. In the context
of Form CRS, the term ``retail investor'' is used in connection with
disclosures to prospective customers, and as in the context of
Regulation BI, relates to the relationship between an investor and a
financial professional. See Securities Exchange Act Release No.
86031 (June 5, 2019), 84 FR 33318, 33345 (July 12, 2019) (adopting
Regulation Best Interest: The Broker-Dealer Standard of Conduct)
(''Regulation BI Adopting Release''). Because Proposed Rule 615 is
intended to improve competition for individual investor orders, and
is not related to the relationship between an investor and a
financial professional, the Commission is not proposing to include
the phrase ``primarily for personal, family, or household purposes''
in the definition of segmented order. For purposes of Proposed Rule
615, limiting segmented orders to orders for the accounts of natural
persons, and specifically those with less than 40 trades in NMS
stocks in each of the preceding 6 months, is intended to address
adverse selection costs and is not related to the purposes for which
a natural persons may be seeking the services of a broker-dealer.
\188\ See supra note 151 (generally describing exchange RLPs).
\189\ E.g., IEX Rule 11.190(b)(15) (providing, among other
things, that ``[a] Retail order must reflect trading interest of a
natural person'' and that ``[a]n order from a retail customer can
include orders submitted on behalf of accounts that are held in a
corporate legal form--such as an Individual Retirement Account,
Corporation, or a Limited Liability Company--that have been
established for the benefit of an individual or group of related
family members, provided that the order is submitted by an
individual.''); and Nasdaq, Equity 7, section 118 (defining a
``Designated Retail Order'' as originating from a ``natural person''
and explaining that ``[a]n order from a `natural person' can include
orders on behalf of accounts that are held in a corporate legal
form--such as an Individual Retirement Account, Corporation, or a
Limited Liability Company--that has been established for the benefit
of an individual or group of related family members, provided that
the order is submitted by an individual'').
\190\ FINRA Rule 7620A (defining a ``Retail Order'' as
originating from a ``natural person'' and explaining that ``[a]n
order from a `natural person' can include orders on behalf of
accounts that are held in a corporate legal form, such as an
Individual Retirement Account, Corporation, or a Limited Liability
Corporation that has been established for the benefit of an
individual or group of related family members, provided that the
order is submitted by an individual'').
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For purposes of the definition of ``segmented order,'' a ``group of
related family members'' would be defined broadly to include a group of
natural persons with any of the following relationships: child,
stepchild, grandchild, great grandchild, parent, stepparent,
grandparent, great grandparent, domestic partner, spouse, sibling,
stepbrother, stepsister, niece, nephew, aunt, uncle, mother-in-law,
father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-
in-law, including adoptive and foster relationships; and any other
natural person (other than a tenant or employee) sharing a household
with any of the foregoing natural persons.\191\ This definition is
designed to be broad so as not to restrict the types of arrangements
that may be set up to benefit family groups, including individual
retirement accounts, corporations, and limited liability companies for
the benefit of related family members.\192\
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\191\ Proposed Rule 600(b)(91)(iii).
\192\ Given the proposed broad definition of ``group of related
family members'' in Proposed Rule 600(b)(91), an account held in
legal form on behalf of a group of related family members could
include some accounts with an extensive portfolio of NMS stocks. The
second prong of the definition of segmented order, however, would
exclude accounts with average daily trades of 40 or more and likely
would exclude many accounts with large portfolios.
---------------------------------------------------------------------------
The second part of the proposed definition of segmented orders
focuses on the frequency of trading in an account. It would limit the
average daily number of trades executed in NMS stocks in an account to
less than 40 for each of the six preceding calendar months. This part
of the proposed definition would exclude very active traders whose
orders are likely to impose a much higher level of adverse selection
costs on liquidity providers than the less-active accounts that are
more typical of individual investors. For example, very active traders
may use sophisticated trading tools, such as application programming
interfaces (APIs) and computer algorithms, to submit their orders.
These tools can enable highly active trading strategies that impose
much higher adverse selection costs on liquidity providers than the
manual placement of orders by a natural person. Rather than prohibiting
any opportunity for investors to use potentially beneficial trading
tools,\193\ however, the proposed
[[Page 150]]
definition specifies a maximum level of trading activity as a means to
limit the level of adverse selection costs.
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\193\ Some SRO rules, for example, prohibit the use of any
computerized technology for submitting retail orders. See, e.g.,
NYSE Rule 7.44(a)(3) (defining ``retail order'' in the context of
NYSE's RLP to require that ``the order does not originate from a
trading algorithm or any other computerized methodology'').
---------------------------------------------------------------------------
The proposed level is supported by an analysis of the distribution
of order activity across accounts reported to the Consolidated Audit
Trail as being held for the benefit of an ``Individual Customer'' for
the first six months of 2022.\194\ Across this period, slightly more
than 99.9% of Individual Customer accounts originated, on an average
daily basis, 40 or fewer orders associated with a trade. The median
number of daily-average orders associated with a trade from accounts at
or below this threshold was less than one.\195\ The median number of
daily-average orders associated with a trade from accounts above this
threshold was approximately 68.\196\ Accordingly, the threshold in the
proposed rule is designed to capture the overwhelming majority of
individual investor accounts that could benefit from strengthened
competition for their orders, while excluding accounts that might
impose a high level of adverse selection costs on liquidity providers.
Including orders highly likely to impact short-term price changes in
qualified auctions could detract from the quality of execution prices
for segmented orders as a whole.\197\ Specifically, including orders
with high adverse selection costs in qualified auctions would increase
the overall level of adverse selection costs of the order flow
submitted to qualified auctions. Because auction responders could not
know in advance whether any particular order was likely to impose high
adverse selection costs, they would need to adjust the prices of all
their auction responses to reflect the higher level of adverse
selection costs of qualified auction order flow as a whole.
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\194\ Analysis of Consolidated Audit Trail data for all orders
originated from an account marked as held for the benefit of an
Individual Customer, Jan. 1, 2022, through June 30, 2022. This
analysis counted any order associated with one or more trades or
fills in an order lifecycle. For the Consolidated Audit Trail,
account type definitions are available in Appendix G to the CAT
Reporting Technical Specifications for Industry Members (https://catnmsplan.com), for the field name ``accountHolderType.'' Account
types represent the beneficial owner of the account for which an
order was received or originated, or to which the shares or
contracts are allocated. Possible types are: Institutional Customer,
Employee, Foreign, Individual Customer, Market Making, Firm Agency
Average Price, Other Proprietary, and Error. An Institutional
Customer account is defined by FINRA Rule 4512(c) as a bank,
investment adviser, or any other person with total assets of at
least $50 million. An Individual Customer account means an account
that does not meet the definition of an ``institution'' and is also
not a proprietary account. Therefore, the CAT account type
``Individual Customer'' includes natural persons as well as
corporate entities that do not meet the definitions for other
account types.
\195\ Id.
\196\ Id.
\197\ In other contexts, national securities exchanges currently
characterize certain types of orders according to the level of
activity associated with a market participant's account. With
respect to trading in listed options, several exchanges include the
concept of ``Professional'' order, and these orders, which must be
identified as such, are distinguished from other customer orders.
For example, pursuant to Cboe Exchange, Inc. (``CBOE'') Rule 1.1,
``Professional'' means any person or entity that is not a broker or
dealer in securities and places more than 390 orders in listed
options per day on average during a calendar month for its own
beneficial account(s). Under CBOE's rules, all Professional orders
are distinguished from other public customer orders (i.e., orders
for persons other than broker-dealers), must be marked as such, and
are handled by CBOE's trading platform in the same manner as broker-
dealer orders unless otherwise specified. See CBOE Rule 1.1. See
also NYSE Arca Rule 1.1; Nasdaq, Options 1, section 1(a)(47); and
BOX Rule 100(a)(52).
---------------------------------------------------------------------------
The proposed definition of segmented order does not have a size
limitation and therefore encompasses orders of all sizes, whether large
or small. As discussed in section IV.B.5 below, however, the execution
of large orders with sizes of $200,000 or more would be eligible for an
exception from the order competition requirement of Proposed Rule
615(a). Such orders would, however, remain segmented orders and, if
consistent with a broker-dealer's best execution responsibilities,
could be submitted for execution in a qualified auction.
Orders with small sizes would also be included in the proposed
definition of segmented orders and would be subject to the order
competition requirement. These include both odd lot orders with a size
of less than one round lot (generally less than 100 shares) and orders
with a fractional share component (less than one share). As discussed
further below, while orders for less than one share and orders for more
than one share with a fractional share component would also fall within
the proposed definition of a segmented order, Proposed Rule 615 would
include an exception for orders for less than one share and for the
fractional component of a segmented order, if there is no qualified
auction available for such orders.\198\
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\198\ See infra section IV.B.5.
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Finally, the proposed definition of a segmented order does not
include a limit price component. All segmented orders that are market
orders would be subject to the order competition requirement prior to
execution because, by definition, such orders are instructed to be
executed immediately at the best available prices. For segmented orders
that are limit orders, compliance with the order competition
requirement would depend on the relation of the segmented order's limit
price to the NBBO at the time it was received by the restricted
competition trading center. For segmented orders with limit prices that
are equal to or more favorable for the segmented order than the NBBO
midpoint at the time of receipt (lower for buy orders and higher for
sell orders), execution of the order would qualify for the exceptions
from the order competition requirement in paragraphs (b)(3) and (b)(4)
of Proposed Rule 615. Given the favorable price at which these non-
marketable orders would be executed, however, they often may be
publicly displayed as a means to attract contra-side trading interest
(as well as to comply with Rule 604 of Regulation NMS).
Segmented orders with a limit price that is less favorable for the
segmented order than the NBBO midpoint at the time of receipt (i.e.,
segmented buy orders with a limit price higher than the NBBO midpoint
and segmented sell orders with a limit price lower than the NBBO
midpoint) often would not be executed at the NBBO midpoint or better
(and therefore would not qualify for the exceptions in paragraphs
(b)(3) or (b)(4) of Proposed Rule 615(b)(3)). Those orders not executed
at the NBBO midpoint or better necessarily will pay a half-spread of
some amount on the transaction (i.e., orders executed beyond the NBBO
midpoint, by definition, are paying a spread), even if it is less than
the full NBBO half-spread. These include segmented orders that are
marketable and a subset of non-marketable limit orders with limit
prices that are beyond the NBBO midpoint but within the far-side NBBO
(lower than the national best offer for segmented orders to buy and
higher than the national best bid for segmented orders to sell)
(hereinafter referred to as ``beyond-the-midpoint non-marketable limit
orders''). A broker-dealer responsible for handling this subset of
segmented orders that are non-marketable would need to determine how to
achieve best execution of such orders. Under the limit order display
requirements of Rule 604 of Regulation NMS, as discussed in section
III.B.2.a above, such an order generally would need to be immediately
displayed (which would narrow the NBBO spread) or immediately executed.
To immediately execute the order, a restricted competition trading
center would need to comply with the order competition requirement of
Proposed Rule 615(a).
[[Page 151]]
2. Definition of Open Competition Trading Center
The term ``open competition trading center,'' as proposed to be
defined in Rule 600(b)(64), determines the scope of coverage of
Proposed Rule 615 in two important respects. First, it identifies those
trading centers that would be authorized to operate qualified auctions.
Second, it conversely specifies those trading centers that would be
subject to the order competition requirement of paragraph (a) of
Proposed Rule 615 because a ``restricted competition trading center''
is defined as any trading center other than an open competition trading
center or a national securities exchange.
The proposed definition of open competition trading center is
designed to address three primary concerns. First and foremost, trading
centers that operate qualified auctions must offer sufficient access,
transparency, and trading by a wide range of market participants to
support the goal of fair competition in auctions to provide the best
prices for investor orders. Second, the proposed definition of open
competition trading center seeks to establish as level a regulatory
playing field as possible regarding Proposed Rule 615 between the
national securities exchanges and NMS Stock ATSs \199\ that are
eligible to operate a qualified auction, while recognizing the distinct
regulatory regimes for national securities exchanges under the Exchange
Act and for NMS Stock ATSs under Regulation ATS.\200\ As described in
section III.A above, section 11A(c)(1)(F) of the Exchange Act grants
rulemaking authority to the Commission to assure equal regulation of
all markets for NMS stocks, with equal regulation defined in section
3(a)(36) to mean that no member of a class has a competitive advantage
over any other member of a class resulting from a regulatory disparity
that the Commission determines is unfair and not necessary or
appropriate in furtherance of the purposes of the Exchange Act.\201\
Qualified auctions would be a new trading mechanism, mandated by rule
in some contexts, that could be operated by both national securities
exchanges and NMS Stock ATSs, and open competition trading centers
would be a new class of market participants. Because national
securities exchanges and NMS Stock ATSs operating as open competition
trading centers would fall within the same class of market participant,
and given the functional similarity between these two types of trading
centers, neither type should have a competitive advantage in operating
qualified auctions that is attributable to an unfair and unnecessary
regulatory disparity.\202\ Third, the proposed definition of open
competition trading center is designed to address a concern that
qualified auctions, as a new mandatory mechanism for execution of
segmented orders, should not further exacerbate the fragmentation of
trading interest in NMS stocks among different trading centers that
already characterizes the NMS. As discussed in section VII.B.1 below,
trading centers for NMS stocks include 16 national securities
exchanges, 32 NMS Stock ATSs,\203\ 6 wholesalers, and more than 230
other broker-dealers. Allowing only national securities exchanges and
NMS Stock ATSs that meet the prescribed transparency and volume
thresholds to meet the proposed definition of open competition trading
center is also designed to prevent additional complexity and
connectivity costs to market participants arising from the introduction
of qualified auctions. Such trading centers that meet the proposed
definition are likely to have already attracted a wide variety of
market participants with the established connectivity necessary to
promote vigorous competition in qualified auctions.
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\199\ The Commission is proposing that for purposes of
Regulation NMS, which would include Proposed Rule 615, NMS Stock
ATS, as would be defined in Proposed Rule 600(b)(59), will have the
meaning provided in 17 CFR 242.300(k) (Rule 300(k) of Regulation
ATS).
\200\ A trading center that operates a qualified auction for
segmented orders necessarily would fall within the definition of an
exchange under section 3(a)(1) of the Exchange Act [15 U.S.C.
78c(a)(1)], and 17 CFR 240.3b-16(a) (``Rule 3b-16(a)'') thereunder,
because it would be bringing together the orders of multiple buyers
and sellers using established non-discretionary methods (i.e., the
qualified auction trading facility) under which such orders would
interact and the buyers and sellers would agree upon terms of a
trade. If a trading center falls within the definition of an
exchange, it either must register as an exchange or comply with an
exemption to such registration, such as the exemption for ATSs under
Regulation ATS.
\201\ 15 U.S.C. 78c(a)(36). In discussing equal regulation in
the context of Exchange Act Section 11A(c)(1), the Commission stated
that the legislative history of section 3(a)(36) emphasizes that
equal regulation ``is a competitive concept intended to guide the
Commission in its oversight and regulation of the trading markets
and the conduct of the [s]ecurities industry.'' See Securities
Exchange Act Release No. 42208 (Dec. 1999), 64 FR 70613, 70623 n.80
(Dec. 17, 1999) at 70623 n.80 (Concept Release on Market Information
Fees and Revenues) (quoting S. Rep. No. 94-75, 94th Cong., 1st Sess.
7 (1975) at 94).
\202\ The Commission has expressed, in other contexts, its
belief that the regulatory differences between NMS Stock ATSs and
national securities exchanges may create a competitive imbalance
between two functionally similar trading centers, and sought to
address those concerns by more closely aligning certain requirements
for NMS Stock ATSs with those of national securities exchanges. See,
e.g., ATS-N Adopting Release, supra note 159, 83 FR at 38775-76.
\203\ As of Sept. 30, 2022, there were 32 NMS Stock ATSs that
had filed an effective Form ATS-N with the Commission.
---------------------------------------------------------------------------
Given the differing regulatory regimes for national securities
exchanges and NMS Stock ATS that were described in section III above,
the elements of the proposed definition of open competition trading
center vary for national securities exchanges and NMS Stock ATSs. As
discussed in section IV.D below, paragraph (d) of Proposed Rule 615
would prohibit both national securities exchanges and NMS Stock ATSs
from operating a qualified auction if they do not meet the elements of
the definition of an open competition trading center.
a. National Securities Exchanges
As discussed in section III.A above, the Exchange Act sets forth a
comprehensive regulatory regime for national securities exchanges with
a variety of requirements that address, among other things, access and
competition. For example, national securities exchanges must allow any
registered broker-dealer to become a member, subject to the limitations
of section 6(c) of the Exchange Act, and their rules cannot impose a
burden on competition not necessary or appropriate in furtherance of
the purposes of the Exchange Act. The Commission has crafted the
proposed definition of open competition trading center for national
securities exchanges having taken into account that such exchanges
already are subject by statute to this regulatory regime.
The proposed definition of open competition trading center for
national securities exchanges has four elements. First, such an
exchange would be required to operate a trading facility that is an
automated trading center and displays automated quotations that are
disseminated in consolidated market data pursuant to Rule 603(b) of
Regulation NMS. The terms ``automated trading center'' and ``automated
quotation'' are defined in Rule 600(b)(8) and Rule 600(b)(7) of
Regulation NMS. Each is an element of the definition of a ``protected
bid or protected offer'' in Rule 600(b)(70), which are eligible for
protection against trade-throughs pursuant to Rule 611 of Regulation
NMS. Rule 603(b) provides for the dissemination of consolidated market
data by SROs. This element of the proposed definition of an open
competition trading center would help ensure transparency of quotations
and fair and efficient access to such quotations. It is also designed
to ensure that qualified auctions are held on lit
[[Page 152]]
trading centers, and that the requirements for open competition trading
centers are consistent between national securities exchanges and NMS
Stock ATSs. Also, incorporating the requirements for an automated
trading center and automated quotations would help ensure that such
exchange has the necessary technology to run qualified auctions
efficiently.
Second, a national securities exchange would be required to provide
transaction reports identifying it as the venue of execution that are
disseminated in consolidated market data pursuant to Rule 603(b).
Identifying the venue of execution would help market participants
assess where liquidity for an NMS stock can be found in the NMS,
including for qualified auctions. Current arrangements for
disseminating consolidated market data provide this execution venue
information for exchanges, but not, as discussed below, for NMS Stock
ATSs. This requirement is designed to provide a parallel requirement
for national securities exchanges and NMS Stock ATSs operating
qualified auctions, and require the identification of the venue of
execution by rule for national securities exchanges operating as open
competition trading centers.
Third, a national securities exchange would be required to have had
an average daily share volume of 1.0 percent or more of the aggregate
average daily share volume for all NMS stocks as reported by an
effective transaction reporting plan during at least four of the
preceding six calendar months.\204\ The proposed 1.0 percent threshold
across all NMS stocks, and not merely for a single NMS stock, is
designed to help ensure that, prior to operating a qualified auction,
the national securities exchange has attracted a wide range of market
participants with connectivity to such exchange already in place that
would be sufficient to support vigorous competition in qualified
auctions to provide the best prices for segmented orders. As of
September 30, 2022, 6 of the 16 national securities exchanges trading
NMS stocks reported less than 1% of share volume in NMS stocks.\205\
Five of these (Nasdaq BX, Nasdaq Phlx, NYSE American, NYSE CHX, and
NYSE National), however, were part of exchange groups with other
national securities exchanges that reported more than 1% of share
volume in NMS stocks. Any exchange that was below the 1% threshold,
even if it were part of a group of exchanges with some exchanges that
meet the threshold, would not meet the definition of an open
competition trading center and could not operate a qualified auction.
The one remaining national securities exchange that reported less than
1% of share volume in NMS stocks was LTSE, with less than 0.01% of
share volume in NMS stocks.
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\204\ As discussed in section IV.B.2.b below, NMS Stock ATSs
operating as open competition trading centers would be subject to
the same volume threshold.
\205\ See, e.g., Cboe, U.S. Historical Market Volume Data,
available at https://cboe.com/us/equities/market_statistics/historical_market_volume/.
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The 1% threshold also would impose a hurdle for a new entrant that
wished to register as a national securities exchange to become an open
competition trading center. In the absence of a minimum volume
threshold, however, the introduction of qualified auctions as a new
trading mechanism mandated by regulation could lead to the entry of
multiple new national securities exchanges intended solely to operate
qualified auctions, which could result in either (1) a substantial
increase of connectivity costs and complexity for market participants
to connect to every open competition trading center, or (2) a refusal
of many market participants to incur such costs and complexity, which
could detract from the level of competition to provide the best prices
for segmented orders at open competition trading centers with
relatively few connected market participants. The 1% threshold is
designed to be low enough to help ensure that the core competition
objective of Proposed Rule 615 is achieved through qualified auctions
operated by multiple national securities exchanges, while being high
enough to demonstrate that a national securities exchange has attracted
a sufficient level of interest from market participants to avoid unduly
exacerbating the already substantial level of fragmentation in NMS
stocks.
Given that only a small percentage of marketable orders of
individual investors currently are routed to national securities
exchanges, the competitive opportunity to operate qualified auctions
that would enable their members and members' customers to interact with
low-cost marketable order flow is likely to be an attractive new line
of business. If, for example, a single national securities exchange
began operating qualified auctions, it would have a monopoly on the
business, which would be quite likely to attract multiple additional
competitors. It therefore is likely that each of the three exchange
groups associated with CBOE, Nasdaq and NYSE would select one of their
national securities exchanges to operate qualified auctions,\206\ and
the three non-group national securities exchanges that exceed the 1%
threshold would operate qualified auctions as well.
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\206\ See infra note 276 and accompanying text.
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Fourth and finally, a national securities exchange would be
required to operate pursuant to its own rules providing that such
exchange will comply with the proposed requirements for qualified
auctions in paragraph (c) of Proposed Rule 615. This element would help
to ensure that the operation of a qualified auction would be fully
described in the exchange's rules and that the exchange's compliance
with those rules would be subject to the examination and enforcement
tools in place for exchange rules.\207\ Market participants therefore
would be able to reference the rules of a national securities exchange
to determine whether it operates a qualified auction and the material
terms of such auctions, including the hours of operation.
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\207\ Also, because national securities exchanges must file with
the Commission proposed changes to their rules, an exchange's
adoption of rules for operating qualified auctions would be subject
to public notice, comment, and Commission review, as well as
Commission oversight. See 15 U.S.C. 78s(b).
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b. NMS Stock ATSs
As discussed above in section III.B, NMS Stock ATSs are subject to
a quite different set of statutory and regulatory requirements than
national securities exchanges. The definition of open competition
trading center for NMS Stock ATSs would reflect these differences and
includes seven elements.
First, an NMS Stock ATS would be required to display quotations
through an SRO display-only facility (currently, the only such facility
is FINRA's ADF) in compliance with Rule 610(b) of Regulation NMS.\208\
To add an NMS Stock ATS as a new ADF participant, FINRA would need to
file a proposed rule change that, after an opportunity for public
notice and comment and review by the Commission, became effective
pursuant to section 19(b) of the Exchange Act and Rule 19b-4
thereunder.\209\ An NMS Stock ATS, by displaying quotations in the ADF
that
[[Page 153]]
FINRA provides to the SIPs, would have established an ability to
disseminate information in consolidated market data, as would be
required for auction messages under Proposed Rule 615(c)(1). In
addition, as discussed in section III.B above, Rule 610(b) imposes
heightened connectivity obligations on an NMS Stock ATS that displays
quotations in the ADF, which would help assure that market participants
have fair and efficient access to any NMS Stock ATS that wished to
operate a qualified auction. This requirement is not needed for
national securities exchanges, which, as discussed in section III.A
above, are subject to a series of Exchange Act access requirements.
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\208\ Under Rule 600(b)(88), the term ``SRO display-only
facility'' means a facility operated by or on behalf of a national
securities exchange or national securities association that displays
quotations in a security, but does not execute orders against such
quotations or present orders to members for execution. As discussed
above in section III.B.3, FINRA's ADF is the only SRO display-only
facility, but currently has no participating members.
\209\ See Regulation NMS Adopting Release, supra note 78, 70 FR
at 37543 (addition of ADF participant would constitute a change to a
material aspect of FINRA's facilities that would require the filing
of a proposed rule change).
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Second, an NMS Stock ATS would be required to operate as an
automated trading center and display automated quotations that are
disseminated in consolidated market data pursuant to Rule 603(b) of
Regulation NMS. This element matches an element of the proposed
definition of open competition trading center for national securities
exchanges and is proposed for the same reason.
Third, an NMS Stock ATS would be required to identify the NMS Stock
ATS as the venue of execution in transaction reports that are
disseminated in consolidated market data pursuant to Rule 603(b). As
discussed above, this element also would be required for national
securities exchanges and is designed to help market participants assess
where liquidity can be found in the NMS for a particular NMS stock. In
contrast to the transaction reports of national securities exchanges,
the transaction reports of off-exchange venues that FINRA currently
provides for dissemination in consolidated market data do not identify
the particular FINRA member (including both NMS Stock ATSs and broker-
dealers) that reported the trade. For NMS Stock ATSs that display
quotations in the ADF and operate qualified auctions, full post-trade
transparency concerning the identity of the NMS Stock ATS that executed
trades, including the execution of segmented orders in qualified
auctions, would be needed to promote fair competition among markets and
the practicability of broker-dealers determining the best market for
executing customer orders. For example, real-time dissemination of a
transaction report indicating that an NMS Stock ATS had executed a
segmented order in an NMS stock in a qualified auction could assist
broker-dealers in identifying where to route segmented orders, as well
as market participants in identifying where they could interact with
segmented orders in qualified auctions. Accordingly, if Proposed Rule
615 were adopted, an NMS Stock ATS would not be able to meet the
definition of an open competition trading center unless the effective
NMS plans for NMS stocks were conformed to provide for the collection
and dissemination of an identification of the NMS Stock ATS as the
venue of execution in its transaction reports.
Fourth, an NMS Stock ATS would be required to permit any registered
broker-dealer to become a subscriber,\210\ except those with statutory
disqualifications or financial responsibility or operational capability
concerns. This element parallels the Exchange Act section 6(b)(2)
requirement that, subject to the provisions of section 6(c), a national
securities exchange must permit any registered broker-dealer to become
a member. It thereby would help ensure that all market participants
seeking to trade on an NMS Stock ATS, whether they be broker-dealers
trading proprietarily or investors trading through the services of a
broker-dealer, would have access to the NMS Stock ATS in the same
manner as they have access to national securities exchanges. An NMS
Stock ATS could not, however, permit a registered broker-dealer subject
to a statutory disqualification to become a subscriber.\211\ In
contrast, national securities exchanges may, subject to Commission
oversight, allow a registered broker-dealer with a statutory
disqualification to become a member.\212\ The stricter standard for NMS
Stock ATSs is appropriate because, as non-SROs, they are not subject to
the same level of Commission oversight as national securities
exchanges.\213\ For example, section 6(c)(2) of the Exchange Act
provides that a national securities exchange must file notice with the
Commission not less than thirty days prior to admitting any person to
membership, if the exchange knew, or in the exercise of reasonable care
should have known, that such person was subject to a statutory
disqualification. An NMS Stock ATS is not subject to this notice
requirement. An NMS Stock ATS could, however, pursuant to written
policies and procedures, prohibit any registered broker-dealer from
becoming a subscriber, or impose conditions upon such a subscriber,
that did not meet specified standards of financial responsibility and
operational capability.\214\ This ability to prohibit or limit
subscribers is patterned on the ability of national securities
exchanges under section 6(c)(3)(A) of the Exchange Act,\215\ which also
permits a national securities exchange to deny or condition membership
to a broker-dealer that has engaged, and is reasonably likely to engage
again, in acts or practices inconsistent with just and equitable
principles of trade. It would not be appropriate for NMS Stock ATSs, as
non-SROs, to have this disciplinary authority over its subscribers.
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\210\ NMS Stock ATSs generally have subscribers, unlike national
securities exchanges with self-regulatory responsibilities for
members. The proposed definition of ``subscriber'' in Rule
600(b)(100) of Regulation NMS is a cross-reference to the definition
of ``subscriber'' in 17 CFR 242.300(b) (Rule 300(b) of Regulation
ATS). The Regulation ATS definition is being proposed to be used in
this context to leverage industry experience and help minimize
compliance costs.
\211\ Proposed Rule 600(b)(64)(ii)(D)(1).
\212\ Pursuant to Exchange Act section 6(c)(2), a national
securities exchange may, and in cases in which the Commission, by
order, directs as necessary or appropriate in the public interest or
for the protection of investors shall, deny membership to any
registered broker or dealer or natural person associated with a
registered broker or dealer, and bar from becoming associated with a
member any person, who is subject to a statutory disqualification.
If a national securities exchange knowingly allows a registered
broker-dealer with a statutory disqualification to become a member,
or should have known in the exercise of reasonable care, section
6(c)(2) further requires the national securities exchange to file
notice with the Commission.
\213\ See, e.g., Regulation ATS Adopting Release, 63 FR at 70858
(discussing when ATS regulation may not be appropriate and stating
that ``it may be necessary for the Commission's greater oversight
authority over registered exchanges to apply'').
\214\ An NMS Stock ATS must disclose on its Form ATS-N whether
it can exclude, in whole or in part, any subscriber from the ATS's
services, and if so, it must provide a summary of the conditions for
excluding, in whole or in part, a subscriber from those services.
Form ATS-N, Part III, Item 3.a. Consequently, an NMS Stock ATS would
be required to disclose its policies and procedures for excluding a
broker-dealer on its Form ATS-N. Additionally, an NMS Stock ATS that
is subject to the fair access requirements of Rule 301(b)(5) (see
supra section III.B.3), must also disclose a list of all persons
granted, denied, or limited access to the ATS during the quarterly
period covered by the report, and, among other things, the nature of
any denial or limitation of access. Form ATS-R, Instruction 8 and
Item 7.
\215\ Pursuant to Exchange Act section 6(c)(3), a national
securities exchange may deny membership to, or condition the
membership of, a registered broker or dealer if such broker or
dealer does not meet such standards of financial responsibility or
operational capability or such broker or dealer or any natural
person associated with such broker or dealer does not meet such
standards of training, experience, and competence as are prescribed
by the rules of the exchange.
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Fifth, an NMS Stock ATS would be required to provide equal access
among all subscribers of the NMS Stock ATS and the registered broker-
dealer of the NMS Stock ATS to all services that are related to a
qualified auction operated by the NMS Stock ATS under Proposed Rule
615(c) and to any continuous order book operated by the NMS Stock ATS.
[[Page 154]]
This equal access element would require an NMS Stock ATS to provide
access on the same terms and conditions among all subscribers and the
registered broker-dealer of the NMS Stock ATS. It therefore would
impose a more stringent standard on NMS Stock ATSs than the ``no unfair
discrimination'' standard for national securities exchanges under
section 6(b)(5) of the Exchange Act. The more stringent standard is
designed to reflect the different statutory and regulatory regimes for
NMS Stock ATSs and national securities exchanges and particularly to
help achieve the goal of equal regulation, as defined in section
3(b)(36) of the Exchange Act and described in section III.A above.
For example, as discussed in section III above, national securities
exchanges must comply with a variety of statutory requirements that are
not applicable to NMS Stock ATSs. While they fall within the statutory
definition of an exchange, NMS Stock ATSs have been exempted from
compliance with the statutory requirements for registered national
securities exchanges if they are registered as a broker-dealer and
comply with Regulation ATS. Among other things, the rules for all
national securities exchanges (1) must be designed affirmatively to
remove impediments to and perfect the mechanism of a free and open
market and an NMS; (2) must not be designed to permit unfair
discrimination between customers, issuers, or broker-dealers; and (3)
must not impose any burden on competition that is not necessary or
appropriate in furtherance of the purposes of the Exchange Act.\216\
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\216\ As discussed above, in comparison, national securities
exchanges are also required to file proposed rule changes to
establish or modify trading services, which must be published for
public comment. See supra notes 68-71, 207, and accompanying text.
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Each of the foregoing requirements promotes the objective of
ensuring fair and efficient access to the trading services of national
securities exchanges, which is essential for promoting fully
competitive pricing in qualified auctions, but none applies to NMS
Stock ATSs. While they must file amendments to Form ATS-N, the
amendments are not published for public comment and do not require
Commission approval prior to implementation. Moreover, the standards
for access to NMS Stock ATSs are much more limited than those that
apply to national securities exchanges.\217\ An NMS Stock ATS must
comply with the fair access requirement of Rule 301(b)(5) only for a
particular NMS stock in which it exceeds 5% of volume.\218\ As
discussed above in sections II.B and III.B.3.b, only one NMS Stock ATS
discloses on its Form ATS-N that it is subject to this fair access
requirement for securities that are available for trading on its
platform. Most importantly, in light of the core order competition
requirement of Proposed Rule 615, Regulation ATS does not impose any
requirement on NMS Stock ATSs that is equivalent to section 6(b)(8) of
the Exchange Act, which prohibits national securities exchanges from
imposing any burden on competition not necessary or appropriate in
furtherance of the provisions of the Exchange Act.
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\217\ See, e.g., ATS-N Adopting Release, supra note 159, 83 FR
at 38841.
\218\ 17 CFR 242.301(b)(5)(i).
---------------------------------------------------------------------------
Given that NMS Stock ATSs currently are subject to different
requirements for promoting fair and efficient access to their trading
services than are national securities exchange, the Commission believes
an NMS Stock ATS should be required to meet a more stringent standard
to help ensure equal regulation regarding Proposed Rule 615 and
sufficient access and transparency for a wide range of market
participants. Accordingly, an NMS Stock ATS would, if it wished to
operate a qualified auction under Proposed Rule 615, be required to
provide equal access to all trading services related to its qualified
auctions, as well as to all trading services related to a continuous
order book operated by the NMS Stock ATS. The extension of equal access
to services related to a continuous order book is needed because, as
discussed in section IV.C below, such a book would be required to be
integrated with qualified auctions.\219\ The proposed equal access
requirement is designed to help ensure a level playing field regarding
Proposed Rule 615 for competition among national securities exchanges
and NMS Stock ATSs and thereby promote the Exchange Act principle of
equal regulation. Specifically, consistent with the NMS objective in
section 11A(1)(C)(ii) of promoting fair competition among markets,
neither type of trading center should have a significant regulatory
advantage for operating qualified auctions that could drive volume in
such auctions to either type, whether it be national securities
exchanges or NMS Stock ATSs.
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\219\ As discussed below in section IV.C.5, a displayed order
resting on the continuous order book would have priority over an
equally-priced auction response, and an undisplayed order resting on
the continuous order books would have priority if it provided a
better price for a segmented orders than an auction response.
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Sixth, an NMS Stock ATS would be required to have had an average
daily share volume of 1.0 percent or more of the aggregate average
daily share volume for NMS stocks as reported by an effective
transaction reporting plan during at least four of the preceding six
calendar months.\220\ The methodology for this calculation would be the
same as prescribed for application of the fair access requirements of
ATSs by Rule 301(b)(5)(i)(A) of Regulation ATS, except that the
numerator and denominator in the percent calculation is volume in all
NMS stocks, rather than in any particular NMS stock. As with the fair
access requirement, the proposed methodology is designed to encompass
NMS Stock ATSs that have demonstrated a consistent historical level of
volume. To promote fair competition and equal regulation, this proposed
element is the same as that proposed for national securities exchanges
and is proposed for the same primary reasons--(1) to help ensure that
an NMS Stock ATS has attracted a wide range of market participants with
connectivity already in place that would be sufficient to support
vigorous competition in qualified auctions to provide the best prices
for segmented orders; and (2) to avoid exacerbating the costs and
complexity of fragmentation that already exists of trading interest in
NMS stocks.
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\220\ A 1% volume threshold in NMS stocks is also one of the
thresholds used to determine whether an NMS Stock ATS is an SCI
entity subject to the requirements of 17 CFR 242.1000 through
242.1007 (``Regulation SCI''). See 17 CFR 242.1000 paragraph (1)(ii)
of ``SCI alternative trading system or SCI ATS'' definition, and
``SCI entity'' definition. Among other things, each SCI entity is
required to comply with the capacity, integrity, resiliency,
availability, and security requirements of Rule 1001 of Regulation
SCI. In adopting a volume threshold for NMS Stock ATSs for purposes
of Regulation SCI, the Commission recognized that certain ATSs play
an important role in today's securities markets, and that higher
volume ATSs collectively represent a significant source of liquidity
for NMS stocks, with some ATSs having similar and, in some cases,
greater trading volume than some national securities exchanges. See
Securities Exchange Act Release No. (Nov. 19, 2014), 73639 79 FR
72252, 72262 (Dec. 5, 2014) (adopting Regulation SCI and related
amendments to Regulation ATS).
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Seventh and finally, an NMS Stock ATS would be required to operate
pursuant to an effective Form ATS-N that sets forth the operations of
the qualified auction and compliance by the NMS Stock ATS with the
requirements of Proposed Rule 615(c) for a qualified auction, as well
as with all of the other elements of the definition of open competition
trading center for NMS Stock ATSs that are discussed above. This
proposed disclosure element is designed to ensure that an NMS Stock ATS
fully discloses material operating
[[Page 155]]
practices to the public on Form ATS-N, and that these operating
practices are subject to the examination and enforcement tools in place
for NMS Stock ATSs. Market participants therefore would be able to
reference the Form ATS-N of an NMS Stock ATS to determine whether it
operates a qualified auction and the material terms of such auctions,
including the hours of operation.
3. Definition of Restricted Competition Trading Center
The proposed definition of restricted competition trading center
\221\ encompasses any trading center that is neither an open
competition trading center nor a national securities exchange. Some
national securities exchanges may not meet all of the elements of the
proposed definition of an open competition trading center, such as the
minimum 1% volume threshold. Nevertheless, all national securities
exchanges, as well as open competition trading centers, would be
excluded from the definition of restricted competition trading center
because both these types of trading centers either are not permitted by
the Exchange Act (in the case of all national securities exchanges) or
would not be permitted by Proposed Rule 615(d)(1) and its incorporation
of the proposed definition of an open competition trading center (in
the case of NMS Stock ATSs) to unfairly restrict access to their
platforms.
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\221\ Proposed Rule 600(b)(87).
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Currently, no NMS Stock ATS displays quotations in the ADF. Unless
this changes,\222\ no NMS Stock ATS would meet the proposed definition
of an open competition trading center, and therefore all would be
restricted competition trading centers. The three other types of
broker-dealer trading centers are exchange market makers, OTC market
makers (including wholesalers), and internalizing broker-dealers.\223\
These broker-dealers, as stated in section IV.B.2 above, could not
operate a qualified auction without falling within the Exchange Act
definition of exchange.\224\ Unless such a broker-dealer became an NMS
Stock ATS and met all of the elements of the proposed definition of an
open competition trading center, it would fall within the definition of
a restricted competition trading center and would be subject to the
order competition requirements of Proposed Rule 615(a).
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\222\ See supra note 208.
\223\ See supra section II.B.
\224\ See supra note 200 and accompanying text.
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4. Definition of Originating Broker
As discussed in section IV.E below, originating brokers would
perform several vital functions under Proposed Rule 615, including
making the original determination that an order falls within the
definition of a segmented order and identifying the order as such when
routed for execution. The proposed definition of originating broker
\225\ reflects these important functions. It would cover any broker
with responsibility for handling a customer account, including, but not
limited to, opening and monitoring the customer account and accepting
and transmitting orders for the customer account.\226\ As such and as
discussed further below, there may be more than one originating broker
for a particular customer account.
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\225\ Proposed Rule 600(b)(69).
\226\ The broker-dealer functions specifically enumerated in the
proposed definition of originating broker are included in the list
of responsibilities that FINRA requires its members to allocate for
accounts that are carried on an omnibus or fully disclosed basis.
See infra note 227. See also Securities Investment Advisers Act
Release No. 5429 (June 5, 2019), 84 FR 33681 (July 12, 2019)
(clarifying the scope of the broker-dealer exclusion from the
definition of ``investment adviser'' under the Investment Advisers
Act of 1940 for broker-dealers whose performance of advisory
services is ``solely incidental'' to the conduct of its business as
a broker-dealer and for which the broker-dealer ``receives no
special compensation''); and Regulation BI Adopting Release, supra
note 187, at 33358 (discussing disclosure requirements for broker-
dealers related to ``monitoring the performance of the retail
customer's account'').
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The Commission understands that broker business practices can vary
widely in terms of how customer accounts are handled. Some brokers may
perform this entire function internally, while others may work with
additional brokers to handle customer orders. A single broker that is
solely responsible for the handling of a customer account would be an
originating broker. To the extent that multiple brokers perform
different functions for a customer account (sometimes referred to as
``introducing brokers,'' ``carrying brokers,'' or ``clearing
brokers''), each such broker would be an originating broker. In
addition, as discussed further in section IV.E below, different types
of brokers enter into agreements with one another to allocate certain
responsibilities with respect to their handling of customer
accounts.\227\ As discussed in section IV.C.1 below, paragraph
(c)(1)(ii) of Proposed Rule 615 specifies that, if multiple brokers for
a segmented order fall within the proposed definition of originating
broker, the broker responsible for approving the opening of accounts
for customers (commonly performed by an introducing broker) would be
required to be identified in auction messages under Proposed Rule
615(c)(1).
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\227\ FINRA Rule 4311 addresses the allocation of
responsibilities between members for accounts that are carried on an
omnibus or fully disclosed basis. FINRA Rule 4311(c)(1) specifies
the minimum requirements for carrying agreements in which accounts
are carried on a fully disclosed basis. FINRA Rule 4311(c)(1)
(``Each carrying agreement in which accounts are to be carried on a
fully disclosed basis shall specify the responsibilities of each
party to the agreement, including at a minimum the allocation of the
responsibilities set forth in paragraphs (c)(1)(A) through (I) and
(c)(2) of this Rule.''); FINRA Rules 4311(c)(1)(A) through (I)
(``(A) Opening and approving accounts. (B) Acceptance of orders. (C)
Transmission of orders for execution. (D) Execution of orders. (E)
Extension of credit. (F) Receipt and delivery of funds and
securities. (G) Preparation and transmission of confirmations. (H)
Maintenance of books and records. (I) Monitoring of accounts.'');
FINRA Rule 4311(c)(2) (prescribing the requirements for how each
carrying agreement in which accounts are to be carried on a fully
disclosed basis must allocate responsibility for the safeguarding of
funds and securities, and the preparing and transmitting of
statements of accounts to customers). FINRA Rules are available at
https://www.finra.org/rules-guidance/rulebooks/finra-rules.
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5. Exceptions
Paragraph (b) of Proposed Rule 615 sets forth five exceptions from
the order competition requirement of paragraph (a). The first exception
is for a segmented order that is received and executed by a restricted
competition trading center during a time period when no open
competition trading center is operating a qualified auction for the
segmented order. This exception would be necessary to enable segmented
orders to trade during such a time period, since compliance with
Proposed Rule 615 would otherwise be impossible if no qualified auction
were available. Proposed Rule 615 does not specify any particular time
period during which an open competition trading center must operate a
qualified auction. Given, however, the requirement in paragraph (c)(3)
of Proposed Rule 615 that auction messages must be provided for
dissemination in consolidated market data,\228\ a qualified auction
could not operate at any time when the facilities for disseminating
consolidated market data were not operating. As discussed in section
III.B above, such facilities currently are operated by the SIPs. The
current SIP hours of operation are from 4 a.m. to 8 p.m. eastern time
on trading days for the U.S. equity markets. While the trade-through
restrictions of Rule 611 of Regulation NMS apply only
[[Page 156]]
during regular trading hours of 9:30 a.m. to 4:00 p.m. eastern
time,\229\ the order competition requirement of Proposed Rule 615(a) is
needed for additional hours given the enhanced risks for individual
investors. Unlike Rule 611, Proposed Rule 615 is narrowly targeted on
protecting the interests of individual investors and the risks they
face when using marketable orders to trade in NMS stocks. These include
the risks of lower liquidity and wider spreads that are particularly
significant in after-hours trading and that qualified auctions could
address effectively.\230\
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\228\ The phrase ``provided for dissemination in consolidated
market data'' reflects that, while national securities exchanges
send quotation and transaction information directly to the SIPs, NMS
Stock ATSs would provide such information to the ADF operated by
FINRA, which would send the information to the SIPs.
\229\ See Rule 600(b)(94) of Regulation NMS (limiting definition
of trade-through to regular trading hours); Rule 600(b)(77) of
Regulation NMS (defining regular trading hours).
\230\ See FINRA Rule 2265 (Extended Hours Trading Risk
Disclosure) (requiring disclosure to customers of the risks of
extended hours trading, including the risks of lower liquidity and
wider spreads).
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The second exception from Proposed Rule 615 would be for large
orders with a market value of at least $200,000 calculated with
reference to the NBBO midpoint when the order is received by a
restricted competition trading center. This exception is designed to
address the heightened liquidity need of large orders that often may be
more appropriately addressed outside of a qualified auction. The
$200,000 threshold is the same dollar amount as in other Regulation NMS
rules to exclude orders or trades that are so large as to warrant
different treatment than smaller orders.\231\ A specific methodology
for calculating market value (NBBO midpoint at time of order receipt)
is prescribed to provide additional clarity for restricted competition
trading centers on complying with Proposed Rule 615 that should be
readily implementable when qualified auctions are operating. The
$200,000 threshold is designed to except orders that may be difficult
to execute efficiently in qualified auctions at prices that generally
would be at or within the NBBO. While these large orders are eligible
for an exception, they still would meet the definition of a ``segmented
order'' and could be routed for execution in a qualified auction if the
broker-dealer handling the order determines that such routing would
promote best execution of the segmented order.
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\231\ See, e.g., Rule 604(b)(4) of Regulation NMS (providing an
exception for orders of block size from required limit order
display) and Rule 600(b)(12) of Regulation NMS (defining ``block
size'' as, in part, an order for a quantity of stock having a market
value of at least $200,000).
---------------------------------------------------------------------------
The third exception, provided by Proposed Rule 615(b)(3), is for
segmented orders that are executed by a restricted competition trading
center at a price that is equal to the NBBO midpoint or more favorable
for the segmented order (i.e., the NBBO midpoint or lower for segmented
orders to buy or the NBBO midpoint or higher for segmented orders to
sell), as determined with reference to the NBBO at the time the
segmented order was received by the restricted competition trading
center. For trades at these prices, an investor would either be paying
no spread (with a price at the NBBO midpoint) or earning a spread (with
a buy order executed at a price lower than the NBBO midpoint and a sell
order executed at a price higher than the NBBO midpoint). In such
circumstances, the submission of a segmented order to a qualified
auction would not be necessary to obtain a competitive price for such
order.
The fourth exception, provided by Proposed Rule 615(b)(4), is for
segmented orders that are limit orders with a limit price selected by
the customer that is equal to or more favorable for the segmented order
than the midpoint of the national best bid and national best offer when
the segmented order is received by the restricted competition trading
center. This exception is designed so that when the customer has
selected a limit price that will result in a favorable execution,
submission of the segmented order to a qualified auction would not be
necessary to obtain a competitive price. This exception would work in
conjunction with the third exception for executions of segmented orders
at a price equal to the midpoint or more favorable to the segmented
order. As discussed above in section IV.B.1, this exception would not
apply to beyond-the-midpoint non-marketable limit orders.
Finally, the fifth exception, provided by Proposed Rule 615(b)(5),
is for the fractional share component of a segmented order. Fractional
share orders typically are submitted by individual investors in dollar
sizes rather than share sizes, and often are referred to as ``cash
orders.'' If the dollar size of an order is less than the share price
for an NMS stock (such as a $200 order for a $450 stock), the size of
the order will be less than one share. If the dollar size of the order
is greater than the share price for an NMS stock (such as a $1000 order
for a $450 stock), the size of the order will be greater than one share
and have a fractional share component. While these orders for less than
one share and orders for more than one share or with a fractional share
component would fall within the definition of segmented order, they
raise practical difficulties for executing in qualified auctions
because currently, most trading centers, including all national
securities exchanges, only accept orders with whole share sizes and do
not accept orders for less than one share or orders with a fractional
share component. The Commission is concerned that applying the
requirements of Proposed Rule 615 to orders for less than one share and
orders for more than one share with a fractional component would
interfere with broker-dealers willingness to accept such customer
orders. For these reasons, Proposed Rule 615 would provide an exception
for orders less than one share and the fractional component of a
segmented order, if no qualified auction is available for such orders.
Specifically, the rule would provide an exception if the segmented
order is received and executed by the restricted competition trading
center during a time period when no open competition trading center is
operating a qualified auction for the segmented order that accepts
orders that are not entirely in whole shares, and the customer selected
a size for a segmented order that is not entirely in whole shares of an
NMS stock, in which case any portion of such segmented order that is
less than one whole share of the NMS stock, and only such portion,
would not be subject to the order competition requirement of Proposed
Rule 615(a).\232\ As is the case with each of the exceptions, a broker-
dealer's responsibilities with respect to best execution of a segmented
order, including the fractional share portion of a segmented order,
would remain in effect. The exception would only address whether the
segmented order, or fractional portion thereof, is required to be
exposed in a qualified auction.
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\232\ Proposed Rule 615(b)(5).
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Proposed Rule 615 does not provide an exception for orders directed
by a customer to a particular restricted competition trading center for
execution. Currently, 98% of the marketable orders of individual
investors routed to wholesalers are not directed to any particular
trading center, with the investor instead relying on their broker-
dealer, and their broker-dealer's best execution responsibilities, for
order routing.\233\ Moreover, because the rule would only apply to the
internalization of segmented orders by a restricted competition trading
center, customers could continue to direct segmented orders to any
trading center
[[Page 157]]
that was not a restricted competition trading center (i.e., an open
competition trading center or national securities exchange, which are
excluded from the definition of restricted competition trading center)
without their orders being subject to the requirement for exposure in a
qualified auction. Segmented orders directed to a restricted
competition trading center would need to comply with Proposed Rule 615
and, absent an exception, be exposed to competition in a qualified
auction. Any delay would be limited, however, to a very short, sub-
second time period (as specified in Proposed Rule 615(c)(2)) and would
give individual investors an opportunity to obtain fully competitive
prices for their segmented order, as well as give other market
participants, including institutional investors, an opportunity to
interact with segmented orders.
---------------------------------------------------------------------------
\233\ See infra section VII.B.2.a for a discussion of the
routing of individual investor orders in today's market structure.
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C. Qualified Auction Requirements
The term ``qualified auction'' is proposed to be defined in
Proposed Rule 600(b) of Regulation NMS as an auction that is operated
by an open competition trading center pursuant to paragraph (c) of
Proposed Rule 615.\234\ Paragraph (c), in turn, sets forth a series of
specific requirements for qualified auctions, which could be operated
only by national securities exchanges and NMS Stock ATSs that meet the
definition of an open competition trading center. Given that routing
segmented orders to qualified auctions would be mandated by rule in
some contexts, these auctions should be operated in a manner that
primarily promotes the core order competition objective of Proposed
Rule 615.\235\ The proposed requirements for qualified auctions are
designed to achieve this competition objective.
---------------------------------------------------------------------------
\234\ Proposed Rule 600(b)(81).
\235\ A number of exchanges, for example, currently operate
auctions for orders in listed options. See, e.g., CBOE Rule 5.37
(Automated Improvement Mechanism (``AIM'' or ``AIM Auction'')).
These auctions are not mandated by Commission rule, and trading in
listed options varies in important respects from trading in NMS
stocks. For example, there are far more series of listed options
than NMS stocks, which contributes to a market structure in which
market makers dominate liquidity provision (a ``quote-driven''
market), rather than the ``order-driven'' market that characterizes
NMS stocks. Proposed Rule 615 is designed to achieve policy
objectives that are particular to mandatory auctions in NMS stocks.
See also supra section I (discussing the difference between the
markets for listed options and NMS stocks).
---------------------------------------------------------------------------
1. Auction Messages
Proposed Rule 615(c)(1) specifies the requirements for an auction
message that announces the initiation of a qualified auction for a
segmented order. The first is that the message must be provided for
dissemination in consolidated market data pursuant to Rule 603(b) of
Regulation NMS. As stated in section III.B.1 above, the Commission has
adopted amendments to Regulation NMS that expand the information
required to be included in consolidated market data, which would
include auction information.\236\ Because these amendments have not yet
been implemented, if Proposed Rule 615 is adopted, the effective NMS
plans for NMS stocks would need to be conformed to provide for the
collection and dissemination of auction messages pursuant to Proposed
Rule 615(c)(1)(i). The wide dissemination of qualified auction messages
in consolidated market data would help ensure the broadest possible
participation of market participants in qualified auctions and the best
prices for segmented orders.
---------------------------------------------------------------------------
\236\ Rule 600(b)(19) defines consolidated market data to
include, among other things, core data, consolidated across all
national securities exchanges and national securities associations.
Rule 600(b)(21) defines core data to include, among other things,
auction information with respect to quotations for, and transactions
in, NMS stocks.
---------------------------------------------------------------------------
The phrase ``provided for dissemination in consolidated market
data'' reflects that, while national securities exchanges send
quotation and transaction information directly to the SIPs, NMS Stock
ATSs would provide such information to the ADF operated by FINRA, which
would send the information to the SIPs.\237\ The primary purpose of an
auction message is to promote competition by soliciting potential
auction responses from a wide spectrum of market participants. The
inclusion of the auction messages in consolidated market data, rather
than being limited to the proprietary data feed of a national
securities exchange or NMS Stock ATS, is designed to help achieve this
purpose. In addition, wide dissemination of auction messages would help
address some of the problems raised by the current level of fragmented
trading interest in NMS stocks. For example, market participants that
wish to interact with segmented orders would not need to predict the
trading center to which segmented orders are likely to be routed and
post a resting order in that trading center in advance of the arrival
of a segmented order. Rather, market participants would be able to
direct their auction responses to the particular open competition
trading center that disseminated the auction message signaling that a
segmented order was available for interaction.
---------------------------------------------------------------------------
\237\ See supra section III.B.1 (discussing rules addressing
dissemination of consolidated market data).
---------------------------------------------------------------------------
Qualified auctions therefore may be useful, for example, to
institutional investors that currently seek to trade with marketable
order flow using resting undisplayed orders, often priced at the NBBO
midpoint, that are intended to minimize information leakage concerning
the typically large trading interest of institutional investors. Today,
these market participants must select one or more trading centers on
which to rest their orders based on predictions of the frequency and
level of adverse selection costs of the marketable order flow with
which they may interact at a particular trading center. With qualified
auctions, such market participants would know the specific open
competition trading centers where they could interact directly with
segmented order flow that had low adverse selection costs. The
Commission anticipates that qualified auctions thereby could benefit
investors on both sides of the trades in qualified auctions--segmented
orders could receive highly favorable prices (such as a ``no spread''
execution at the NBBO midpoint) and institutional investors would have
a much greater opportunity to interact with the low-cost order flow of
individual investors than they have today.\238\ Information leakage
would be limited because, as discussed below, an institutional
investor's auction response would not be displayed, and, if the
institutional investor traded in a qualified auction, the only
displayed information would be a transaction report that maintained the
anonymity of the parties to the transaction.
---------------------------------------------------------------------------
\238\ In addition to participating in qualified auctions by
submitting auction responses, institutional investors could interact
with segmented orders by submitting orders, including undisplayed
NBBO midpoint orders, to the continuous order book of an open
competition trading center that operates qualified auctions. As
discussed below in section IV.C.5, any better-priced order resting
on the continuous order book would have priority over lesser-priced
auction responses to trade with segmented orders in a qualified
auction.
---------------------------------------------------------------------------
Proposed Rule 615(c)(1) also specifies the information content of
an auction message, including disclosure that the auction is for a
segmented order, the identity of the open competition trading center,
NMS stock symbol, side (buy or sell), size, limit price, and identity
of the originating broker for the segmented order. For auction
responders, all of this information is necessary or useful in deciding
whether to respond to the auction message and, if so, at what price.
The fact that the order is a segmented order would indicate that the
order is likely to have low adverse
[[Page 158]]
selection costs compared to other marketable order flow, such as orders
routed to the continuous order books of national securities exchanges.
Moreover, the identity of the originating broker likely would convey
additional information concerning the level of adverse selection costs
that an auction responder could expect. Data analysis indicates that
adverse selection costs can vary substantially among different retail
brokers.\239\ Knowing the identity of the originating broker would
therefore be a significant piece of information in pricing an auction
response. Accordingly, if only some market participants knew the
identity of the originating broker, other potential responders may not
participate due to fear of the winner's curse (winning the least
advantageous auctions and losing the most advantageous auctions because
of an information disadvantage). Limited participation could harm the
competitiveness of qualified auctions.
---------------------------------------------------------------------------
\239\ Table 12, infra, section VII.B.5.
---------------------------------------------------------------------------
Paragraph (c)(1)(ii) of Proposed Rule 615 specifies that, if
multiple broker-dealers fall within the proposed definition of
originating broker, it would be the broker-dealer responsible for
approving the opening of accounts with customers \240\ (commonly
performed by an introducing broker) that would be required to be
identified by an open competition trading center in auction messages
under Proposed Rule 615(c)(1). The business model of broker-dealers
(including the types of services they offer and the nature of the
commissions and fees they charge) determines the types of customers
that broker-dealers will attract, and different business models may be
associated with lower or higher adverse selection costs. As between an
introducing broker and a clearing broker, it is the introducing broker
that typically determines the business model for attracting customers.
For this reason, knowing the identity of the introducing broker
associated with a segmented order (i.e., the broker typically with
responsibility for approving the opening of the customer account)
likely would be more important for market participants in assessing the
potential adverse selection costs of trading with a segmented order
than knowing the identity of other broker-dealers that may handle the
segmented order during its lifecycle. Because the types of orders that
would meet the definition of ``segmented order'' are generally
associated with lower adverse selection costs,\241\ most originating
brokers with responsibility for approving the opening of customer
accounts likely would choose to have their identity disclosed in
auction message.
---------------------------------------------------------------------------
\240\ See, e.g., FINRA Rule 4311(c)(1)(A); supra note 227 and
accompanying text.
\241\ See infra section VII.B.2 discussing why certain orders
are segmented because they are low-cost flow.
---------------------------------------------------------------------------
The Commission recognizes, however, that some originating brokers
or their customers may not wish to have the identity of the originating
broker for a segmented order publicly disseminated. Proposed Rule
615(c)(1)(iii) therefore would provide a choice for the originating
broker. It could either allow its identity to be disclosed in an
auction message or it could withhold this information by certifying
that it has established, maintained, and enforced written policies and
procedures reasonably designed to assure that its identity will not be
disclosed, directly or indirectly, to any person that potentially could
participate in the qualified auction or otherwise trade with the
segmented order. If the originating broker makes this certification,
paragraph (c)(1)(iii) would prohibit disclosure of the identity of the
originating broker in the auction message.\242\ Proposed paragraph
(c)(1)(iii) would also require that the certification be communicated
to the open competition trading center conducting the auction. In
addition, proposed paragraph (e)(3), discussed in section IV.E below,
specifies the requirements for an originating broker that makes the
certification, and proposed paragraph (f)(2), discussed in section IV.F
below, specifies certain trading prohibitions for any broker-dealer
with knowledge of where a segmented order is to be routed for
execution. The overriding purpose of these proposed requirements is to
help ensure fair competition among auction responders and persons that
could otherwise trade with the segmented order. If one or more auction
responders or persons that could otherwise trade with the segmented
order knew the identity of the originating broker, but others did not,
those that knew would have a substantial information advantage in
pricing their orders over those that did not. The proposed requirements
would give originating brokers a choice on whether to disclose their
identity, while at the same time promoting fair competition among
auction responders and persons that could otherwise trade with the
segmented order, both when such identity is disclosed and when it is
not. Under Proposed Rule 615(c)(1), (e)(3), and (f)(2), either all
auction responders and persons that could otherwise trade with the
segmented order would know the identity of the originating broker, or
no auction responder or person that could otherwise trade with the
segmented order would be permitted to know the identity of the
originating broker. In either event, the fairness of qualified auctions
would not be impacted.
---------------------------------------------------------------------------
\242\ See infra section IV.E discussing potential procedures for
an originating broker to assure that its identity will not be
disclosed.
---------------------------------------------------------------------------
2. Auction Responses
Proposed Rule 615(c)(2) specifies that the time period for a
qualified auction must be no shorter than 100 milliseconds (1/10th of a
second) and no longer than 300 milliseconds (3/10ths of a second) after
an auction message is provided for dissemination in consolidated market
data. The intent of these limits is to help ensure that a wide variety
of market participants will have the technological capacity to submit
responses to fast automated auctions, while also helping to assure that
the execution of segmented orders is not unduly delayed. Several
national securities exchanges operate auctions that fall within these
time periods, which indicates that the time periods are workable with
technologies that currently are available to market participants (i.e.,
the fact that multiple national securities exchanges already operate
auctions in these time frames indicates that market participants
generally would be able to submit auction responses within the
specified time periods).\243\ The Commission anticipates individual
investors would manually submit to their brokers the great majority of
segmented orders. Proposing to limit the auction length to no more than
300 milliseconds is designed to promote competition to obtain the best
prices for segmented orders, but without a delay long enough to be
inconsistent with an investor's intent to trade immediately at the best
available prices.
---------------------------------------------------------------------------
\243\ See, e.g., Securities Exchange Act Release No. 91423 (Mar.
26, 2021), 86 FR 17230 (Apr. 1, 2021) (SR-CboeBYX-2020-021) (order
approving Cboe BYX's proposed rule change for periodic auctions in
NMS stocks with a 100 millisecond auction period); Nasdaq PHLX Rule
3, section 13(b)(1)(D) (providing that the time period for PHLX's
Price Improvement XL Mechanism (``PIXL'') auctions in listed options
will be no less than 100 milliseconds and no more than one second).
---------------------------------------------------------------------------
Paragraph (c)(2) would further require that auction responses
remain undisplayed during the time frame of the auction and not be
disseminated thereafter. This proposed requirement is designed to
prevent the market participants with the fastest systems
[[Page 159]]
from obtaining an advantage by observing the pricing of auction
responses and submitting their auction responses near the end of the
time period for the auction. It also is designed to prevent information
leakage, both during auctions themselves and by analyzing historical
auction data, concerning the trading interest of market participants,
particularly institutional investors, that submit auction responses.
3. Pricing Increment
Under Proposed Rule 615(c)(3), segmented orders and auction
responses must be priced in an increment of no less than $0.001 (or 0.1
cent) if their prices are $1.00 or more per share, in an increment of
no less than $0.0001 (or 0.01 cent) if their prices are less than $1.00
per share, or at the midpoint of the NBBO.
These proposed increments are designed to balance the objectives of
being sufficiently narrow to allow frequent price improvement for
segmented orders (the wider the pricing increment, the greater the
minimum amount of price improvement that is required, which could limit
the frequency of price improvement), while being sufficiently wide to
prevent market participants from attempting to gain execution priority
by pricing their auction responses in very small increments. An
analysis of current wholesaler trading in NMS stocks indicates that
18.64% of the price improved shares of wholesaler principal
transactions received price improvement of less than 0.1 cent.\244\
Accordingly, the 0.1 cent price increment for qualified auctions would
allow much of the existing price improvement to continue in qualified
auctions. Moreover, as discussed in section IV.C.5 below, one of the
prescribed execution priority requirements for qualified auctions in
paragraph (c)(5) of Proposed Rule 615 is that the auction responses of
customers, including institutional investors, would have priority over
the auction responses of broker-dealers at the same price, thereby
furthering the NMS objective of promoting direct interaction of
investor orders without the participation of a dealer. A smaller
pricing increment (such as 0.05 cent per share (or 1/20th of a cent per
share) would allow more price improvement, but also would double the
number of increments at which auction responses could be priced, which
would enable execution priority advantages at the larger number of
increments. The objective of promoting direct interaction of investor
orders could be undermined if broker-dealers with the most
sophisticated algorithmic trading strategies could submit auction
responses with very small pricing increments designed to obtain
execution priority.
---------------------------------------------------------------------------
\244\ Table 7, infra, section VII.B.4.
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4. Fees and Rebates
Proposed Rule 615(c)(4) sets forth a number of requirements that
would govern the fees and rebates of open competition trading centers
with respect to qualified auctions.\245\ In general, these requirements
are designed to provide reasonable compensation for operating a
qualified auction, while maximizing an opportunity for competitive
forces to generate the best possible prices for segmented orders.
Qualified auctions would be a new business line for open competition
trading centers (both national securities exchanges and NMS Stock
ATSs), which would provide them an opportunity to compete to attract
the marketable orders of individual investors that, as discussed in
section VII.B.2 below, are mostly routed to, and executed by,
wholesalers in the current market structure. Accordingly, the proposed
requirements for fees and rebates are designed to provide sufficient
financial incentives for open competition trading centers to operate
qualified auctions, but the primary objective of such requirements is
to promote the regulatory objectives of Proposed Rule 615--better
prices for individual investors and an enhanced opportunity for
investors to interact directly with the marketable orders of individual
investors.
---------------------------------------------------------------------------
\245\ The Commission also is proposing to amend rules addressing
fees and rebates more generally. See Minimum Pricing Increments
Proposal, supra note 98. The Commission encourages commenters to
review that proposal to determine whether it might affect their
comments on this proposing release.
---------------------------------------------------------------------------
First, no fee could be charged for submission or execution of a
segmented order, or for submission of an auction response. Second, the
fee for execution of an auction response could not exceed $0.0005 per
share for auction responses priced at $1.00 per share or more, could
not exceed 0.05% of the auction response price per share for auction
responses priced at less than $1.00 per share, and otherwise would have
to be the same rate for executed auction responses in all auctions.
Third and similarly, any rebate for the submission or execution of a
segmented order or for the submission or execution of an auction
response could not exceed $0.0005 per share for segmented orders or
auction responses priced at $1.00 per share or more, cannot exceed
0.05% of the segmented order or auction response price per share for
segmented orders or auction responses priced at less than $1.00 per
share, and otherwise must be the same rate for segmented orders in all
auctions and must be the same rate for auction responses in all
auctions.
Proposed Rule 615 would prohibit fees for the submission or
execution of segmented orders in a qualified auction. As discussed in
section II above, the trading economics of executing segmented orders,
particularly their low adverse selection costs, has led to a market
structure where restricted competition trading centers generally do not
charge fees to the broker-dealers that route such orders and, indeed,
often offer PFOF to retail brokers in return for routing such orders.
With Proposed Rule 615, routing segmented orders to qualified auctions
would often, absent an exception, be mandated by rule--a restricted
competition trading center generally would be prohibited from executing
a segmented order internally without first routing such order to a
qualified auction. The Commission believes that broker-dealer
compliance with a new rule requiring the routing of segmented orders to
qualified auctions in certain circumstances should not lead to the
imposition of fees by trading centers on broker-dealers that are not
charged for the execution of such orders today. Instead, as discussed
below, open competition trading centers could fund their operation of
qualified auctions by imposing fees on auction responses that execute
against segmented orders. In this respect, the market participants that
benefit from the opportunity to trade with segmented orders, with their
low adverse selection costs, would pay the open competition trading
center for that trading service.
With respect to auction responses, no fee could be charged for the
submission of an auction response that is not executed. Such a practice
potentially could be used to deter a wide range of market participants
from participating in qualified auctions and thereby dampen competition
to provide the best prices for segmented orders. Fees could be charged
for executed auction responses, consistent with the cap on such fees,
which, for most NMS stocks, would be 0.05 cent per share, also known as
5 ``mils.'' The proposed 5 mils cap on fees is designed to be
sufficient to provide reasonable compensation to an open competition
trading center. For example, an analysis of financial data for national
securities exchanges indicates that average total net capture (the
difference between fees levied and rebates paid) for such exchanges is
[[Page 160]]
currently around 4 mils for all trading types.\246\ Accordingly, the
proposed 5 mils fee cap would provide a revenue source to fund
qualified auctions that is consistent with their revenue to fund their
other trading services, particularly their services during continuous
trading hours.\247\ In addition, pursuant to Proposed Rule 615(c)(4),
any fee charged for execution of an auction response must be the same
rate for all auctions (i.e., an open competition trading center would
not be permitted to charge different fees for auctions for different
securities, nor would an open competition trading center be permitted
to charge different fees to different market participants or different
classes of market participants, such as preferential fees based on
volume). This proposed uniform rate for fees is designed to promote a
level playing field among all potential market participants that may
wish to trade with segmented orders. It would, for example, prohibit
any volume discount that could give the largest participants an
economic advantage in pricing their auction responses compared to other
market participants. The uniform rate also would prevent a fee discount
for the executed auction response of a broker-dealer that routed the
segmented order to the qualified auction.
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\246\ See infra section VII.C.1.a (discussing effects of 5 mils
cap on competition to supply liquidity to the marketable orders of
individual investors).
\247\ Id. (net capture for the executions of orders during
continuous trading hours (but not opening or closing auctions)
priced at $1.00 per share or greater is likely close to 2 mils).
---------------------------------------------------------------------------
The proposed requirements for rebates mirror the requirements for
fees in terms of the 5 mils cap and the requirement of a uniform rate
for all auctions. In particular, rebates could not exceed the maximum
fee for qualified auctions. The equivalent proposed 5 mils cap on
rebates is designed to limit cross-subsidization of qualified auctions
by the largest open competition trading centers in ways that would not
be available to smaller competitors, because larger competitors may
have more or larger alternative revenue sources. The uniform rate of
rebates for all auctions is designed, as with the uniform rate of fees,
to level the playing field among larger and smaller broker-dealers. The
proposed requirements for rebates differ from those for fees, however,
in that open competition trading centers would have discretion on
whether to offer rebates for the submission of segmented orders and of
auction responses, as well as the execution of segmented orders and of
auction responses. If such rebates were offered, however, they would
have to be a uniform rate among all auctions to promote a level playing
field and fair competition among broker-dealers and among auction
responders.
5. Auction Execution Priority
Proposed Rule 615(c)(5) would specify five requirements for the
execution priority of auction responses and orders resting on the
continuous order book of an open competition trading center, which can
be divided into three categories. The first two would specify
affirmative requirements for how priority among auction responses must
be handled; the second two would specify negative requirements for how
priority among auction responses cannot be handled; and the fifth
requirement would address how qualified auctions must be integrated
with a continuous order book operated by an open competition trading
center. These five requirements would not exhaust all possible contexts
for which additional priority rules may be needed, and, as discussed
below, open competition trading centers would have flexibility to
develop additional priority rules as long as such rules are consistent
with the requirements in Proposed Rule 615(c)(5).
Pursuant to Proposed Rule 615(c)(5)(i), the first affirmative
requirement would be price priority--the most favorable price for a
segmented order would have priority of execution (the lowest priced
auction response to a segmented order to buy and the highest priced
auction response to a segmented order to sell). Price priority
maximizes competitive incentives to obtain the best prices for
segmented orders.
Pursuant to Proposed Rule 615(c)(5)(ii), the second affirmative
requirement would be customer priority. ``Customer'' is defined in Rule
600(b)(23) of Regulation NMS to mean any person that is not a broker-
dealer. When two auction responses have the best price, and one is
submitted for the account of a customer and one is submitted for the
account of a broker-dealer, the customer's auction response would be
required to have priority. In such a case, the segmented order of an
investor would interact directly with the auction response of another
investor without the participation of a dealer, thereby promoting the
NMS objective set forth in section 11A(a)(1)(C)(v) of the Exchange Act.
Pursuant to Proposed Rule 615(c)(5)(iii), the first negative
requirement for execution priority would be the prohibition of time
priority, subject only to an auction response being received by an open
competition trading center within the time period prescribed in
paragraph (c)(2) of Proposed Rule 615. Prohibiting time priority for
equally priced auction responses eliminates the incentive for a speed
race that otherwise could reward market participants with resources to
spend the most on sophisticated, low-latency trading systems and
connectivity.
Pursuant to Proposed Rule 615(c)(5)(iv), the second negative
requirement for execution priority would be a prohibition against
favoring the broker-dealer that routed the segmented order to the
auction, the originating broker for the segmented order, the open
competition trading center operating the auction, or any affiliate of
the foregoing persons.\248\ This requirement is designed to help
maintain a level playing field among market participants submitting
auction
[[Page 161]]
responses and thereby focus competition in the auctions on providing
the best prices for segmented orders. Assigning priority to any firm
associated with the handling of the orders or their affiliates would be
one means for an open competition trading center to attempt to attract
order flow by rewarding the firms that control such flow coming from
the customer, which could undermine competition among auction
responders to provide the best prices in qualified auctions. Given that
Proposed Rule 615 would require segmented orders to be routed to
qualified auctions in some contexts, the competition among open
competition trading centers to attract segmented orders should be
focused on generating the best prices for investors.
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\248\ ``Affiliate'' is proposed to be defined in Proposed Rule
600(b)(3) of Regulation NMS to mean, with respect to a specified
person, any person that, directly or indirectly, controls, is under
common control with, or is controlled by, the specified person.
``Control'' is proposed to be defined in Proposed Rule 600(b)(23) of
Regulation NMS to mean the power, directly or indirectly, to direct
the management or policies of a broker, dealer, or open competition
trading center, whether through ownership of securities, by
contract, or otherwise. A person is presumed to control a broker,
dealer, or open competition trading center if that person: (1) is a
director, general partner, or officer exercising executive
responsibility (or having similar status or performing similar
functions); (2) directly or indirectly has the right to vote 25% or
more of a class of voting securities or has the power to sell or
direct the sale of 25% or more of a class of voting securities of
the broker, dealer, or open competition trading center; or (3) in
the case of a partnership, has contributed, or has the right to
receive upon dissolution, 25% or more of the capital of the broker,
dealer, or open competition trading center. Proposed Rule 600(b)(3)
and Proposed Rule 600(b)(23). These definitions are substantially
the same as the definitions of ``affiliate'' and ``control''
prescribed for purposes of an NMS Stock ATS's disclosures about its
operations on Form ATS-N with the following modifications: the Form
ATS-N definition of ``affiliate'' uses a separately defined term
``Person'' instead of the statutory definition of ``person,'' and
Form ATS-N defines ``control'' as applicable to the ``broker-dealer
of the alternative trading system'' instead of as applicable to a
``broker, dealer, or open competition trading center.'' It is
appropriate to use substantially similar definitions of
``affiliate'' and ``control'' in the context of Proposed Rule 615
because, for purposes of Form ATS-N, the Commission defined such
terms for use with respect to disclosures designed to enable market
participants to better evaluate how relationships between certain
persons could affect the handling of orders on a particular NMS
Stock ATS. See ATS-N Adopting Release, supra note 159, 83 FR at
88318. The substantially similar proposed definitions, as used in
the context of Proposed Rule 615, are similarly designed to
recognize that relationships among certain persons may impact the
handling of orders, and are designed to help ensure that the
execution priority rules of an open competition trading center do
not undermine full competition among auction responders in qualified
auctions by favoring related parties that were involved in routing
and executing the order at the open competition trading center.
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Finally, the execution priority requirements set forth in paragraph
(c)(5)(v) of Proposed Rule 615 address how auction responses would be
required to be integrated with the continuous order book of an open
competition trading center. A continuous order book is proposed to be
defined in Rule 600(b) of Regulation NMS as a system that allows orders
for NMS stocks to be accepted and executed on a continuous basis.\249\
This definition would exclude single-priced auctions that are limited
to a specified time, such as the opening and closing auctions of the
primary listing exchanges, and that are not continuously available for
trading based on the initiative of market participants or the open
competition trading center. As discussed above, all open competition
trading centers would operate as automated trading centers displaying
automated quotations and therefore would have facilities in which
orders from market participants are accepted and executed on a
continuous basis.
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\249\ Proposed Rule 600(b)(22).
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The proposed execution priority requirements primarily are designed
to balance the objectives of obtaining the best prices for segmented
orders and maintaining fair competition both in qualified auctions and
on continuous order books.\250\ The first such requirement is that
orders resting on the continuous order book of the open competition
trading center operating the qualified auction, whether displayed or
undisplayed, would have priority over auction responses at a less
favorable price for the segmented order. This is another application of
the principle of price priority that underlies proposed paragraph
(c)(5)(i).
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\250\ Trades executed in qualified auctions would not qualify
for an exception from the trade-through requirements of Rule 611 of
Regulation NMS, which are discussed in section III above.
Accordingly, if a qualified auction did not generate a price that
was at or within the best-priced protected quotations, the open
competition trading center would, absent an exception, be prohibited
by Rule 611 from executing the segmented order. If a restricted
competition trading center subsequently decided to execute such
segmented order, it would need, absent an exception, to comply both
with the trade-through requirements of Rule 611 and with Proposed
Rule 615(a) by immediately executing the segmented order at a price
that was equal to or better for the segmented order than the
specified limit price in the qualified auction.
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The second requirement is that displayed orders resting on the
continuous order book would be required to have priority at the same
price over auction responses, while, in turn, auction responses would
be required to have priority at the same price over undisplayed orders
resting on the continuous order book. Rewarding the display of orders
serves the purpose of promoting public price transparency, consistent
with the NMS objective in section 11A(a)(1)(C)(iii) of the Exchange
Act. As between undisplayed orders and auction responses, however,
giving priority to auction responses at the same price would encourage
participation in qualified auctions, thereby promoting the core order
competition objective of Proposed Rule 615. Moreover, unlike displayed
orders that can be executed immediately because they present a known
opportunity to trade for market participants, undisplayed orders on
continuous order books are not known to other market participants and
potentially create a risk of gaming behavior by broker-dealers with
knowledge of segmented orders that could undermine competition in
qualified auctions. As discussed in section IV.F below, this potential
gaming behavior is prohibited in paragraph (f) of Proposed Rule 615.
Assigning priority to auction responses over undisplayed orders at the
same price would help address the root incentives for such behavior.
While Proposed Rule 615(c) sets forth a series of execution
priority requirements for qualified auctions, open competition trading
centers also would have flexibility to develop additional execution
priority rules for their auction mechanism, as long as they were
consistent with the proposed requirements. As one example, Proposed
Rule 615(c) does not prescribe execution priority when an open
competition trading center receives multiple best priced responses for
the account of customers because multiple possibilities would be
consistent with the objectives of Proposed Rule 615. An open
competition trading center would be free to develop rules for assigning
execution priority among such customer responses, as long as they were
consistent with Proposed Rule 615(c).\251\
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\251\ As discussed above in section IV.B.2, national securities
exchanges must file proposed rules with the Commission to reflect
material changes in their rules, while NMS Stock ATSs must update
their Form ATS-Ns to reflect material changes in their rules.
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Moreover, Proposed Rule 615 allows flexibility for open competition
trading centers in a variety of other contexts. For example, it does
not specify whether an open competition trading center may or may not
simultaneously operate multiple qualified auctions for the same NMS
stock, and if so, the execution priority required for auction responses
across such auctions. Proposed Rule 615 also would not impose
requirements for auction responses, other than the requirement in
paragraph (c)(1) that an auction message initiating a qualified auction
would be required to invite ``priced'' auction responses.
D. Open Competition Trading Center Requirements
Paragraph (d) of Proposed Rule 615 sets forth requirements for
national securities exchanges and NMS Stock ATSs that intend to act as
open competition trading centers that operate qualified auctions for
segmented orders. First, it would prohibit a national securities
exchange or NMS Stock ATS from operating a qualified auction unless the
exchange or ATS meets the definition of open competition trading center
and complies with the provisions of Proposed Rule 615 for qualified
auctions, which were discussed in section IV.B.2 and IV.C above.
Second, it would prohibit an open competition trading center from
operating a system, other than a qualified auction, that is limited in
whole or in part to the execution of segmented orders, unless any
segmented order executed through the system meets requirements that
parallel those specified for an exception in paragraph (b) of Proposed
Rule 615.\252\ This proposed prohibition is
[[Page 162]]
identical to the prohibition in paragraph (g) of Proposed Rule 615 that
would apply to all national securities exchanges, regardless of whether
they meet the definition of an open competition trading center, and is
discussed further in section V.G below.
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\252\ Proposed Rule 615(b); Proposed Rule 615(d)(2)(i) through
(v). Specifically, a segmented order executed through such system of
an open competition trading center would be required to: (1) be
received and executed during a time period when no open competition
trading center is operating a qualified auction for the segmented
order; (2) have a market value of at least $200,000 calculated with
reference to the midpoint of the NBBO when the segmented order was
received by the open competition trading center; (3) be executed by
the open competition trading center at a price that is equal to or
more favorable for the segmented order than the midpoint of the NBBO
when the segmented order was received by the open competition
trading center; (4) be a limit order with a limit price selected by
the customer that is equal to or more favorable for the segmented
order than the midpoint of the national best bid and national best
offer when the segmented order is received by the open competition
trading center; or (5) be received and executed by the open
competition trading center during a time period when no open
competition trading center is operating a qualified auction for the
segmented order that accepts orders that are not entirely in whole
shares, and be a size, selected by the customer, that is not
entirely in whole shares of an NMS stock, in which case any portion
of such segmented order that is less than one whole share of the NMS
stock, and only such portion, may be executed through such system.
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E. Originating Broker Requirements
Paragraph (e) of Proposed Rule 615 sets forth three requirements
for originating brokers. First, an originating broker would be required
to establish, maintain, and enforce written policies and procedures
reasonably designed to identify the orders of customers as segmented
orders. Given that the order competition requirement of paragraph (a)
would apply solely to segmented orders, it is imperative that customer
orders be properly identified as such by the originating broker, which
will have the knowledge of its customer accounts necessary to make such
identification. As discussed above in section IV.B.1, the first part of
the proposed definition of segmented order relating to the nature of
the account is based on existing SRO rules and, accordingly, is
designed to facilitate ease of compliance by originating brokers. The
second part of the proposed definition relating to frequency of trading
in an account would be based on customer trading information that
originating brokers are required to maintain.\253\
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\253\ See 17 CFR 240.17a-3(a) (requiring broker-dealers to make
and keep, among other things, current blotters containing an
itemized daily record of all purchases and sales of securities and
the account for which each such purchase and sale was effected).
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Second, an originating broker would be prohibited from routing a
customer order identified as a segmented order without also identifying
the order to the routing destination as a segmented order.\254\ This
requirement would work together with an analogous requirement in
paragraph (f) of Proposed Rule 615 for all broker-dealers that route
segmented orders that is discussed in section IV.F below. Together, the
proposed requirements are designed to ensure that a segmented order
continues to be identified as such throughout the routing chain from
origination through execution. Proper marking of segmented orders would
be essential for a restricted competition trading center to know that
it must comply with the order competition requirement of paragraph (a).
The proposed identification requirements of paragraph (e) for
originating brokers and paragraph (f) for all broker-dealers are
designed to assure that no segmented order reaches a restricted
competition trading center without the proper identification. If there
is more than one originating broker for a segmented order, the broker
that carries the individual investor's customer account would likely be
the originating broker that maintains the policies and procedures to
identify segmented orders as such, as well as identifies and marks the
orders.
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\254\ 17 CFR 242.613 (Rule 613 of Regulation NMS) requires each
national securities exchange and national securities association to
jointly file an NMS plan governing the creation, implementation, and
maintenance of a consolidated audit trail (``CAT'') which is
reported to a central repository. The rule specifies the type of
data to be collected and reported. Pursuant to Rule 613(c)(7), any
CAT plan participant or broker-dealer that receives, originates, or
handles orders in NMS stocks must report certain information
regarding those orders, including the ``material terms'' of each
order. Rule 613(j)(7) defines ``material terms of an order'' to
include ``any special handling instructions.'' Because Proposed Rule
615 would mandate special handling for segmented orders, the
identification of the order as a segmented order, any exceptions
applicable to its handling, and the identity of the originating
broker or an indication of a certification of anonymity would be
required by current Rule 613 to be reported as material terms in
each event in the lifecycle.
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Third, an originating broker that makes the certification referred
to in paragraph (c)(1)(iii) of Proposed Rule 615 would be required to
establish, maintain, and enforce written policies and procedures
reasonably designed to assure that the identity of the originating
broker will not be disclosed, directly or indirectly, to any person
that potentially could participate in the qualified auction or
otherwise trade with the segmented order. As discussed in section
IV.C.1 above, knowing the identity of an originating broker could
provide a significant information advantage to a market participant
when pricing an auction response if other market participants did not
have this information. The effect of the certification referred to in
paragraph (c)(1)(iii) of Proposed Rule 615 would be that either all
responders in a qualified auction would know the identity of the
originating broker (if the certification is not made) or no responders
in a qualified auction would know the identity of the originating
broker (if the certification is made). In the absence of an appropriate
certification from an originating broker, an open competition trading
center would be required to identify the originating broker in the
auction message disseminated in consolidated market data. The ``written
policies and procedures'' requirement of proposed paragraph (e)(3)
specifies the responsibility of an originating broker in making such a
certification. As one potential example of such policies and
procedures, an originating broker could provide that such originating
broker will route all the segmented orders of its customers directly to
an open competition trading center for a qualified auction, without
disclosing the existence of such orders to any other person. Another
potential example would be for the originating broker to use a single
broker for routing segmented orders to open competition trading centers
for qualified auctions, and the single executing broker represents in
writing that it will not participate in any qualified auction for the
segmented orders or otherwise trade with the segmented orders, and that
it will not disclose the existence of such segmented orders to any
other person.
As mentioned in section IV.B.4 above, broker business practices can
vary in terms of how customer accounts are handled, and there may be
multiple originating brokers for a segmented order. In addition, such
brokers currently enter into agreements with one another to allocate
certain responsibilities with respect to the handling of customer
accounts, such as those referred to as carrying agreements. The
Commission has designed Proposed Rule 615 to preserve brokers' existing
flexibility to allocate responsibilities among themselves. Accordingly,
paragraph (e)(4) of Proposed Rule 615 provides that, where there are
multiple originating brokers for a segmented order, an originating
broker shall not be deemed to be in violation of the provisions of
paragraph (e)(1) through (3) arising solely from a failure to meet a
responsibility that was specifically allocated by prior written
agreement to another originating broker.
F. Broker-Dealer Requirements
Paragraph (f) of Proposed Rule 615 sets forth two requirements for
all broker-dealers with respect to segmented orders. First, pursuant to
proposed paragraph (f)(1), a broker-dealer that receives an order
identified as a segmented order would be prohibited from routing such
order without identifying the order to the routing destination as a
segmented order. As discussed in section IV.E above, this requirement
is designed to work together with an analogous requirement for
originating brokers to
[[Page 163]]
help assure that no segmented order reaches a restricted competition
trading center, even if routed through multiple broker-dealers or
trading centers, without being properly identified as a segmented
order.
Second, paragraph (f)(2) of Proposed Rule 615 sets forth a
requirement for all broker-dealers, which includes originating brokers,
that is designed to prevent gaming behavior that could undermine fair
competition in qualified auctions and on continuous order books. In
particular, it would prohibit a broker-dealer with knowledge of where a
segmented order is to be routed from submitting an order, or enabling
an order to be submitted by any other person, to the continuous order
book of an open competition trading center or of a national securities
exchange that could have priority to trade with the segmented order at
such open competition trading center or national securities exchange.
The prohibition of paragraph (f)(2) is designed to address two
types of potential gaming behavior by broker-dealers. First, absent
this proposed prohibition, a broker-dealer with knowledge that a
segmented order is to be routed to a qualified auction could submit, or
enable another person to submit (such as by providing information to
another person), to the open competition trading center conducting such
auction a displayed contra-side order that was priced at or better than
the specified limit price of the segmented order. As discussed in
section IV.C above, displayed orders on the continuous order book of an
open competition trading center could have priority to trade with a
segmented order ahead of equally priced auction responses. The
submission of contra-side orders to a continuous order book to avoid
participating in a qualified auction, however, could undermine fair
competition in the qualified auction and therefore would be prohibited
by paragraph (f)(2).
A second type of gaming behavior prohibited by paragraph (f)(2) of
Proposed Rule 615 relates to segmented orders that are not routed to
qualified auctions, but rather to a continuous order book of an open
competition trading center or a national securities exchange. As stated
in section IV.A above, the order competition requirement of paragraph
(a) of Proposed Rule 615 does not apply to an open competition trading
center or to a national securities exchange, regardless of whether such
exchange is an open competition trading center, and therefore, a
broker-dealer could route a segmented order directly to an open
competition trading center or a national securities exchange.\255\
However, there remains an incentive for a broker-dealer to seek to
trade with a segmented order outside of the fair competition of a
qualified auction by submitting a contra-side order at the same time it
submits the segmented order (i.e., a ``paired order'') to a continuous
order book of an open competition trading center or national securities
exchange with the expectation of executing against the segmented order.
Paragraph (f)(2) is designed to address this potential by prohibiting a
broker-dealer with knowledge of where a segmented order is to be routed
from submitting, or enabling any other person to submit (such as by
providing information to another person), an order to an open
competition trading center or a national securities exchange that could
have priority to trade with the segmented order.
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\255\ As discussed elsewhere in this release, both of these
types of trading centers are subject to rigorous requirements for
access and competition, and they therefore would not be prohibited
from executing a segmented order without it being submitted to a
qualified auction. In addition to the applicable proposed
requirements under Proposed Rule 615, a broker-dealer still would be
required to satisfy its best execution responsibilities if bypassing
a qualified auction and routing a segmented order directly to an
open competition trading center or a national securities exchange.
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In addition to the requirements for broker-dealers set forth in
Proposed Rule 615, all other existing obligations of broker-dealers for
customer orders, including best execution discussed in section III.B
above, would continue to apply. For example, an important consideration
for broker-dealers in handling a segmented order would be the relative
performance of qualified auctions at different open competition trading
centers in terms of their order execution quality. Broker-dealers with
best execution responsibilities for segmented orders generally should
consider the available information on execution quality for segmented
orders at different qualified auctions. To provide broker-dealers with
relevant information on qualified auctions, if Proposed Rule 615 is
adopted, the effective NMS plans for NMS stocks would need to be
conformed to provide for the collection and dissemination of a sale
condition in transaction reports for national securities exchanges and
NMS Stock ATSs indicating that the transaction was executed in a
qualified auction under Proposed Rule 615(c).\256\
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\256\ The technical specifications of the NMS plans for
disseminating consolidated market data include sale condition
modifiers for trade reports that specify various types of trades,
including some auction trades.
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G. National Securities Exchange Requirements
Exchanges are excluded from the proposed definition of a restricted
competition trading center because, as discussed in section III.B
above, they are subject to the extensive Exchange Act requirements for
access and competition. Accordingly, the order competition requirement
of paragraph (a) of Proposed Rule 615 does not apply to a national
securities exchange, regardless of whether such exchange meets the
definition of an open competition trading center. To the extent
consistent with their best execution responsibilities, broker-dealers
would be permitted to route segmented orders directly to any national
securities exchange without first routing the order to a qualified
auction. One potential example of when such a direct route could be
consistent with best execution is a fast market when prices are moving
rapidly away from a segmented order (prices increasing for buy orders
and prices decreasing for sell orders). In this example, a broker-
dealer could determine that obtaining a better price in a qualified
auction than a displayed quotation is unlikely, and the broker-dealer
could route a segmented order directly to execute against the best
available price available at a national securities exchange or an open
competition trading center. Competition in qualified auctions, however,
could be undermined if national securities exchanges and open
competition trading centers were permitted to siphon segmented order
flow away from qualified auctions by operating trading mechanisms that
were limited, in whole or in part, to segmented orders.
Accordingly, paragraphs (d)(2) (as discussed above) and (g) of
Proposed Rule 615 would prohibit all open competition trading centers
and national securities exchanges from operating a system, other than a
qualified auction, that is limited, in whole or in part, to the
execution of segmented orders, unless any segmented order executed
through such system qualifies for exceptions that are the same as those
in Proposed Rule 615(b).\257\ This prohibition would apply
[[Page 164]]
to many of the RLPs currently operated by national securities
exchanges.\258\ An example of a trading system that would not be
prohibited under paragraphs (d)(2) and (g), however, would be one that
is limited to the execution of segmented orders at prices equal to the
NBBO midpoint, which would qualify for the exception in Proposed Rule
615(g)(3).\259\
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\257\ Proposed Rule 615(b); Proposed Rule 615(d)(2)(i) through
(v); Proposed Rule 615(g)(1) through (5); and supra note 252 and
accompanying text. Specifically, a segmented order executed through
such system of a national securities exchange would be required to:
(1) be received during a time period when no open competition
trading center is operating a qualified auction for the segmented
order; (2) have a market value of at least $200,000 calculated with
reference to the midpoint of the NBBO when the segmented order was
received by the national securities exchange; (3) be executed by the
national securities exchange at a price that is equal to or more
favorable for the segmented order than the midpoint of the NBBO when
the segmented order was received by the national securities
exchange; (4) be a limit order with a limit price selected by the
customer that is equal to or more favorable for the segmented order
than the midpoint of the national best bid and national best offer
when the segmented order is received by the national securities
exchange; or (5) be received and executed by the national securities
exchange during a time period when no open competition trading
center is operating a qualified auction for the segmented order that
accepts orders that are not entirely in whole shares, and be a size,
selected by the customer, that is not entirely in whole shares of an
NMS stock, in which case any portion of such segmented order that is
less than one whole share of the NMS stock, and only such portion,
may be executed through such system.
\258\ As discussed in section III.B.2.c, RLPs are exchange
trading mechanisms limited to retail orders, as defined in the
exchanges' rules.
\259\ IEX's RLP, for example, only permits retail liquidity
provider orders to be midpoint peg orders. See Securities Exchange
Act Release No. 93217 (Sep. 30, 2021), 86 FR 55663 (Oct. 6, 2021)
(order approving an exemption from Rule 602 of Regulation NMS for
IEX's retail price improvement program and describing that IEX's
program is different because retail liquidity provider orders can
only be midpoint peg orders); IEX Rules 11.190(b)(14) (Retail
Liquidity Provider Order) and 11.232 (Retail Price Improvement
Program). IEX has rules that will also permit orders in its RLP to
be executed at prices better than the NBBO midpoint. See Securities
Exchange Act Release No. 94884 (May 10, 2022), 87 FR 29768 (May 16,
2022) (SR-IEX-2022-04).
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V. Request for Comment
The Commission generally requests comment from the public on all
aspects of Proposed Rule 615, including its objectives and its terms to
achieve those objectives. The Commission also generally requests
comment on the proposed definitions to be added to Rule 600 and their
use in the context of Proposed Rule 615. More specific requests for
comment are set forth below. With respect to any comments, the
Commission notes that they are of the greatest assistance to this
rulemaking initiative if accompanied by supporting data and analysis of
the issues addressed in those comments.
1. The Commission requests comment on the operation and
effectiveness of Proposed Rule 615. Would exposing segmented orders to
competition in qualified auctions be likely to generate better prices
for individual investors than are provided by current broker-dealer
routing practices? Would the likelihood of better prices vary across
different types of NMS stocks, such as those with different levels of
liquidity and trading volume? Do commenters believe that the wide
dissemination of auction messages for qualified auctions in NMS stocks
would be likely to affect trading or quoting behavior in NMS stocks
during the time period of the auction and, if so, would such an effect
promote or detract from obtaining the best possible price for segmented
orders in the qualified auctions?
2. Proposed Rule 615(c)(2) would prohibit display of auction
responses. In the case of an execution in a qualified auction, a
transaction report maintaining the anonymity of the parties would be
displayed in consolidated market data. Does the proposed prohibition
sufficiently mitigate the possibility of information leakage for
participants in a qualified auction? Are there different or additional
requirements that would better mitigate the possibility of information
leakage?
3. Is focusing on the accounts of natural persons, as well as
accounts held in legal form on behalf of a natural person or group of
related family members, and the level of trading activity in such
accounts an appropriate approach to identify orders that are included,
and those that are excluded, from the proposed definition of a
segmented order?
4. Should the proposed definition of ``group of related family
members'' be more or less inclusive, and if so, in what regard?
5. Should the level of trading activity used to determine which
accounts are associated with segmented orders be lower or higher than
40 trades per day? Is the six-month time frame is appropriate? If other
metrics would be more appropriate, please explain why and, if possible,
provide data to support your position.
6. Should any large orders be entirely excluded from the definition
of segmented order and therefore not eligible to trade in qualified
auctions, as opposed to the rule proposal which would provide an
exception for orders of $200,000 or more and that allows a choice of
whether to submit such orders to qualified auctions?
7. The proposed definition of an open competition trading center
would require national securities exchanges to operate as an SRO
trading facility that is an automated trading center and displays
automated quotations that are disseminated in consolidated market data?
Is this requirement appropriate or should it be modified in any
respect?
8. Is requiring a minimum level of trading volume for national
securities exchanges to qualify as open trading competition centers an
appropriate means to achieve the objectives of Proposed Rule 615? If
so, should the 1% level should be lower or higher? For example, should
the 1% level be lowered to enable additional national securities
exchanges to compete for segmented orders by operating qualified
auctions, or should the 1% be increased to help limit the potential
costs of market fragmentation? Are the other parameters of the volume
threshold appropriate to achieve the objective of ensuring that
qualified auctions are offered by trading centers that have sufficient
volume to provide vigorous competition? Is average daily volume during
at least 4 of the preceding 6 calendar months an appropriate parameter,
or are there more appropriate parameters? Is there another approach
that would be more effective to help limit the potential costs of
market fragmentation that could be associated with the requirements of
Proposed Rule 615?
9. Under the proposal, national securities exchanges would be
required to operate pursuant to their own rules providing that such
exchanges would comply with the requirements for qualified auctions.
Would this requirement provide sufficient notice to market participants
concerning the operation of qualified auctions by national securities
exchanges?
10. Should an NMS Stock ATS, to meet the proposed definition of an
open competition trading center, be required to display quotes through
an SRO display-only facility? Also, should an NMS Stock ATS be required
to operate as an automated trading center and display automated
quotations that are disseminated in consolidated market data?
11. Do commenters believe that identifying an NMS Stock ATS as the
venue of execution in transaction reports that are disseminated in
consolidated market data would be helpful to market participants when
assessing qualified auctions?
12. Should an NMS Stock ATS be required to permit any registered
broker-dealer to become a subscriber, except for a broker-dealer that
is subject to a statutory disqualification or, pursuant to written
policies and procedures, does not meet standards of financial
responsibility or operational capability?
13. Is an equal access standard appropriate for NMS Stock ATSs to
meet the definition of an open competition trading center and operate
qualified auctions? Alternatively,
[[Page 165]]
should other approaches be used to achieve the objective of a level
playing field regarding Proposed Rule 615 between NMS Stock ATSs and
national securities exchanges, given their different statutory and
regulatory regimes? For example, should the existing fair access
requirement in Rule 301(b)(5) of Regulation ATS be used instead of the
proposed equal access requirement? Are there other aspects of access to
an NMS Stock ATS operating as an open competition trading center
offering qualified auctions that should be addressed by Proposed Rule
615?
14. Is requiring a minimum level of trading volume for NMS Stock
ATSs an appropriate means to achieve the objectives of Proposed Rule
615? If so, should the 1% volume threshold should be lower or higher?
Are the other parameters of the volume threshold appropriate to achieve
the objective of ensuring that qualified auctions are offered by
trading centers that have sufficient volume to provide vigorous
competition? Is average daily volume during at least 4 of the preceding
6 calendar months an appropriate parameter, or are there more
appropriate parameters? Is there another approach that would be more
effective to help limit the potential costs of market fragmentation
that could be associated with the requirements of Proposed Rule 615?
15. Would market participants have sufficient notice concerning the
operation of qualified auctions by NMS Stock ATSs if they operate
pursuant to an effective Form ATS-N that evidences compliance with the
requirements for a qualified auction in Proposed Rule 615(c) and with
the other provisions of the proposed definition of an open competition
trading center?
16. Are there any other requirements, beyond those specified in the
proposed definition of an open competition trading center, that
national securities exchanges or NMS Stock ATSs should meet to be
eligible to qualify as open competition trading centers and operate
qualified auctions?
17. Should national securities exchanges that do not meet the
proposed definition of an open competition trading center be excluded,
as proposed, from the definition of a restricted competition trading
center based on their statutory requirements relating to access and
competition?
18. Does the proposed definition of originating broker
appropriately capture the brokers that would make the determination of
whether an order falls within the definition of a segmented order, as
well as the broker that would be required to be identified in auction
messages? Instead of allowing originating brokers to choose whether to
be identified in auction messages, should Proposed Rule 615, as a means
to promote greater uniformity of execution quality for segmented orders
from different originating brokers, prohibit any identification of the
originating broker in auction messages and require originating brokers
to certify that their identity will not be disclosed for all segmented
orders? Should originating brokers for a segmented order, other than
the broker responsible for approving the opening of accounts with
customers, be identified in the auction message? Should carrying or
clearing brokers that are an originating broker for a segmented order
also be disclosed in an auction message? Would such information be
useful to market participants' decisions whether to submit auction
responses and at what prices?
19. Are the five proposed exceptions in paragraph (b) of Proposed
Rule 615 appropriate? Should additional exceptions be included, such as
an exception for orders directed by the customer to a particular
trading center?
20. Instead of providing an exception for executions of segmented
orders during a time period when no open competition trading center is
operating a qualified auction, should the execution of segmented orders
during such a time period be prohibited? Is market value an appropriate
approach to identifying large trades that should be excepted from
Proposed Rule 615? If so, should the threshold amount of $200,000 be
lower or higher? For example, do commenters believe that segmented
orders in NMS stocks with a market value of up to $200,000 could be
executed efficiently in qualified auctions at prices that mostly would
be at or within the NBBO? If not, what market value should be used to
achieve this objective and should it vary based on the trading
characteristics of a particular NMS stock?
21. Would it be appropriate for Proposed Rule 615(b) to include an
exception for executions at a price less favorable to the segmented
order than a midpoint execution, so long as the segmented order is
executed at a price with a specified amount of price improvement? If
so, what would be the appropriate level of price improvement?
22. Is it appropriate for Proposed Rule 615(b) to include an
exception for executions of a segmented order with a limit price
selected by the customer that is equal to or more favorable for the
segmented order than the midpoint of the national best bid and national
best offer when the segmented order is received by the restricted
competition trading center? Should there be an exception for a wider
range of limit orders, in addition to, or instead of this proposed
exception? For example, should there be an exception for all non-
marketable limit orders (i.e., any buy limit order with a price less
than the NBO and any sell limit order with a price greater than the
NBB)?
23. Is it appropriate for Proposed Rule 615(b) to include the
exception for executions of segmented orders where no qualified
auctions are being offered for orders that are not entirely in whole
shares, and the customer selected a size for a segmented order that is
not entirely in whole shares of an NMS stock, in which case any portion
of such segmented order that is less than one whole share of the NMS
stock, and only such portion, would not be subject to the order
competition requirement of paragraph (a) of Proposed Rule 615? Would a
broker-dealer's best execution responsibilities be sufficient to ensure
that the fractional portion of the segmented order is executed in the
best market available? Do commenters believe that, if Proposed Rule 615
were adopted, open competition trading centers would offer qualified
auctions that accommodate fractional shares? If not, should a broker-
dealer be required to round up a segmented order with a fractional
component before submitting the order to a qualified auction, with the
broker-dealer required to accept the rounded up portion of the order?
Or would broker-dealers be less willing to offer their customers
transactions in fractional shares if rounding up were required?
24. Should auction messages be required to include the side (buy or
sell) of a segmented order? For example, if side were not included in
auction messages, market participants could be allowed to provide
auction responses for one or both sides, with only auction responses on
the opposite side of the segmented order considered for execution. Do
commenters believe that such an approach would limit the extent to
which quoted price might move away from segmented orders during the
pendency of a qualified auction?
25. Should the minimum or maximum time periods for qualified
auctions be shorter or longer? Should a restricted competition trading
center be permitted to execute a segmented order that was not executed
in a qualified auction at the specified limit price as soon as
reasonably possible, or should there be a specified time period for
execution?
26. Should the pricing increment be smaller or larger than the
proposed 0.1
[[Page 166]]
cent for segmented orders and auction responses with prices of $1.00 or
more per share? Would, for example, the potential benefit for segmented
orders of a smaller pricing increment, such as 0.05 cent, outweigh the
potential cost of less direct interaction of investor orders without
the participation of a dealer?
27. Does Proposed Rule 615(c)(4) appropriately address the fees and
rebates for qualified auctions? Is the proposed prohibition of any fee
for the submission or execution of segmented orders appropriate? Should
the proposed 5 mil cap on fees for executed auction responses priced at
$1.00 per share or more be higher or lower? Should the proposed 5 mil
cap on rebates for segmented orders priced at $1.00 per share or more
be higher or lower? Is it appropriate to require that the rates for
fees and rebates be flat in all auctions?
28. Are the execution priority requirements specified in Proposed
Rule 615(c)(5) appropriate? Should auction responses of customers have
priority over auction responses of broker-dealers at the same price? Is
it appropriate to prohibit execution priority terms that favor the
broker-dealer that routed the segmented order, the originating broker
for the segmented order, and the open competition trading center
operating the auction, as well as affiliates of the foregoing persons?
Should the requirements for execution priority of orders resting on the
continuous order book of an open competition trading center be
modified? Should displayed orders on the continuous order book have
priority over auction responses at the same price? Should auction
responses have priority over undisplayed orders on the continuous order
book at the same price?
29. Should an open competition trading center be permitted to give
execution priority advantages to market makers that accept objective
affirmative obligations, such as public quoting obligations or an
obligation to fill segmented orders at the relevant NBBO if such orders
do not otherwise receive an execution in qualified auctions? For
example, Table 7 in section VII.B.4 below shows that 1.67% of
marketable order shares are executed by wholesalers at prices outside
the NBBO at the time the wholesaler received the order. Do commenters
believe that, if Rule 615 were adopted as proposed, a larger percentage
of marketable orders of individual investors would be executed at
prices outside the NBBO when the order is received by a trading center?
30. Should the broker routing a segmented order to a qualified
auction be required to execute the order, or any unexecuted portion
thereof, at the specified limit price or some other price if the
segmented order is not executed in full in the auction?
31. Should there be parameters for what the specified limit price
selected by a broker routing a segmented order to a qualified auction
could be? For example, should the specified limit price be required to
be within a range that is tied to the midpoint of the NBBO at the time
the segmented order is received?
32. Should an open competition trading center be permitted to
operate multiple qualified auctions in the same NMS stock
simultaneously?
33. Should open competition trading centers have flexibility to
determine aspects of qualified auctions that are not specified by
Proposed Rule 615? Are there additional aspects for qualified auctions
that should be specified by rule? For example, are there additional
aspects of execution priority that should be specified by rule or,
alternatively, that open competition trading centers should have
greater flexibility to determine?
34. Should open competition trading centers and national securities
exchanges be allowed to continue to operate trading systems, other than
qualified auctions, that are limited, in whole or in part, to the
execution of segmented orders and that do not fall within one of the
five exceptions in Proposed Rule 615(d)(2) and (g)? For example, should
national securities exchanges be permitted to continue to operate RLPs
that do not qualify for one of the exceptions in Proposed Rule 615(g)?
Are there other types of limited trading facilities operated by
national securities exchanges or open competition trading centers that
should be permitted?
35. Is it appropriate, as provided in Proposed Rule 615(f)(4), to
prohibit broker-dealers with knowledge of where a segmented order is to
be routed for execution from submitting, or enabling the submission, of
an order to the continuous order book of an open competition trading
center that could trade with that segmented order? Do commenters
believe that this prohibition could significantly interfere with
broker-dealer handling of customer orders and, if so, would limiting
the prohibition to the proprietary orders of a broker-dealer and its
affiliates be consistent with the purposes of Proposed Rule 615?
36. Does Proposed Rule 615(e)(4) provide sufficient clarification
as to which broker-dealer would be subject to the obligations of
Proposed Rule 615(e) when there are multiple originating brokers for a
segmented order and such originating brokers have in place a written
agreement that allocates their responsibilities with respect to
customer orders?
37. Does Rule 613 of Regulation NMS and the Consolidated Audit
Trail NMS Plan require adequate reporting of all elements of this
proposed rule so that regulators can evaluate compliance and study its
effectiveness?\260\
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\260\ See supra note 254 (discussing the type of data to be
collected and reported pursuant to the CAT NMS Plan).
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VI. Paperwork Reduction Act Analysis
Certain provisions of Proposed Rule 615 contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\261\ The Commission is submitting
these collections of information to the Office of Management and Budget
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR
1320.11. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless the agency
displays a currently valid control number. The title of the new
collection of information is ``Order Competition Rule.'' The
requirements of this collection of information would be mandatory for
originating brokers, brokers and dealers that route segmented orders,
national securities exchanges and NMS Stock ATSs that operate qualified
auctions as open competition trading centers, and national securities
associations that provide auction message information for dissemination
in consolidated market data.
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\261\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
A. Summary of Collection of Information
Proposed Rule 615 and the proposed related amendments would create
burdens under the PRA by creating the new collections of information
described below for market participants that handle or execute
segmented orders, or operate qualified auctions to provide competition
for segmented orders.
1. Auction Messages
Proposed Rule 615 would require an open competition trading center
to comply with the requirements of paragraph (c) for operation of a
qualified auction for segmented orders.\262\ Pursuant to paragraph
(c)(1), an open competition trading center operating a qualified
auction would be required to provide an auction message announcing
[[Page 167]]
the initiation of a qualified auction for a segmented order for
dissemination in consolidated market data. Each auction message shall
invite priced auction responses to trade with a segmented order and
shall include, among other things, the identity of the originating
broker.\263\
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\262\ Supra section IV.C.
\263\ As discussed above in section IV.C.1, the identity of the
originating broker is not required to be disclosed, however, if the
originating broker makes the requisite certification.
---------------------------------------------------------------------------
2. Identifying and Marking Segmented Orders
a. Identification of Segmented Orders
Paragraph (e)(1) would require originating brokers to establish,
maintain, and enforce written policies and procedures reasonably
designed to identify the orders of customers as segmented orders.
b. Marking Segmented Orders
Paragraph (e)(2) of Proposed Rule 615 would require originating
brokers to identify a segmented order as such to any destination the
broker routes the order. Additionally, pursuant to paragraph (f)(1) of
Proposed Rule 615, no broker-dealer that receives an order identified
as a segmented order shall route the order without identifying the
order as a segmented order to the routing destination. Thus,
originating brokers and other broker-dealers that route segmented
orders would be required to mark segmented orders as such.
3. Originating Broker Certification
Pursuant to paragraph (e)(3), if the originating broker for a
segmented order that is the originating broker responsible for
approving the opening of accounts with customers determines to make the
certification referenced in paragraph (c)(1)(iii) of Proposed Rule 615,
the originating broker shall establish, maintain, and enforce the
required policies and procedures reasonably designed to assure that the
identity of the originating broker will not be disclosed.\264\ As
discussed above, the certification must also be communicated to the
open competition trading center operating the qualified auction.\265\
The Commission believes that broker-dealers would likely use order
marking systems to communicate to an open competition trading center
whether an originating broker has made the certification referenced in
Proposed Rule 615(c)(1)(iii). Accordingly, the originating broker with
responsibility for transmitting orders for a customer's account would
mark segmented orders to indicate that the certification has been made,
and other broker-dealers that receive and route such orders would also
mark such orders accordingly. As discussed below, the Commission
believes that broker-dealers would have an initial burden to modify
their systems to be able to mark segmented orders as such, and an
ongoing burden to mark segmented orders. The Commission also believes
that broker-dealers would include in those systems modifications, the
ability to communicate whether an originating broker has made the
referenced certification, and on an ongoing basis would include the
certification information, as applicable, when marking segmented
orders. Thus, the Commission believes that the initial burden for
broker-dealers to modify their systems to mark orders as segmented
orders and the ongoing burden to mark segmented orders as such, as
discussed below, would subsume the burden to mark orders to communicate
when the certification has been made and therefore estimates no
additional costs associated with communication of the certification.
---------------------------------------------------------------------------
\264\ Supra section IV.E.
\265\ Supra section IV.C.1.
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4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
Pursuant to paragraph (d)(1) of Proposed Rule 615, a national
securities exchange or NMS Stock ATS shall not operate a qualified
auction for segmented orders unless it meets the definition of open
competition trading center in Proposed Rule 600(b)(64).\266\ For an NMS
Stock ATS to qualify as an open competition trading center eligible to
operate a qualified auction, Proposed Rule 600(b)(64)(ii)(D) would
require the NMS Stock ATS to permit any registered broker or dealer
(other than a broker or dealer subject to a statutory disqualification)
to become a subscriber of the ATS. The NMS Stock ATS could, however,
pursuant to written policies and procedures, prohibit a broker or
dealer from being or becoming a subscriber, or impose conditions on a
broker or dealer subscriber, that does not meet standards of financial
responsibility or operational capability, as are prescribed by the
written policies and procedures. Thus, to be able to exclude a broker-
dealer from becoming a subscriber (other than a broker or dealer
subject to a statutory disqualification), or imposing conditions on
such a subscriber, the NMS Stock ATS would be required to have written
policies and procedures.
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\266\ Supra section IV.B.2, and IV.D.
---------------------------------------------------------------------------
B. Proposed Use of Information
As discussed above,\267\ Proposed Rule 615 is designed to benefit
individual investors by enhancing the opportunity for their orders to
receive more favorable prices than they receive in the current market
structure, as well as to benefit investors generally by giving them an
opportunity to interact directly with a large volume of individual
investor orders that are mostly inaccessible to them in the current
market structure, by requiring that individual investor orders be
exposed to order-by-order competition in fair and open auctions
designed to obtain the best prices before such orders could be
internalized by wholesalers or any other type of trading center that
restricts order-by-order competition.
---------------------------------------------------------------------------
\267\ Supra section I.
---------------------------------------------------------------------------
1. Auction Messages
The auction messages provided under paragraph (c)(1) of Proposed
Rule 615 would be disseminated in consolidated market data and would be
used by market participants to determine whether to submit auction
responses. As discussed above, the wide dissemination of these auction
messages would promote competition by soliciting potential auction
responses from a wide spectrum of market participants.\268\
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\268\ Supra section IV.C.1.
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2. Identifying and Marking Segmented Orders
a. Identification of Segmented Orders
The requirements of paragraph (e)(1) of Proposed Rule 615 are
designed to ensure that originating brokers are able to properly
identify segmented orders. Specifically, written policies and
procedures established pursuant to Proposed Rule 615(e)(1) would help a
broker develop a process, relevant to its customers and the nature of
its business, for properly identifying the orders of its customers as
segmented orders. Further, the maintenance of written policies and
procedures would generally: (1) assist a broker-dealer in supervising
and assessing its compliance with Proposed Rule 615; and (2) assist the
Commission and SRO staff in connection with examinations and
investigations.
b. Marking Segmented Orders
Marking segmented orders as such pursuant to paragraphs (e)(2) and
(f)(1) of Proposed Rule 615 would inform other market participants that
the orders must be handled in accordance with the requirements of
Proposed Rule 615, which, as discussed above, is designed
[[Page 168]]
to provide competition for individual investor orders in fair and open
auctions.
3. Originating Broker Certification
Written policies and procedures established pursuant to Proposed
Rule 615(e)(3) would help a broker develop a process, relevant to the
nature of its business, to ensure that its identity will not be
disclosed and to support its certification. Further, the maintenance of
written policies and procedures would generally: (1) assist a broker in
supervising and assessing its compliance with Proposed Rule 615(e)(3);
and (2) assist the Commission and SRO staff in connection with
examinations and investigations.
Communication of the certification to the relevant open competition
trading center would enable the open competition trading center to
comply with the requirements of Proposed Rule 615(c)(1) that an auction
message disclose the identity of the originating broker for a segmented
order, unless the originating broker has made the requisite
certification.\269\
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\269\ As discussed above, the disclosure of the identity of the
originating broker in an auction message, absent the corresponding
certification, is designed to help ensure fair competition among
auction responders and persons that could otherwise trade with the
segmented order, while giving originating brokers a choice as to
whether or not to disclose their identity. Supra section IV.C.1.
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4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
To qualify as an open competition trading center, an NMS Stock ATS
would be required to permit any registered broker-dealer (other than a
broker-dealer subject to a statutory disqualification) to become a
subscriber of the NMS Stock ATS, and must provide equal access among
all subscribers of the NMS Stock ATS.\270\ These requirements are
designed to help ensure a level playing field regarding Proposed Rule
615 for competition among NMS Stock ATSs and national securities
exchanges, in light of the different regulatory regimes for each.
Similar to the requirements for national securities exchanges, under
Proposed Rule 600(b)(64)(ii)(D), NMS Stock ATSs could exclude a
registered broker-dealer, or impose conditions on a broker-dealer
becoming a subscriber, that does not meet certain standards of
financial responsibility or operational capability, but may only do so
pursuant to written policies and procedures. While national securities
exchanges must prescribe rules, consistent with the Exchange Act, for
denying membership to a broker-dealer, the requirements applicable to
NMS Stock ATSs are less stringent.\271\ Requiring NMS Stock ATSs to
establish written policies and procedures would help an NMS Stock ATS
to develop a process for identifying registered broker-dealers that
should be excluded because they do not meet certain standards, and
would help level the competitive playing field regarding Proposed Rule
615 between NMS Stock ATSs and national securities exchanges. Further,
the written policies and procedures would generally: (1) assist an NMS
Stock ATS in supervising and assessing its compliance with the access
requirements of proposed Rule 600(b)(64)(ii)(D); and (2) assist the
Commission and SRO staff in connection with examinations and
investigations.
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\270\ Supra section IV.B.2.
\271\ Id.
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C. Respondents
A summary of the Commission's initial estimates of the number of
respondents for each collection of information requirement is set forth
below:
Collection of Information--Order Competition Rule
----------------------------------------------------------------------------------------------------------------
Number of
Description of burden Rule Applicable respondents respondents
----------------------------------------------------------------------------------------------------------------
Dissemination of Auction Messages... Rule 615(c)(1)................... National securities 6
exchanges operating
qualified auctions.
National securities 1
associations.
NMS Stock ATSs 3
operating qualified
auctions.
---------------
Total........................... ................................. ....................... 10
Policies and Procedures to Identify Rule 615(e)(1)................... Originating broker- 157
Segmented Orders. dealers with
responsibility for
identifying segmented
orders.
Identification of Segmented Orders Rule 615(e)(2)................... Originating broker- 157
by Originating Brokers. dealers with
responsibility for
identifying segmented
orders.
Marking of Segmented Orders:
Marking of Segmented Orders by Rule 615(e)(2)................... Originating broker- 157
Originating Brokers. dealers with
responsibility for
marking segmented
orders.
Marking of Segmented Orders by Rule 615(f)(1)................... Broker-dealers that 25
Broker-Dealers. route orders
identified as
segmented orders.
---------------
Total....................... ................................. ....................... 182
Policies and Procedures for Rule Rule 615(e)(3)................... Originating broker- 20
615(c) Certification. dealers certifying
that they established,
maintained, and
enforced policies and
procedures reasonably
designed to assure
that their identity
will not be disclosed.
NMS Stock ATS Policies and Rule 615(d)(1)................... NMS Stock ATSs 3
Procedures to Exclude Subscribers. operating qualified
auctions that may
exclude subscribers.
----------------------------------------------------------------------------------------------------------------
1. Auction Messages
As discussed above,\272\ the open competition trading centers that
would be required to provide auction messages for dissemination in
consolidated market data pursuant to paragraph (c)(1) of Proposed Rule
615 would be national securities exchanges and NMS Stock ATSs that meet
certain requirements and are eligible to operate qualified auctions for
segmented orders. As is currently the case for quotation and trading
information in NMS stocks, auction information would be provided by
national securities exchanges and FINRA, as the only national
securities association, to the SIPs for
[[Page 169]]
dissemination in consolidated market data.\273\
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\272\ Supra section IV.B.2.
\273\ Supra sections III.B.1 and IV.C.1.
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Given that all national securities exchanges already have systems
and processes for providing information for dissemination in
consolidated market data as well as systems and processes for
disseminating certain auction information,\274\ the Commission
estimates that it is likely that 6 of the 16 national securities
exchanges that trade NMS stocks would choose to qualify as open
competition trading centers and operate qualified auctions. Of the 16
registered national securities exchanges currently trading NMS
stocks,\275\ 12 are part of one of 3 corporate affiliate groups, and
the Commission estimates that one of the national securities exchanges
from each of the three corporate groups would likely choose to operate
qualified auctions.\276\ Of the four other national securities
exchanges that currently trade NMS stocks, the Commission estimates
that three exchanges would likely choose to operate qualified
auctions.\277\
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\274\ Supra section IV.B.1. In addition to providing
consolidated market data, national securities exchanges also sell
their individual proprietary market data products, and their depth
of book (``DOB'') products typically include, among other things,
information about orders participating in auctions, including
auction order imbalances. See, e.g., Nasdaq Rule 123(a)(1)(B)
available at https://listingcenter.nasdaq.com/rulebook/nasdaq/rules/Nasdaq%20Equity%207#section_123_nasdaq_depth-of-book_data (defining
Nasdaq's ``Nasdaq TotalView'' data product); and https://www.nyse.com/market-data/real-time/integrated-feed (describing
NYSE's ``NYSE Integrated'' data product).
\275\ Supra note 82 and accompanying text.
\276\ CBOE Holdings, Inc. is the parent company of Cboe BYX,
Cboe BZX, Cboe EDGA, and Cboe EDGX; Nasdaq, Inc. is the parent
company of Nasdaq BX, Nasdaq PhlX, and Nasdaq; Intercontinental
Exchange, Inc. is the parent company of NYSE, NYSE American, NYSE
Arca, NYSE CHX, and NYSE National.
\277\ The remaining four national securities exchanges that
trade NMS stocks are IEX, LTSE, MEMX, and MIAX PEARL, which is a
subsidiary of MIAX International Holdings, Inc. Of these, based on
examination of data related to national securities exchanges, for
the month ended Nov. 30, 2022, only LTSE did not report more than 1%
of share volume in NMS stocks. Proposed Rule 600(b)(64) requires a
national securities exchange to have had an average daily share
volume for NMS stocks of 1% or more during at least four of the
preceding 6 calendar months to qualify as an open competition
trading center eligible to operate a qualified auction. See Cboe,
U.S. Historical Market Volume Data, available at: https://cboe.com/us/equities/market_statistics/historical_market_volume/.
---------------------------------------------------------------------------
The Commission also estimates that some, but not all NMS Stock ATSs
would chose to operate qualified auctions for segmented orders. One of
the requirements of Proposed Rule 615 is that an open competition
trading center must meet the definition set forth in Proposed Rule
600(b)(64), which would require that an NMS Stock ATS permit any
registered broker or dealer (other than a broker or dealer subject to a
statutory disqualification) to become a subscriber and provide equal
access among all subscribers. To qualify as an open competition trading
center, Proposed Rule 600(b)(64) would also require an NMS Stock ATS to
display quotations through an SRO display-only facility and operate as
an automated trading center that displays automated quotations
disseminated in consolidated market data. Given that NMS Stock ATSs
often differentiate between groups or classes of subscribers with
respect to access to services and most have adopted a ``dark'' trading
model,\278\ of the 32 NMS Stock ATSs, the Commission estimates that
approximately three are likely to make the business model modifications
necessary to meet the open competition trading center definition and be
eligible to operate qualified auctions.\279\
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\278\ NMS Stock ATSs must publicly disclose information about
their trading system and services, including differences in access,
on Form ATS-N. Links to Form ATS-N filings are available on the
Commission's website at https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm. See also ATS-N Adopting Release, supra note
159, 83 FR at 38886 n.1292 and accompanying text (discussing the
dark trading model adopted by most NMS Stock ATSs).
\279\ The Commission bases this estimate on the following
considerations. While currently no NMS Stock ATS would qualify as an
Open Competition Trading Center, there is currently one NMS Stock
ATS that discloses that it crosses the 5% volume threshold for fair
access under Regulation ATS for securities that are available for
trading on its platform. This NMS Stock ATS may choose to make the
necessary modifications to operate as an Open Competition Trading
Center. In addition, given the low-cost nature of segmented order
flow that is likely to be attractive to market participants, the
Commission estimates that two additional NMS Stock ATSs would choose
to make the necessary modifications to operate as Open Competition
Trading Centers.
---------------------------------------------------------------------------
As discussed above, broker-dealers provide certain NMS stock
information to FINRA through its facilities, and FINRA provides
information for dissemination in consolidated market data. To qualify
as open competition trading centers, the three NMS Stock ATSs would
have systems and processes in place to display quotations disseminated
in consolidated market data. These ATSs would provide auction message
information to FINRA, and FINRA would transmit the information for
dissemination in consolidated market data.
The Commission requests comment on its estimates of the number of
exchanges and NMS Stock ATSs that would become open competition trading
centers operating qualified auctions, including whether the estimates
should be lower or higher.
2. Identifying and Marking Segmented Orders
As discussed above, Proposed Rule 615 would impose certain
obligations on originating brokers, and all other broker-dealers, with
respect to their handling of segmented orders. Proposed Rule 600(b)(69)
defines ``originating broker'' to mean any broker with responsibility
for handling a customer account,\280\ and Proposed Rule 600(b)(91)
defines ``segmented order'' as an order for the account of a natural
person (or an account held on behalf of a natural person or group of
related family members) that meets certain trading volume
thresholds.\281\ Most segmented orders are handled by large, customer-
facing broker-dealers that accept orders from customers and then route
these orders to various execution centers. Also, as discussed above, in
section IV.B.4, broker business practices can vary widely in terms of
how customer accounts are handled, with some brokers performing the
entire function internally and others allocating various
responsibilities of an originating broker to other brokers-dealers such
as carrying or clearing brokers. Those originating brokers who have
been assigned responsibilities that include the transmission of orders
for execution would need to identify and mark segmented orders as such
to comply with Proposed Rule 615.\282\
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\280\ Supra section IV.B.4.
\281\ Supra section IV.B.1.
\282\ Supra section IV.B.4.
---------------------------------------------------------------------------
Based on FOCUS Report data,\283\ the Commission estimates that as
of June 30, 2022 there were 3,498 registered broker-dealers,\284\ and
of these there were 157 reporting that they carry public customer
accounts \285\ that would likely be subject to the requirements of
paragraphs (e)(1) and (2) of Proposed Rule 615.
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\283\ FOCUS Reports, or ``Financial and Operational Combined
Uniform Single'' Reports, are monthly, quarterly, and annual reports
that broker-dealers are generally required to file with the
Commission and/or SROs pursuant to Exchange Act Rule 17a-5. See 17
CFR 240.17a-5.
\284\ The data is obtained from FOCUS Reports, Part II filed for
the second quarter of 2022.
\285\ Information on the number broker-dealers that carry public
customer accounts is from broker-dealers' responses on their most
recently available FOCUS Report Form X-17A-5 Schedule I. Because
``public customer accounts'' may hold orders other than segmented
orders, for example institutional customers would also fall within
the definition of ``public customer'' for purposes of FOCUS Report
Form X-17A-5 Schedule I, 157 is likely an overestimate.
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Paragraph (f)(1) of Proposed Rule 615 would also require every
broker-dealer that receives a segmented order and routes that order to
identify the order as such. This would include broker-dealers
[[Page 170]]
that act as wholesalers that would be required to route a segmented
order to be exposed in a qualified auction at a price prior to
executing it, or that route the order to another execution center; and
any other broker-dealer, including originating broker-dealers assigned
responsibilities that include identifying and marking orders, that
routes segmented orders. The Commission estimates that approximately 25
broker-dealers that do not also carry customer accounts would route
retail orders.\286\
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\286\ This estimate is based broker-dealers' responses on their
most recently available FOCUS Report Form X-17A-5 Schedule I,
showing that there are 25 broker-dealers that effect public customer
transactions in equity securities on a national securities exchange
or OTC that do not carry public customer accounts.
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a. Identification of Segmented Orders
As discussed above, the Commission estimates that there are 157
originating brokers that would be required to establish, maintain, and
enforce written policies and procedures reasonably designed to identify
customer orders as segmented orders pursuant to paragraph (e)(1) of
Proposed Rule 615. While there are additional broker-dealers, such as
introducing brokers, that would meet the definition of ``originating
broker,'' only those broker-dealers carrying customer accounts are
likely to have been allocated responsibility for routing orders and
therefore would have burdens and costs associated with implementing the
requirements of paragraph (e)(1) of Proposed Rule 615.
The Commission requests comment on whether its estimate of the
number of brokers that would fall within the scope of Proposed Rule
615(e)(1), including whether the estimate should be higher or lower.
b. Marking Segmented Orders
As discussed above, the Commission estimates that there would be
157 originating brokers that would be required to identify segmented
orders as such prior to routing those orders pursuant to Proposed Rule
615(e)(2). Additionally, the Commission estimates that there would be
an additional 25 broker-dealers that route customer orders, and would
not also be originating brokers in the scope of paragraph (e)(2), that
would be required, pursuant to Proposed Rule 615(f)(1) to identify any
segmented orders received as such, when routing the order to a routing
destination.
The Commission requests comment on its estimate of the number of
broker-dealers that would fall within the scope of paragraphs (e)(2)
and (f)(1) of Proposed Rule 615, including whether the estimate should
be higher or lower.
3. Originating Broker Certification
It is likely that most originating brokers with segmented orders
would choose to be identified as the originating broker of a segmented
order because that information would be used by market participants to
help predict the level of adverse selection costs associated with order
flow from a given originating broker. Thus, originating brokers known
to be associated with lower adverse selection costs would likely want
auction responders to know their identity. Based on a review of data
related to broker-dealers, the Commission estimates that there are
approximately 1,267 broker-dealers that would meet the definition of
``originating broker'' and that have responsibility for monitoring
customer accounts.\287\ These broker-dealers would be required to
maintain the policies and procedures required by paragraph(e)(3) of
Proposed Rule 615 if they choose not to have their identity disclosed
in auction messages. While it is very difficult for the Commission to
know how many originating brokers would choose to certify that they
established, maintained, and enforced written policies and procedures
reasonably designed to assure that their identity will not be disclosed
to any person that potentially could participate in the qualified
auction or otherwise trade with the segmented order routed by the
originating broker, the Commission preliminarily estimates that 20 of
the 1,267 originating brokers would choose not to disclose their
identity and would be required to establish, maintain and enforce the
written policies and procedures required by paragraph (e)(3) of
Proposed Rule 615. While segmented orders, by definition, are limited
to orders for accounts with an average daily number of trades in NMS
stocks of less than 40 in each of the six preceding months, and thereby
likely associated with lower adverse selection costs, there may be some
broker-dealers that have order flow associated with higher levels of
adverse selection costs or who have customers or business models that
preference anonymity.\288\
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\287\ The Commission estimates that there are approximately 157
broker-dealers that carry at least one customer account trading in
NMS stocks, and 1,110 broker-dealers that introduce at least one
customer account trading in NMS stocks. The estimate of 157 broker-
dealers that carry at least one customer account trading in NMS
stocks and options is based on the number of broker-dealers that
report carrying at least one customer account on their 2021 FOCUS
Report Form X-17A-5 Schedule I; and the estimate of 1,110 broker-
dealers that introduce at least one customer account trading in NMS
stocks and options is based on estimates using broker-dealers' FDIDs
identified in CAT data during the 2021 calendar year. As CAT data
includes information only about NMS stocks and options, broker-
dealers that introduce or carry customer accounts trading in other
assets classes are not included in these numbers.
\288\ These broker-dealers are likely to be larger broker-
dealers that have customers who are more informed traders. Lower-
volume broker-dealers with fewer orders are not likely to have this
type of customer.
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As discussed above, the originating broker with responsibility for
transmitting orders for a customer's account would likely also mark
segmented orders to indicate that the certification has been made, and
other broker-dealers that receive and route such orders would also need
to mark such orders accordingly. The same broker-dealers that would
mark orders as segmented orders pursuant to paragraphs (e)(2) and
(f)(1) of Proposed Rule 615, discussed above in section VI.C.2.b, would
also likely mark orders, as applicable, to communicate the
certification to the open competition trading center.
The Commission requests comment on its estimate of the number of
originating brokers that would certify that they have established,
maintained, and enforced written policies and procedures reasonably
designed to assure that the identity of the originating broker will not
be disclosed, including whether the estimate should be higher or lower.
The Commission also requests comment on whether it is reasonable to
estimate that such certifications would be communicated to open
competition trading centers via order marking and that the same broker-
dealers that would mark orders as segmented orders would also mark
orders for the purpose of communicating such certifications to the open
competition trading centers operating qualified auctions.
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
As discussed above, of the 32 NMS Stock ATSs, the Commission
estimates that approximately 3 would operate qualified auctions. To do
so, those NMS Stock ATSs would need to meet the definition of open
competition trading center, and as such, would be required to have
written policies and procedures to prohibit any registered broker or
dealer from being or becoming a subscriber, or impose conditions upon a
such a subscriber, that does not meet the standards of financial
responsibility or operational capability of the NMS Stock ATS. The
Commission anticipates that all three NMS Stock ATSs operating
qualified auctions would have standards
[[Page 171]]
for financial responsibility or operational capability for their
subscribers.\289\
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\289\ This estimate is based on a review of NMS Stock ATS
disclosures on Form ATS-N.
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The Commission requests comment on whether its estimate that all
NMS Stock ATSs operating qualified auctions would have standards for
financial responsibility or operational capability for their
subscribers is reasonable.
D. Burdens
1. Auction Messages
As discussed above, the estimated six national securities exchanges
operating as open competition trading centers operating qualified
auctions would be required to collect and provide the information
necessary to generate auction messages in consolidated market data.
These entities currently operate auctions for which messages are
disseminated in their proprietary data feeds, and already provide other
information regarding NMS stocks for dissemination in consolidated
market data. The auction messages would be a new data element that the
national securities exchanges would have to make available for
inclusion in the dissemination of consolidated market data. Because the
national securities exchanges currently collect and calculate data
necessary to generate other elements of consolidated market data, and
also currently provide auction information to subscribers of
proprietary data, the requirements of Rule 615(c)(1) would likely
impose minimal initial and ongoing burdens on these respondents,
including any changes to their systems.
The Commission estimates that a national securities exchange would
require an average of 220 initial burden hours of legal, compliance,
information technology, and business operations personnel time to
prepare and implement a system to collect and provide the information
necessary to generate auction messages for dissemination in
consolidated market data, at a monetized cost per exchange of
$78,580.\290\ And each national securities exchange would incur an
annual average burden on an ongoing basis of 336 hours to collect and
provide auction messages, at a monetized cost per exchange of
$118,560.\291\
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\290\ The Commission estimates the monetized initial burden for
this requirement to be $78,580: (Compliance Manager at $344 for 105
hours) + (Attorney at $462 for 70 hours) + (Sr. Systems Analyst at
$316 for 20 hours) + (Operations Specialist at $152 for 25 hours) =
220 initial burden hours, at a monetized cost of $78,580. Throughout
this section VI.D, the Commission derived estimates for in-house
personnel costs on per hour figures from SIFMA's Management &
Professional Earnings in the Securities Industry 2013, modified to
account for an 1,800-hour work-year and inflation, and multiplied by
5.35 to account for bonuses, firm size, employee benefits and
overhead.
\291\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be $118,560: (Compliance Manager at
$344 for 192 hours) + (Attorney at $462 for 48 hours) + (Sr. Systems
Analyst at $316 for 96 hours) = 336 initial burden hours, at a
monetized cost of $118,560.
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Proposed Rule 615(c)(1) would also require auction messages
initiating qualified auctions held on NMS Stock ATSs operating as open
competition trading centers to be provided for dissemination in
consolidated market data. As discussed above, like national securities
exchanges, FINRA already collects information from broker-dealers for
dissemination in consolidated market data, and the addition of auction
message information as a new data element would impose approximately
the same burdens and costs on FINRA as for national securities
exchanges.\292\
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\292\ Supra notes 290 and 291.
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To qualify as an open competition trading center eligible to
operate qualified auctions, an NMS Stock ATS would need to display
quotations through an SRO display-only facility in compliance with Rule
610(b); display automated quotations disseminated in consolidated
market data pursuant to Rule 603(b); \293\ and provide trade reports
identifying the NMS Stock ATS as the venue of execution that are
disseminated in consolidated market data pursuant to Rule 603(b).\294\
These ATSs would need to have systems in place to collect and calculate
such information and transmit the information to FINRA for
dissemination in consolidated market data. It is likely that NMS Stock
ATSs that run qualified auctions would be operated by large,
sophisticated broker-dealers that have in place systems that could be
modified to collect and disseminate auction message information. The
Commission estimates that the burdens and costs to these NMS Stock ATSs
to modify their systems to also provide auction information for
dissemination in consolidated data would be minimal, and would be the
same as those for national securities exchanges and FINRA.\295\
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\293\ The requirements of Rule 610(b) for trading centers that
choose to display quotations in NMS stock are existing requirements
under Regulation NMS, and the requirements of Rule 603(b) pertaining
to the display of quotations from trading centers that qualify as
automated trading centers, are existing requirements that are not
modified by Proposed Rule 615 and the proposed new definitions under
Rule 600 and do not constitute new collections of information.
\294\ Proposed Rule 600(b)(64)(ii).
\295\ Supra notes 290 and 291.
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The Commission estimates the initial total aggregate burden and
cost for all 10 respondents would be 2,220 hours, at a monetized cost
of $785,800,\296\ and the ongoing total burden and cost would be 3,360
hours, at a monetized cost of $1.12 million.\297\
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\296\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be $785,800: $78,580 x (6 national
securities exchange + 1 registered securities association + 3 NMS
stock ATSs) = $785,800.
\297\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be $1,185,600: $118,560 x (6 national
securities exchange + 1 registered securities association + 3 NMS
stock ATSs) = $1,185,600.
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A summary of the initial and ongoing burdens and costs described
above is set forth below:
Total Estimated Burden Associated With Providing Auction Messages In Consolidated Market Data
----------------------------------------------------------------------------------------------------------------
Burden hours
Respondents per Aggregate Monetized cost Aggregate
respondent burden hours per respondent monetized cost
----------------------------------------------------------------------------------------------------------------
Total Initial Burden............ 10 220 2,220 $78,580 $785,800
Total Ongoing Burden............ 10 336 3,360 118,560 1,185,600
----------------------------------------------------------------------------------------------------------------
The Commission requests comment on whether there would be different
or additional burdens or costs for open competition trading centers to
provide the information necessary to generate auction messages in
consolidated market data. The Commission also requests comment on
whether the burdens and costs for NMS Stock ATSs to provide the
information necessary to generate auction messages in consolidated
market data would be different from those for national securities
exchanges.
[[Page 172]]
2. Identifying and Marking Segmented Orders
a. Policies and Procedures To Identify Segmented Orders
As discussed above, the 157 broker-dealers that would need to
identify and mark orders to comply with paragraphs (e)(1) and (e)(2) of
Proposed Rule 615 likely already would have policies and procedures to
classify orders for compliance with SRO rules and other regulatory
requirements, and would have access to the information that would
enable them to identify orders as being for the account of a natural
person or a group of related family members and to monitor the level of
trading activity in the accounts of their customers, as well as systems
and processes for marking orders.\298\ For example, these broker-
dealers either themselves collect data from their customers, or receive
such information through an introducing broker for whom they are
providing services. These broker-dealers will also be familiar with how
to adapt their systems and processes to identify which customer
accounts meet the proposed volume requirements that would cause their
orders to meet the definition of segmented order in Proposed Rule
600(b)(89) and to accommodate the new order marks.
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\298\ Supra section IV.B.1 (discussing the definition of
segmented order, which is designed to facilitate compliance and
minimize the costs of compliance) and note 253 and accompanying
text.
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While most broker-dealers likely have capabilities to identify the
characteristics of their customers' orders that would be necessary to
identify orders as segmented orders, they would not have written
policies and procedures regarding the identification of segmented
orders, which would be a new classification for a subset of customer
orders, as would be required by Proposed Rule 615(e)(1). The Commission
estimates that, to initially comply with this obligation, broker-
dealers would employ a combination of in-house and outside legal and
compliance counsel to update existing policies and procedures.
Initial Burdens and Costs
The Commission estimates that each of the 157 broker-dealers that
would be subject to the collection of information under Proposed Rule
615(e)(1) would incur an initial average internal burden of 40 hours
for in-house legal and 10 hours for in-house compliance counsel to
update existing policies and procedures to comply with paragraph (e)(1)
of Proposed Rule 615, and an initial in-house burden of 5 hours each
for a General Counsel and a Chief Compliance Officer to review and
approve the updated policies and procedures, for a total of 60 burden
hours, at a monetized cost of $28,800.\299\ In addition, the Commission
estimates a cost of $4,960 for outside counsel to review the updated
policies and procedures on behalf of a broker-dealer.\300\ The
Commission therefore estimates the aggregate initial burden for
originating brokers to be 9,420 burden hours \301\ at a monetized cost
of $4.52 million,\302\ and the aggregate initial cost for outside
counsel to be $778,720 to establish policies and procedures as required
by Proposed Rule 615(e)(1).\303\
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\299\ The Commission estimates the monetized initial burden for
this requirement to be: (Attorney at $462 for 40 hours) +
(Compliance Counsel at $406 for 10 hours) + (Deputy General Counsel
at $663 for 5 hours) + (Chief Compliance Officer at $589 for 5
hours) = 60 initial burden hours and a monetized cost of $28,800.
\300\ The Commission's estimates of the relevant wage rates for
outside legal services takes into account staff experience, a
variety of sources including general information websites, and
adjustments for inflation. The Commission estimates that the average
hourly rate for legal services is $496/hour. This cost estimate is
therefore based on the following calculation: (10 hours of review) x
($496/hour for outside counsel service) = $4,960 in outside counsel
costs.
\301\ This estimate is based on the following calculation: (60
burden hours of review per broker-dealer) x (157 broker-dealers) =
9,420 aggregate burden hours.
\302\ This estimate is based on the following calculation:
($28,800 per broker-dealer) x (157 broker-dealers) = $4,521,600.
\303\ This estimate is based on the following calculation:
($4,960 for outside costs per broker-dealer) x (157 broker-dealers)
= $778,720 in outside counsel costs.
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Ongoing Burdens and Costs
The Commission estimates that broker-dealers would review and
update their policies and procedures for compliance with Proposed Rule
615 on an annual basis, and that they would perform the review and
update using in-house personnel. The Commission estimates that each
broker-dealer would annually incur an internal burden of twelve hours
to review and update existing policies and procedures of 4 hours for
legal personnel, 4 hours for compliance personnel, and 4 hours for
business-line personnel at a monetized cost of $4,476.\304\ The
Commission therefore estimates an ongoing, aggregate burden for broker-
dealers of 1,884 hours, at a monetized cost of $702,732.\305\
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\304\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be: (Attorney at $462 for 4 hours) +
(Compliance Counsel at $406 for 4 hours) + (Intermediate Business
Analyst at $251 for 4 hours) = 12 ongoing burden hours and $4,476.
\305\ These estimates are based on the following calculations:
(12 burden hours per broker-dealer) x (157 broker-dealers) = 1,884
aggregate ongoing burden hours; and $4,476 per broker-dealer x 157
broker-dealers = $702,732.
---------------------------------------------------------------------------
A summary of the initial and ongoing burdens and costs described
above is set forth below:
Total Estimated Outside Costs To Establish Policies and Procedures To Identify Segmented Orders
----------------------------------------------------------------------------------------------------------------
Outside cost Aggregate
Respondents per respondent outside cost
----------------------------------------------------------------------------------------------------------------
Total Initial Outside Costs.................................. 157 $4,960 $778,720
----------------------------------------------------------------------------------------------------------------
Total Estimated Burden To Establish and Maintain Policies and Procedures To Identify Segmented Orders
----------------------------------------------------------------------------------------------------------------
Monetized cost
Respondents Burden hours Aggregate per Aggregate
per respondent burden hours respondent monetized cost
----------------------------------------------------------------------------------------------------------------
Total Initial Burden............ 157 60 9,420 $28,800 $4,521,600
Total Ongoing Burden............ 157 12 1,884 4,476 702,732
----------------------------------------------------------------------------------------------------------------
[[Page 173]]
The Commission requests comment on whether there would be different
or additional burdens or costs for originating brokers to establish and
maintain written policies and procedures to identify segmented orders.
b. Identifying and Marking Segmented Orders
As discussed above, the Commission estimates that there are 157
broker-dealers that would need to mark segmented orders as such to
comply with paragraph (e)(2) of Proposed Rule 615, and an additional 25
broker-dealers that would not be required to comply with the marking
requirements of paragraph (e)(2) of Proposed Rule 615, but would be
required to mark orders prior to routing as required by paragraph
(f)(1) of Proposed Rule 615.\306\
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\306\ As discussed above, these broker-dealers would also mark
orders, as applicable, to communicate that an originating broker
certifies that it established, maintained, and enforced the
requisite policies and procedures to assure that its identity would
not be disclosed.
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Initial Burdens and Costs
For purposes of complying with Proposed Rule 615(e)(2), for an
originating broker to identify whether a customer order meets the
definition of ``segmented order'' and must be marked accordingly, a
broker-dealer would first need to establish mechanisms to proactively
and systematically identify which orders for NMS stocks are for the
account of customers that are natural persons or held in a legal form
on behalf of a natural person or group of related family members; and
of those, which are orders for an account in which the average daily
number of trades in NMS stocks was less than 40 in each of the six
preceding months.\307\ For purposes of this analysis, and as discussed
above, the Commission believes that most broker-dealers already collect
information about their customers' accounts, or receive information
about customer accounts from an introducing broker, and would already
have an existing technological infrastructure in place, and the
Commission assumes that such infrastructure would need to be modified
to effect compliance with Proposed Rule 615.
---------------------------------------------------------------------------
\307\ Supra sections IV.B.1 and IV.E.
---------------------------------------------------------------------------
Acknowledging that costs and burdens may vary greatly according to
the size or complexity of the broker-dealer and that some broker-
dealers would implement the changes in-house, while others would engage
a third party vendor. The Commission estimates that approximately one
third of the 157 broker-dealers (or 52) would implement the changes in-
house, while the remaining 105 would engage a third-party vendor. The
Commission expects that the modification of a broker-dealer's existing
technology performed in-house would require 260 hours at a monetized
cost of $95,480.\308\ The Commission estimates that the burden for a
broker-dealer engaging a third-party to implement the modifications
would be 50 hours at a monetized cost of $18,385,\309\ and $35,000 for
the third-party service provider to perform the necessary work.\310\
The aggregate burden for those broker-dealers to modify existing
technology to identify segmented orders that perform the modification
in-house would therefore be 13,520 burden hours, at a monetized cost of
$4,964,960; \311\ and the aggregate costs and burdens for those broker-
dealers employing a third-party service provider would be $3,675,000
\312\ and 5,250 burden hours, at a monetized cost of $1,930,425.\313\
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\308\ The Commission estimates the monetized initial burden for
this requirement to be: (Sr. Programmer at $368 for 160 hours) +
(Sr. Database Administrator at $379 for 40 hours) + (Sr. Business
Analyst at $305 for 40 hours) + (Attorney at $462 for 20 hours) =
260 initial burden hours and a monetized cost of $95,480.
\309\ The Commission estimates the monetized initial burden for
this requirement to be: (Sr. Business Analyst for 15 hours at $305
per hour) + (Compliance Manager for 20 hours at $344 per hour) +
(Attorney for 15 hours at $462 per hour) = 50 initial burden hours
at a monetized cost of $18,385.
\310\ The Commission's estimate is based on prior estimates for
the cost of systems modifications to capture additional order
handling information. Securities Exchange Act Release No. 84528
(Nov. 2, 2018) 83 FR 58338 (Nov. 19, 2018) at 58383, n.492 and
accompanying text.
\311\ This cost estimate is based on the following calculation:
(260 initial burden hours at a monetized cost of $95,480) x (52
broker-dealers) = 13,520 initial burden hours and a monetized cost
of $4,964,960.
\312\ This cost estimate is based on the following calculation:
($35,000 in third-party service provider costs per broker-dealer) x
(105 broker-dealers) = $3,675,000 in aggregate outside third-party
provider costs.
\313\ The Commission estimates the aggregate monetized initial
burden for this requirement to be: (50 initial burden hours at a
monetized cost of $18,385) x (105 broker-dealers) = 5,250 initial
burden hours and a monetized cost of $1,930,425.
---------------------------------------------------------------------------
For purposes of compliance with Proposed Rule 615(f)(1), a
segmented order received by a routing broker-dealer would already have
been identified as such by the originating broker pursuant to Proposed
Rule 615(e)(2). Like originating broker-dealers, these 25 broker-
dealers, would however, need to modify their systems to enable them to
mark orders as segmented orders prior to routing such orders to a
routing destination.
The Commission estimates that the 157 originating brokers and the
additional 25 routing broker-dealers would each incur ongoing burdens
to mark orders as ``segmented orders'' (and as applicable to
communicate an originating broker's certification), which are discussed
further below, as well as initial, one-time technology project costs to
update their existing order marking systems. The Commission estimates
the initial one-time technology project costs for originating brokers
to add the ``segmented order'' and certification marks to their
existing marking systems to comply with paragraph (e)(2) of Proposed
Rule 615, and the initial one-time technology project costs for routing
broker-dealers to add the ``segmented order'' and certification marks
to their existing marking systems to comply with paragraph (f)(1) of
Proposed Rule 615, to be $170,000 per broker-dealer,\314\ for a an
aggregate total cost of $30.94 million.\315\
---------------------------------------------------------------------------
\314\ This estimate is based on industry sources of the cost to
program systems to add a new marking classification and adjusted for
inflation. See, e.g., Securities Exchange Act Release No. 94313
(Feb. 25, 2022), 87 FR 14950, 14976 (Mar. 16, 2022) (proposing
amendments to Regulation SHO) (``Regulation SHO Amendment
Proposal'').
\315\ This cost estimate is based on the following calculation:
($170,000 system project costs per broker-dealer) x (157 originating
broker-dealers + 25 routing broker-dealers) = $30,940,000 in
aggregate system project costs.
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Ongoing Burdens and Costs
The Commission estimates that a total of approximately 2.2 billion
``segmented orders'' would be entered annually.\316\ This would make
the average number of annual ``segmented order'' order marks by each of
the 182 broker-dealers to be 11.9 million.\317\ Each instance of
marking an order as a ``segmented order,'' and as applicable to
communicate that an originating broker has certified that it has
established, maintained, and enforced the requisite policies and
procedures to assure that its identity will not be disclosed, is
estimated to take between approximately 0.00001158 and 0.000139 hours
(0.042 and 0.5 seconds) to
[[Page 174]]
complete.\318\ Thus, it would take each of the 182 broker-dealers
between approximately 138 to 1,658 hours to mark segmented orders
annually; \319\ and the Commission estimates the aggregate burden to be
between approximately 25,134 and 301,697 hours.\320\ This estimate is
based on a number of factors, including: previously estimated burdens
for the current marking requirements of other Federal securities rules
and regulations; \321\ that broker-dealers should already have the
necessary mechanisms and procedures in place and already be familiar
with processes and procedures to comply with other marking requirements
under Federal securities rules and regulations (such as the
requirements of Rule 200(g) of Regulation SHO); and that broker-dealers
should be able to continue to use the same or similar mechanisms,
processes and procedures to comply with Proposed Rule 615.
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\316\ This estimate is based on CAT data for individual investor
stock orders handled by wholesalers during Q1 2022. See Tables 7 and
10, infra, sections VII.B.4 and VII.B.5 (showing a total of
approximately 271,310,000 orders handled during the period). Because
as discussed in section VII.B.4 below, this number excludes certain
orders, it likely significantly understates the total number of
individual investor orders handled by wholesalers. We have therefore
doubled the number for purposes of our estimate, and multiplied by
four to arrive at an estimated annual number of segmented orders of
2,170,480,000.
\317\ This figure was calculated as follows: 2,170,480,000
``segmented orders'' orders requiring order marking divided by 182
broker-dealers.
\318\ The upper end of this estimate--0.5 seconds--is based on
the same time estimate for marking sell orders ``long'' or ``short''
under Rule 200(g) of Regulation SHO. See Regulation SHO Amendment
Proposal, supra note 314, 87 FR at 14975 (citing Securities Exchange
Act Release No. 50103 (July 28, 2004), 69 FR 48008, 48023 (Aug. 6,
2004) (``Regulation SHO Adopting Release''). See also Securities
Exchange Act Release No. 48709 (Oct. 28, 2003) 68 FR 62972, 63000 n.
232 (Nov. 6, 2003) and Securities Exchange Act Release No. 59748
(Apr. 10, 2009), 74 FR 18042, 18089 (Apr. 20, 2009) (providing the
same estimate--0.5 seconds--for marking sell orders ``short exempt''
under Rule 200(g) of Regulation SHO)). The lower end of this
estimate--0.042 seconds--is based on a Commission estimate that
computing speeds are twelve times faster today than they were in
2007. Regulation SHO Amendment Proposal, supra note 314, 87 FR at
14975, 15000 (stating that according to an industry performance
evaluation for server processors, computing speed has increased by
at least 12 times since 2007 (the earliest year in the data and
citing Year on Year Performance (for server processors), PassMark
Software Pty. Ltd., available at https://www.cpubenchmark.net/year-on-year.html).
\319\ These figures were calculated as follows: (11,925,714
``segmented orders'' orders per broker-dealer) x (0.00001158 hours)
= 138.10 hours; and (11,925,714 ``segmented orders'' orders per
broker-dealer) x (0.000139 hours) = 1,657.67 hours.
\320\ These figures were calculated as follows: (2,170,480,000
``segmented orders'' orders requiring order marking) x (0.00001158
hours) = 25,134.16 hours; and (2,170,480,000 ``segmented orders''
orders) x (0.000139 hours) = 301,696.70 hours.
\321\ See, e.g., Regulation SHO Amendment Proposal, supra note
314, 87 FR at 14975 (discussing estimated marking requirements to
comply with Rule 200(g) of Regulation SHO which requires broker-
dealers to mark sell orders ``long,'' ``short,'' or ``short
exempt'').
---------------------------------------------------------------------------
A summary of the estimated initial and ongoing burdens and costs
described above is set forth below:
Total Estimated Initial Burdens and Costs To Identify Segmented Orders
----------------------------------------------------------------------------------------------------------------
Monetized
Respondents Burden cost per Third-party Aggregate Aggregate cost
hours respondent cost burden hours
----------------------------------------------------------------------------------------------------------------
Initial Burden to Modify In- 52 260 $95,480 ........... 13,520 $4,964,960
house......................
Initial In-house Burden in 105 50 18,385 ........... 5,250 1,930,425
connection with use of
Third-party................
Outside Costs for Third- 105 ........ ........... $35,000 .............. 3,675,000
party Services.............
----------------------------------------------------------------------------------------------------------------
Total Estimated Initial System Modification Costs To Mark Segmented Orders
----------------------------------------------------------------------------------------------------------------
Cost per
Respondents respondent Aggregate cost
----------------------------------------------------------------------------------------------------------------
Initial Technology Costs..................................... 182 $170,000 $30,940,000
----------------------------------------------------------------------------------------------------------------
Total Estimated Ongoing Burden To Mark Segmented Orders
--------------------------------------------------------------------------------------------------------------------------------------------------------
Annual
Originating brokers with Annual segmented
individual accounts and routing segmented orders per Estimated burden hours Total annual industry Annual burden per originating
brokers orders originating per segmented order burden hours broker
broker
--------------------------------------------------------------------------------------------------------------------------------------------------------
182............................. 2,170,480,000 11,925,714 0.00001158 to 0.000139... 25,134 to 301,697....... 138.10 to 1,657.68.
--------------------------------------------------------------------------------------------------------------------------------------------------------
The Commission requests comment on whether there would be different
or additional burdens or costs for brokers to identify and mark
segmented orders as such. Would the burdens and be lower or higher? Are
broker-dealers more likely to perform these function in-house, or use
third-party service providers? Should the estimated cost to employ a
third-party service provider be lower or higher?
3. Originating Broker Certification
Those originating brokers that do not want their identity to be
disclosed in the auction message initiating a qualified auction would
be required to establish, maintain and enforce written policies and
procedures reasonably designed to assure that the identity of the
originating broker will not be disclosed, directly or indirectly, to
any person that potentially could participate in the qualified auction
or otherwise trade with the segmented order. The Commission believes
that originating brokers choosing to make certifications referred to in
Proposed Rule 615(c)(1)(iii) would be familiar with how to adapt their
systems and processes to assure that the identity of the originating
broker is not disclosed, in compliance with the requirements of
Proposed Rule 615(e)(3). The Commission acknowledges that policies and
procedures may vary greatly by broker-dealer, given the differences in
size and the complexity of broker-dealer business models. Accordingly,
the Commission believes that the need to update policies and
procedures, as well as the ongoing compliance costs, might also vary
greatly.
Initial Burdens and Costs
The Commission estimates that there would be 20 broker-dealers that
would chose to make a Proposed Rule 615(c)(1)(iii) certification. To
initially comply with the obligation to establish written policies and
procedures to comply with Proposed Rule 615(e)(3), broker-dealers would
employ a combination of in-house and outside
[[Page 175]]
legal and compliance counsel to update their existing policies and
procedures. The Commission estimates that each of these 20 broker-
dealers would incur a one-time average internal burden of 40 hours for
in-house legal and 10 hours for in-house compliance counsel to update
existing policies and procedures to comply with paragraph (e)(3) of
Proposed Rule 615, and a one-time burden of 5 hours each for a General
Counsel and a Chief Compliance Office to review and approve the updated
policies and procedures, for a total of 60 burden hours.\322\ In
addition, the Commission estimates a cost of $4,960 for outside counsel
to review the updated policies and procedures on behalf of a broker-
dealer.\323\ The Commission therefore estimates the aggregate initial
burden for originating brokers to be 1,200 burden hours \324\ at a
monetized cost of $576,000,\325\ and the aggregate total cost for
outside counsel to be $99,200 to establish policies and procedures as
required by Proposed Rule 615(e)(3).\326\
---------------------------------------------------------------------------
\322\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be: (Attorney at $462 for 40 hours) +
(Compliance Counsel at $406 for 10 hours) + (Deputy General Counsel
at $663 for 5 hours) + (Chief Compliance Officer at $589 for 5
hours) = 60 initial burden hours and $28,800.
\323\ This cost estimate is based on the following calculation:
(10 hours of review) x ($496 per hour for outside counsel service) =
$4,960 in outside counsel costs.
\324\ This estimate is based on the following calculation: (60
burden hours of review per broker-dealer) x (20 broker-dealers) =
1,200 aggregate burden hours.
\325\ This estimate is based on the following calculation:
($28,800 per broker-dealer) x (20 broker-dealers) = $576,000.
\326\ This estimate is based on the following calculation:
($4,960 for outside costs per broker-dealer) x (20 broker-dealers) =
$99,200 in outside counsel costs.
---------------------------------------------------------------------------
Ongoing Burdens and Costs
The Commission estimates that broker-dealers would review and
update their policies and procedures for compliance with Proposed Rule
615 on an annual basis, and that they would perform the review and
update using in-house personnel. The Commission estimates that each
broker-dealer would annually incur an internal burden of twelve hours
to review and update existing policies and procedures: four hours for
legal personnel, four hours for compliance personnel, and four hours
for in-line business personnel, at a monetized cost of $4,476.\327\ The
Commission therefore estimates an ongoing, aggregate burden for broker-
dealers of approximately 240 hours \328\ and a monetized cost of
$89,520.\329\ The ongoing burden to communicate certifications is
included with the cost for ``segmented order'' marking discussed above
in section VI.D.2.b. A summary of the estimated initial and ongoing
burdens and costs described above in this section VI.D.3 are set forth
below:
---------------------------------------------------------------------------
\327\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be: (Attorney at $462 for 4 hours) +
(Compliance Counsel at $406 for 4 hours) + (Compliance Counsel at
$406 for 4 hours) + (Intermediate Business Analyst at $251 for 4
hours) = 12 ongoing burden hours and $4,476.
\328\ This estimate is based on the following calculation: (12
burden hours of review per broker-dealer) x (20 broker-dealers) =
240 aggregate burden hours.
\329\ The Commission estimates the monetized ongoing, annual
burden for this requirement to be: ($4,476 per broker-dealer) x 20
broker-dealers = $89,520.
Total Estimated Outside Costs To Establish Policies and Procedures Reasonably Designed to Assure That the
Originating Broker of a Segmented Order Will Not Be Disclosed
----------------------------------------------------------------------------------------------------------------
Outside cost per Outside aggregate
Respondents respondent cost
----------------------------------------------------------------------------------------------------------------
Initial Outside Costs.................................. 20 $4,960 $99,200
----------------------------------------------------------------------------------------------------------------
Total Estimated Burden To Establish and Maintain Policies and Procedures Reasonably Designed To Assure That the
Originating Broker of a Segmented Order Will Not Be Disclosed
----------------------------------------------------------------------------------------------------------------
Burden hours Monetized cost
Respondents per Aggregate per Aggregate
respondent burden hours respondent monetized cost
----------------------------------------------------------------------------------------------------------------
Initial Burden.................. 20 60 1,200 $28,800 $576,000
Ongoing Burden.................. 20 12 160 4,476 89,520
----------------------------------------------------------------------------------------------------------------
The Commission requests comment on whether there would be different
or additional burdens or costs for originating brokers to establish and
maintain written policies and procedures reasonably designed to assure
that its identity will not be disclosed. For example, do brokers have
existing policies and procedures related to ensuring confidentiality in
other contexts that could be expanded upon or are there are additional
burdens and costs associated with review of a broker's internal systems
that should be factored into the Commission's estimate? Are originating
broker's likely to perform the function of establishing and maintaining
these policies and procedures in-house or would they employ third-party
service providers, such as outside counsel? Would originating brokers
also have costs to modify their internal systems to prevent disclosure
of the identity of the originating broker in support of a Proposed Rule
615(c)(1)(iii) certification or other costs in support of such a
certification?
4. NMS Stock ATS Policies and Procedures for Excluding Subscribers
The Commission believes that NMS Stock ATSs--in particular those
whose broker-dealer operators are large, multi-service broker-dealers--
generally have,\330\ and likely maintain in writing, standards of
financial responsibility and operational capability for subscribers to
their system, and also generally have policies and procedures for
admitting new persons as subscribers or limiting access to services.
NMS Stock ATSs are not, however, currently required to have written
policies and procedures for granting access to their trading system,
unless they meet the fair access threshold of Rule 301(b)(5).\331\ NMS
Stock ATSs are, however, required to disclose on Form ATS-N whether
there are any conditions the ATSs requires a person to satisfy to
become a subscriber and whether there are any limitations
[[Page 176]]
on access to services.\332\ The Commission therefore estimates that the
burdens and cost for an NMS Stock ATS to comply with Proposed Rule
600(b)(64)(ii)(D) to qualify as an open competition trading center
eligible to operate a qualified auction pursuant to Proposed Rule
615(d)(1) to be minimal. The Commission acknowledges that policies and
procedures may vary greatly by NMS Stock ATS, given the differences in
size and the complexity of business models. Accordingly, the Commission
would expect that the need to update policies and procedures, as well
as the ongoing compliance costs, might also vary. As discussed above,
the Commission estimates that three NMS Stock ATSs may determine to
modify their systems to operate as open competition trading centers and
operate qualified auctions. To comply with this obligation, these NMS
Stock ATSs would likely employ in-house legal and compliance
counsel.\333\
---------------------------------------------------------------------------
\330\ This belief is based on a review of NMS Stock ATS
disclosures on Form ATS-N.
\331\ See supra note 214 and accompanying text. As discussed
above, currently only one NMS Stock ATS discloses that it meets the
fair access threshold. Supra section IV.B.2.b.
\332\ See supra note 214.
\333\ The Commission based its estimate on the burden hour
estimate provided in connection with the adoption of amendments to
Rule 301(b)(10), which as amended requires all ATSs to maintain in
writing their safeguards and procedures to protect subscribers'
confidential trading information, as well as the oversight
procedures to ensure such safeguards and procedures are followed.
See ATS-N Adopting Release, supra note 278, 83 FR at 38868.
---------------------------------------------------------------------------
Initial Burdens and Costs
For NMS Stock ATSs that have not recorded in writing their policies
and procedures to prohibit any registered broker or dealer from being
or becoming a subscriber, or impose conditions upon such a subscriber,
that does not meet the standards of financial responsibility or
operational capability as are prescribed by such written policies and
procedures, the Commission estimates the initial burden and cost for an
NMS Stock ATS that choses to comply with Proposed Rule
600(b)(64)(ii)(D) to be minimal. The Commission estimates that the
initial burden for an NMS Stock ATS to review its existing policies and
procedures for consistency with the proposed rule, to make
modifications as appropriate, and to put the policies and procedures in
writing would be approximately 8 hours, at a monetized cost of
$3,106.\334\ Thus, the Commission estimates the aggregate initial
burden to be 24 hours, at a monetized cost of $9,318.\335\
---------------------------------------------------------------------------
\334\ This estimate is based on the following: (Compliance
Attorney at $406 for 7 hours) + (Sr. Compliance Examiner at $264 for
1 hour) = 8 burden hours and a monetized cost of $3,106.
\335\ These estimates are based on the following calculations:
(8 burden hours per NMS Stock ATS) x (3 NMS Stock ATSs) = 24 burden
hours; and ($3,106 per NMS Stock ATS) x (3 NMS Stock ATSs) = $9,318.
---------------------------------------------------------------------------
Ongoing Burdens and Costs
For purposes of this analysis, the Commission has assumed that NMS
Stock ATSs would review and update their policies and procedures for
compliance with Proposed Rule 600(b)(64)(ii) on an annual basis, and
that they would perform the review and update using in-house personnel.
The Commission estimates that each NMS Stock ATS would annually incur
an internal burden of 8 hours to review and update existing policies
and procedures, made up of four hours for legal personnel and four
hours for compliance personnel, at a monetized cost of $2,680.\336\ The
Commission therefore estimates an ongoing, aggregate burden for NMS
Stock ATSs of approximately 24 hours at a monetized cost of
$8,040.\337\
---------------------------------------------------------------------------
\336\ The Commission estimates the monetized ongoing burden for
this requirement to be: (Compliance Attorney at $406 for 4 hours) +
(Sr. Compliance Examiner at $264 for 4 hours) = 8 initial burden
hours and a monetized cost of $2,680).
\337\ These estimates are based on the following calculations:
(8 burden hours per NMS Stock ATS) x (3 NMS Stock ATSs) = 24 burden
hours; and at ($2,680 per NMS Stock ATS) x 3 NMS Stock ATSs =
$8,040.
---------------------------------------------------------------------------
A summary of the estimated initial and ongoing burdens and costs
described above is set forth below:
Total Estimated Burden To Establish and Maintain Policies and Procedures To Exclude Subscribers Based on
Financial Responsibility or Operational Capability Standards
----------------------------------------------------------------------------------------------------------------
Burden hours
Respondents per Aggregate Monetized cost Aggregate
respondent burden hours per respondent monetized cost
----------------------------------------------------------------------------------------------------------------
Initial Burden.................. 3 8 24 $3,106 $9,318
Ongoing Burden.................. 3 8 24 2,680 8,040
----------------------------------------------------------------------------------------------------------------
The Commission is requesting comment on whether NMS Stock ATSs that
would operate as open competition trading centers operating qualified
auctions would have different or additional burdens and costs to
maintain written policies and procedures to exclude a broker-dealer
subscriber, or impose conditions on such a subscriber, that does not
meet standards of financial responsibility and operational capability.
E. Collection of Information Is Mandatory
The collections of information required by Proposed Rule 615(c)(1)
would be mandatory for national securities exchanges and NMS Stock ATSs
that operate qualified auctions, and the one national securities
association. The collections of information required by Proposed Rule
615(e)(1) and (2) would be mandatory for broker-dealers that meet the
proposed definition of ``originating broker.'' The collection of
information required by Proposed Rule 615(e)(3) would be mandatory for
originating brokers that communicate a certification to an open
competition trading center pursuant to Proposed Rule 615(c)(1). The
collection of information required by Proposed Rule 615(f)(1) would be
mandatory for broker-dealers that receive and route segmented orders.
The collection of information required by Proposed Rule 615(d)(1), in
conjunction with Proposed Rule 600(b)(64)(ii)(D), would be mandatory
for NMS Stock ATSs that operate as open competition trading centers and
prohibit any broker or dealer from becoming a subscriber, or impose
conditions upon such a subscriber, based on standards of financial
responsibility or operational capability.
F. Confidentiality of Information Collected
The Commission would not typically receive confidential information
as a result of Proposed Rule 615 or the related proposed amendments. To
the
[[Page 177]]
extent that the Commission receives--through its examination and
oversight program, through an investigation, or by some other means
records or disclosures from a broker-dealer that relate to or arise
from Proposed Rule 615 or the related amendments that are not publicly
available, such information would be kept confidential, subject to the
provisions of applicable law.\338\
---------------------------------------------------------------------------
\338\ See, e.g., 5 U.S.C. 552 et seq.; 15 U.S.C. 78x (governing
the public availability of information obtained by the Commission).
---------------------------------------------------------------------------
1. Auction Messages
As discussed above, auction messages initiating a qualified auction
would be publicly disseminated in consolidated market data. These
messages would include the identity of the open competition trading
center, symbol, side, size, limit price, and identify of the
originating broker, unless the originating broker made the
certification specified in paragraph (c)(1)(iii) of Proposed Rule 615.
2. Identifying and Marking Segmented Orders
The identification of an order as a segmented order would be made
available to any destination to which the order has been routed. The
information would also be available to the Commission and its staff,
and to other regulators.
3. Originating Broker Certification
If an originating broker determines to make a certification
referred to in paragraph (c)(1)(iii) of Proposed Rule 615, such
certification must be communicated to the open competition trading
center operating the applicable qualified auction, and any interim
broker-dealer routing a segmented order associated with a certification
would also need to be made aware of the certification for purposes of
communicating the certification to the open competition trading center.
The information would also be available to the Commission and its
staff, and to other regulators. Also, the originating broker's written
policies and procedures pursuant to Proposed Rule 615(e)(3) would be
available to the Commission and its staff, and to other regulators.
4. NMS Stock ATS Policies and Procedures To Exclude Subscribers
An NMS Stock ATSs' written policies and procedures to comply with
Proposed Rule 600(b)(64)(ii)(D), if necessary, to qualify as an open
competition trading center eligible to operate a qualified auction
pursuant to Proposed Rule 615(d)(1) would be available to the
Commission and its staff, and to other regulators. As described above,
NMS Stock ATSs are also required to publicly disclose certain
information on Form ATS-N.\339\
---------------------------------------------------------------------------
\339\ Supra note 278.
---------------------------------------------------------------------------
G. Retention Period for Recordkeeping Requirements
Proposed Rule 615 and the related amendments, would not establish
any new record retention requirements. National securities exchanges
and national securities associations are required to retain records and
information pursuant to 17 CFR 240.17a-1 (``Rule 17a-1''), and broker-
dealers are required to retain records and information pursuant to 17
CFR 240.17a-4 (``Rule 17a-4'').
H. Request for Comments
The Commission requests comment on whether the estimates for burden
hours and costs are reasonable. Pursuant to 44 U.S.C. 3506(c)(2)(B),
the Commission solicits comments to: (1) evaluate whether the proposed
collections of information are necessary for the proper performance of
the functions of the Commission, including whether the information
would have practical utility; (2) evaluate the accuracy of the
Commission's estimate of the burden of the proposed collections of
information; (3) determine whether there are ways to enhance the
quality, utility, and clarity of the information to be collected; and
(4) determine whether there are ways to minimize the burden of the
collections of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
Persons submitting comments on the collection of information
requirements should direct them to the Office of Management and Budget,
Attention: Desk Officer for the Securities and Exchange Commission,
Office of Information and Regulatory Affairs, Washington, DC 20503, and
should also send a copy of their comments to Secretary, Securities and
Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, with
reference to File Number S7-31-22. Requests for materials submitted to
OMB by the Commission with regard to this collection of information
should be in writing, with reference to File Number S7-31-22 and be
submitted to the Securities and Exchange Commission, Office of FOIA/PA
Services, 100 F Street NE, Washington, DC 20549-2736. As OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
[[Page 178]]
VII. Economic Analysis
A. Introduction
The Commission is mindful of the economic effects that may result
from Proposed Rule 615, and the amendments proposed in this release
(the ``Proposal''), including the benefits, costs, and the effects on
efficiency, competition, and capital formation. Exchange Act section
3(f) requires the Commission, when it is engaged in rulemaking pursuant
to the Exchange Act and is required to consider or determine whether an
action is necessary or appropriate in the public interest, to consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation.\340\ In
addition, Exchange Act section 23(a)(2) requires the Commission, when
making rules pursuant to the Exchange Act, to consider among other
matters the impact that any such rule would have on competition and not
to adopt any rule that would impose a burden on competition that is not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.\341\ The following economic analysis identifies and considers the
costs and benefits--including the effects on efficiency, competition,
and capital formation--that may result from the Proposal.
---------------------------------------------------------------------------
\340\ See 15 U.S.C. 78c(f).
\341\ See 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
Investors participate in capital markets to save for the future, to
diversify, and to maximize returns given a desired level of risk, among
other reasons. This participation can involve both trades based on
information and trades based on liquidity needs. Many individuals
participate indirectly in equity markets, such as through mutual funds
or through pension funds. However, many individuals participate
directly in equity markets, and this direct participation has grown in
recent years.\342\ While some of this direct participation may be
transitory, forces operating over the long run, such as technological
improvements, may lead the trend to continue.
---------------------------------------------------------------------------
\342\ See, e.g., SIFMA Insights, Gauging the New Normal for
Volatility, Volumes, Market Levels & Retail Investor Participation
(May 2021), available at https://www.sifma.org/wp-content/uploads/2021/05/SIFMA-Insights-Market-Structure-Survey-FINAL-FOR-WEB.pdf;
see also Jennifer J. Schulp, GameStop and the Rise of Retail
Trading, 41 Cato J. 511 (2021). For example, one study estimates
that retail market share has increased from around 23% (as a
percentage of share volume) in Jan. 2020 to around 34% by July 2021;
see Rosenblatt Securities, How Can the Buy Side Interact with Retail
Flow? (Feb. 14, 2022), available at https://www.rblt.com/market-reports/how-can-the-buy-side-interact-with-retail-flow.
---------------------------------------------------------------------------
This increase in participation, coming on top of various other
trends discussed below, motivates concern over the current isolation of
retail orders. At present, the vast majority of retail orders (over 90%
of marketable NMS stock orders) are routed to wholesalers, where they
are frequently executed in isolation, on a captive basis.\343\ This
execution is subject to competitive forces that apply at the level of
average execution quality. Execution of these orders is not subject to
order-by-order competition that occurs when order interactions are
subject to exchange protocols. The empirical analysis below suggests
that this results in suboptimal execution quality compared to an
alternative market structure in which the marketable orders of
individual investors were subject to order-by-order competition.\344\
While wholesalers generally achieve price improvement relative to the
NBBO, Commission analysis indicates that there is the potential for
individual investors to receive additional price improvement in line
with the low adverse selection risk of individual investor order flow.
While acknowledging there is substantial uncertainty in the eventual
outcome, the Commission estimates that qualified auctions as designed
by the Proposal would result in additional price improvement for the
marketable orders of individual investors that could reduce the average
transactions costs of these orders by 0.86 basis points (``bps'') to
1.31 bps.\345\ The Commission estimates that segmented orders that
would be eligible to be included in qualified auctions could account
for 7.3% \346\ to 10.1%\347\ of total executed dollar volume. Given
this estimate, the Commission preliminarily estimates that the Proposal
could potentially result in a total average annual savings in
individual investor transaction costs ranging from $1.12 billion to
$2.35 billion.\348\ These estimated gains would be generated primarily
through increased competition to supply liquidity to marketable orders
of individual investors, which in turn would lower transaction costs
for individual investors, potentially enhance order execution quality
for institutional investors, and improve price discovery. More
generally, it would broaden the set of market participants that
directly interact with individual investor orders of NMS stocks.\349\
For example, Commission analysis indicates that there is often
liquidity available at the NBBO midpoint on exchanges or NMS Stock ATSs
when a wholesaler executes the marketable orders of individual
investors at prices less favorable (for the customer) than the NBBO
midpoint.\350\ Qualified auctions would act as a coordination mechanism
and make the submitters of these resting midpoint orders aware there
was an individual investor order they could potentially trade with. By
increasing competition and enhancing the direct exposure of individual
investor orders to a broader spectrum of market participants, the
Proposal would help achieve the objectives for an NMS set forth in
section 11A of the Exchange Act.\351\
---------------------------------------------------------------------------
\343\ See analysis in infra Table 3. In the current market
structure, retail brokers provide wholesalers with large blocks of
orders, leaving it to the discretion of wholesalers how to execute
each order, consistent with their best execution responsibilities.
Broker-dealers are required to provide best execution for customer
orders, both pursuant to common law and FINRA rules. See discussion
of broker-dealer best execution responsibilities in supra section
III.B.2. The obligation for wholesalers to provide best execution is
required under FINRA Rule 5310 (Best Execution and
Interpositioning). See also supra note 133. The Commission is also
separately proposing a new rule addressing the best execution
obligations of broker-dealers. See Regulation Best Execution
Proposal, supra note 130. The Commission encourages commenters to
review that proposal to determine whether it might affect their
comments on this proposal.
\344\ See infra section VII.B.4 for analysis and discussion of
the potential adverse execution quality effects from the isolation
of individual investor marketable orders.
\345\ See analysis in Table 19 and corresponding discussion in
infra section VII.C.1.b. This estimate accounts only for potential
changes in individual order transaction costs and assumes the PFOF
wholesalers currently pay to retail brokers would be converted into
additional price improvement for the individual investor order, and
does not include costs that may arise in the form of potential
increases in (or the return of) commissions retail brokers charge to
individual investors or other reductions in the services that retail
brokers currently offer. See infra note 514 for further discussion.
\346\ See infra note 533.
\347\ See infra note 535.
\348\ See analysis in Table 19 and corresponding discussion in
infra section VII.C.1.b.
\349\ As discussed above, Proposed Rule 615 covers only NMS
stocks, and as such, the economic analysis includes quantitative and
qualitative analysis of only NMS stocks.
\350\ Commission analysis of CAT data in infra Table 20 found
that, on average, 51% of the shares of individual investor
marketable orders internalized by wholesalers are executed at prices
less favorable than the NBBO midpoint. Out of these individual
investors shares that were executed at prices less favorable than
the midpoint, on average, 75% of these shares could have
hypothetically executed at a better price against the non-displayed
liquidity resting at the NBBO midpoint on exchanges and NMS Stock
ATSs. See infra section VII.C.1.b for further discussion on the
analysis in Table 20.
\351\ See discussion in supra section III.A.
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The Proposal could have additional benefits with respect to trading
costs, liquidity, and capital formation, though the Commission
acknowledges that these are uncertain. The large
[[Page 179]]
percentage of individual investor orders executed off-exchange confers
a substantial competitive advantage on wholesalers and other market
makers with a significant presence both on and off-exchange, as they
observe order flow more quickly and in a more granular fashion than
others. This advantage contributes to asymmetric information and
increased adverse selection on exchanges. Such adverse selection may
reduce market quality for all participants and may ultimately reduce
efficiency and lower capital formation.
The Commission acknowledges considerable uncertainty in the costs
that would arise from Proposed Rule 615, due to whether the current
market practice of routing through wholesalers would persist. First,
the Proposal would likely cause wholesalers and some retail brokers to
incur significant adjustment costs to their operations, as well as a
possible decline in profitability. The Proposal could also result in
costs to individual investors, such as some retail brokers potentially
resuming charging commissions for NMS stock trades, although the
likelihood of this may be low.\352\ There may also be an increase in
trading costs for retail broker customers that carry greater adverse
selection risks and individual investors whose orders would not meet
the definition of a segmented order because they averaged 40 or more
daily trades in NMS stocks over the six preceding calendar months.\353\
Retail brokers could also experience costs from wholesalers reducing
the amount of PFOF they pay to retail brokers or from reducing or
charging for the order handling services they offer to retail brokers,
which could ultimately be passed on to individual investors.
---------------------------------------------------------------------------
\352\ See discussion of potential changes in retail broker
commissions in infra section VII.C.2.b.ii.
\353\ See supra note 186 and corresponding text discussing the
definition of ``segmented order.''
---------------------------------------------------------------------------
Open competition trading centers would also face costs associated
with creating qualified auctions, as would broker-dealers and trading
centers that would incur costs related to establishing policies and
procedures for identifying and handling segmented orders and
identifying the originating retail brokers that submit segmented
orders.\354\ There would also be compliance costs faced by the
respective NMS plans and FINRA to update the consolidated market data
feed and ADF to broadcast qualified auction messages. There may also be
a decrease in displayed liquidity if qualified auctions attract
liquidity away from exchange Limit Order Books (``LOBs''). However,
because the majority of individual investor orders are already
segmented from exchange LOBs, there is the potential that the effect of
qualified auctions on LOB liquidity may not be significant.\355\
---------------------------------------------------------------------------
\354\ If NMS Stock ATSs opted to operate qualified auctions,
they may also incur costs to update their business models and
systems in order to meet the requirements to be an open competition
trading center. See infra section VII.C.2.e.
\355\ See discussion on the effects of the Proposal on exchange
LOB liquidity in infra section VII.C.2.g.
---------------------------------------------------------------------------
The Commission recognizes that there would likely be significant
competitive effects associated with the introduction of qualified
auctions as mandated by Proposed Rule 615. Qualified auctions could
reduce wholesaler market share for the execution of the orders of
individual investors, which could result in the transfer of revenue and
profit from wholesalers to other market participants that end up
supplying more liquidity to the marketable orders of individual
investors. Proposed Rule 615 could also affect competition in the
market for trading services by enhancing the competitive position of
exchanges and ATSs that operate qualified auctions relative to
wholesalers as well as exchanges and ATSs that do not meet the criteria
to operate qualified auctions. The introduction of qualified auctions
would likely lead to a reduction of PFOF in equity markets, which in
turn may weaken the competitive position of retail brokers that are
dependent on PFOF revenue but strengthen the competitive position of
retail brokers that are not. In addition, Proposed Rule 615 could also
increase competition for market access among routing broker-dealers if
the competitive position of wholesalers declines, and retail brokers
that had previously relied on wholesalers for routing services, choose
to route their own orders to qualified auctions.
The Commission has considered the economic effects of the Proposal
and wherever possible, the Commission has quantified the likely
economic effects of the Proposal. The Commission is providing both a
qualitative assessment and quantified estimates of the potential
economic effects of the Proposal where feasible. The Commission has
incorporated data and other information to assist it in the analysis of
the economic effects of the Proposal. However, as explained in more
detail below, because the Commission does not have, and in certain
cases does not believe it can reasonably obtain, data that may inform
the Commission on certain economic effects, the Commission is unable to
quantify certain economic effects. Further, even in cases where the
Commission has some data, quantification is not practicable due to the
number and type of assumptions necessary to quantify certain economic
effects, which render any such quantification unreliable. The
Commission's inability to quantify certain costs, benefits, and effects
does not imply that the Commission believes such costs, benefits, or
effects are less significant. The Commission requests that commenters
provide relevant data and information to assist the Commission in
quantifying the economic consequences of the Proposal.
B. Baseline
The baseline against which the costs, benefits, and the effects on
efficiency, competition, and capital formation of the Proposal are
measured consists of the existing routing practices and execution
quality for the marketable orders of individual investors, the current
state of interactions between institutional investors and the orders of
individual investors, and the current business practices of retail
brokers. These aspects of the baseline are framed by the statutory and
regulatory baseline described above.\356\
---------------------------------------------------------------------------
\356\ The regulatory baseline includes the changes to the
current arrangements for consolidated market data in the MDI Rules;
but those amendments have not been implemented, so they likely have
not affected market practice. See supra section III.B.1 and infra
section VII.B.7. Where implementation of the changes may affect
certain numbers in the baseline, the description of the baseline
below notes those effects.
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[[Page 180]]
Retail brokers route most of their customers' marketable order flow
to wholesalers.\357\ Wholesalers do not typically directly charge
retail brokers for their order routing and execution services. In fact,
they may pay some retail brokers for the opportunity to handle their
order flow with PFOF. Typically, wholesalers' vertical integration of
routing and execution services for the orders of individual investors
provides them flexibility with regard to their handling of order flow.
They utilize sophisticated algorithmic trading technology to deliver
their services.\358\ In particular, wholesalers determine which orders
to internalize (i.e., execute in a principal capacity) and which to
execute in a riskless principal or agency capacity.\359\ Commission
analysis indicates that wholesalers internalize over 90% of the dollar
volume from individual investor marketable orders that are routed to
them and executed.\360\
---------------------------------------------------------------------------
\357\ Commission analysis of broker-dealer Rule 606 report order
routing data in infra Table 3 indicates that retail brokers route
over 90% of their marketable orders to wholesalers.
\358\ Wholesalers, similar to OTC market makers and exchange
liquidity suppliers must establish connections with the numerous
venues in which they wish to operate and provide liquidity. They
also typically design smart order routers that can locate and
provide liquidity in real time, as well as maintain fast data
processing capabilities that enable them to respond to market
conditions while abiding by the relevant trade execution
regulations. Wholesalers also face the costs associated with price
risk. As wholesalers trade against market participants, they takes
positions at the opposite side, accumulating inventory. Holding
inventory exposes wholesaler profits to inventory (price) risk,
where the value of inventory, and hence, that of the wholesaler's
holdings may fluctuate as security prices vary. Scaling up the size
of the business to ensure steady incoming flow from opposite sides
of the markets is a common strategy pursued by wholesalers. This
strategy enables them to execute buy and sell transactions,
offsetting order flow from opposite sides, reducing the possibility
of accumulating prolonged unwanted inventory. However, among other
costs, scaling up requires more comprehensive, efficient
connectivity networks and adds to the costs of establishing and
maintaining such networks.
\359\ See discussion in infra section VII.B.5.a.
\360\ See analysis in infra Table 10.
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The wholesaler business model relies in part on the ability to
segment the order flow of individual investors, which typically have
lower adverse selection risk than the orders of other types of market
participants.\361\ Wholesalers are market makers that can identify
orders with low adverse selection risk.\362\ Through segmentation,
wholesalers typically internalize marketable orders with lower adverse
selection risk and generally execute them at prices better than the
current NBBO, i.e., because of segmentation, wholesalers are typically
able to execute the marketable orders of individual investors at better
prices than these orders would receive if they were routed to an
exchange. An analysis of marketable NMS stock orders presented in Table
10 below indicates that the orders that wholesalers internalize present
lower adverse selection risk and receive higher execution quality
relative to marketable orders wholesalers receive and execute in a
riskless principal or agency capacity.\363\ Furthermore, results from
Table 13 below show that wholesalers internalize a lower share of
orders from retail brokers with the highest adverse selection risk.
Additional results \364\ show that, relative to orders executed on
exchanges, orders internalized by wholesalers are associated with lower
price impacts (i.e., lower adverse selection risk),\365\ lower
effective half-spreads (i.e., higher price improvement),\366\ and
higher realized half-spreads (i.e., higher potential
profitability).\367\
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\361\ Wholesalers and other liquidity providers (including other
market-makers) face adverse selection risk when they accumulate
inventory, for example by providing liquidity to more informed
traders, because of the risk of market prices moving away from
wholesalers and other market makers before they are able to unwind
their positions. Wholesalers and other market makers are usually not
privy to the motives or information of the investors with whom they
are trading. As such, should the liquidity provider trade with an
investor possessing short-lived price information about the security
price, it is exposing its inventory to adverse selection risk.
Hence, liquidity providers, including wholesalers and other market-
makers normally choose their trading strategies to minimize their
interaction with order flow with increased adverse selection risk.
Wholesalers do this by attracting marketable orders of individual
investors, known to be the order flow with the lowest adverse
selection risk.
\362\ See infra note 405 and corresponding discussion. Adverse
selection risk is based on various characteristics of the order,
including the identity of the originating broker.
\363\ See analysis in infra Table 10.
\364\ See infra Table 6 and infra Table 7 and corresponding
discussion in section VII.B.4 for a comparison of exchange and
wholesaler execution quality.
\365\ See supra notes 47-48 and accompanying text for a
definition and discussion of price impact as a measure of adverse
selection risk. By measuring the difference between the NBBO
midpoint at the time of execution and the NBBO midpoint some fixed
period of time after the transaction (e.g., one minute), price
impact measures the extent of adverse selection costs faced by a
liquidity provider. For example, if a liquidity provider provides
liquidity by buying shares from a trader who wants to sell, thereby
accumulating a positive inventory position, and then wants to unwind
this inventory position by selling shares in the market, it will
incur a loss if the price has fallen in the meantime. In this case,
the price impact measure will be positive, reflecting the liquidity
provider's exposure to adverse selection costs.
\366\ See also results in Thomas Ernst & Chester Spatt, Payment
for Order Flow and Asset Choice (last revised Mar. 13, 2022)
(unpublished manuscript), available at https://ssrn.com/abstract=4056512 (retrieved from SSRN Elsevier database)
(hereinafter ``Ernst and Spatt Working Paper''). See supra note 46
and accompanying text for a definition and discussion of effective
half-spreads. The effective half-spread is calculated by comparing
the trade execution price to an estimate of the stock's value (i.e.,
the midpoint of the prevailing NBBO at the time of order receipt)
and thus captures how much more than the stock's estimated value a
trader has to pay for the immediate execution of their order. The
effective spread will be smaller (or less positive) when the
execution price is closer to the NBBO midpoint, reflecting price
improvement received on that order. See, e.g., Bjorn
Hagstr[ouml]mer, Bias in the Effective Bid-Ask Spread, 142 J. Fin.
Econ. 314 (2021). For the remainder of this analysis, we will use
the term ``effective spread'' to refer to the ``effective half-
spread'' as defined in supra section II.D.1.
\367\ See supra notes 49-50 and accompanying text for a
definition and discussion of realized half-spreads. See, e.g.,
Securities Exchange Act Release No. 43590 (Nov. 17, 2000), 65 FR
75423-75424 (Dec. 1, 2000) (Disclosure of Order Execution and
Routing Practices) (``The smaller the average realized spread, the
more market prices have moved adversely to the market center's
liquidity providers after the order was executed, which shrinks the
spread `realized' by the liquidity providers. In other words, a low
average realized spread indicates that the market center was
providing liquidity even though prices were moving against it for
reasons such as news or market volatility.''); see also Larry
Harris, Trading and Exchanges: Market Microstructure for
Practitioners (2003) at 286. See infra note 420 discussing the
limitations of realized spreads for estimating the profits earned by
market makers. For the remainder of this analysis, we will use the
term ``realized spread'' to refer to the ``realized half-spread'' as
defined in supra section II.D.1.
---------------------------------------------------------------------------
Though wholesaler internalization generates price improvement for
individual investors relative to the NBBO, the Commission posits that
the potential isolation of marketable order flow routed to wholesalers
results in suboptimal price improvement for individual investor orders
relative to what the Commission estimates would be achieved under the
Proposal. Specifically, due to the isolation of this order flow by
wholesalers from order-by-order competition, the amount of price
improvement individual investors receive does not fully compensate for
the lower adverse selection risk of their orders. Commission analyses
presented below provide results that support this point.\368\
---------------------------------------------------------------------------
\368\ See infra sections VII.B.4 and VII.B.5.
---------------------------------------------------------------------------
The baseline section below is organized as follows. The baseline
first discusses relevant features of trading services, including
segmentation and interactions between institutional and retail order
flows. Next, the baseline presents the Commission's empirical findings
on execution quality. The
[[Page 181]]
section ends with a discussion of retail broker services and rules
addressing consolidated market data.
1. Competition for Liquidity Provision in NMS Stocks
Investors trade for a variety of reasons, whether because of
informational advantages or because of hedging and liquidity needs. In
an idealized competitive market, these investors would meet and trade
amongst themselves, without the need of an intermediary. In such cases,
trades would occur at the midpoint and neither side would pay the
spread. In real-life markets, not all investors meet at the same time.
Furthermore, investors may avoid trading with one another if they
believe their counterparty has information that they do not, as opposed
to trading for liquidity reasons. Moreover, investors often utilize the
technology and services of a broker-dealer in order to find and
interact efficiently with the trading interest of other investors. For
these reasons, there are broker-dealers who incur fixed costs for
routing orders and charge a spread for acting as a dealer and supplying
liquidity when end investors are not available to directly trade with
each other.
Market centers compete to attract order flow from these broker-
dealers. As shown in Table 1, in Q1 of 2022, NMS stocks were traded on
16 registered securities exchanges,\369\ and off-exchange at 32 NMS
Stock ATSs and at over 230 other FINRA members, including OTC market
makers.\370\ OTC market makers include the 6 wholesalers that
internalize the majority of individual investor marketable orders.\371\
These numerous market centers match traders with counterparties,
provide a framework for price negotiation and/or provide liquidity to
those seeking to trade.
---------------------------------------------------------------------------
\369\ Most of these 16 registered securities exchanges are owned
by three exchange groups. Currently, the CBOE exchange group owns:
Cboe BYX Exchange, Inc. (``Cboe BYX''), Cboe BZX Exchange, Inc.
(``Cboe BZX''), Cboe EDGA Exchange, Inc. (``Cboe EDGA''), and Cboe
EDGX Exchange, Inc. (``Cboe EDGX''); the Nasdaq exchange group owns:
Nasdaq BX, Inc. (``Nasdaq BX''), Nasdaq PHLX LLC (``Nasdaq Phlx''),
and The Nasdaq Stock Market LLC (``Nasdaq''); and the NYSE exchange
group owns: NYSE, NYSE American LLC (``NYSE American''), NYSE Arca,
Inc. (``NYSE Arca''), NYSE Chicago, Inc. (``NYSE CHX''), and NYSE
National, Inc. (``NYSE National''). Other registered securities
exchanges that trade NMS stocks and do not belong to one of these
exchange groups include: Investors Exchange LLC (``IEX''), Long-Term
Stock Exchange, Inc. (``LTSE''), MEMX LLC (``MEMX''), and MIAX
Pearl, LLC (``MIAX PEARL'').The Commission approved rules proposed
by BOX Exchange LLC (``BOX'') for the listing and trading of certain
equity securities that would be NMS stocks on a facility of BOX
known as BSTX LLC (``BSTX''), but BSTX is not yet operational. See
Securities Exchange Act Release Nos. 94092 (Jan. 27, 2022), 87 FR
5881 (Feb. 2, 2022) (SR-BOX-2021-06) (approving the trading of
equity securities on the exchange through a facility of the exchange
known as BSTX); 94278 (Feb. 17, 2022), 87 FR 10401 (Feb. 24, 2022)
(SR-BOX-2021-14) (approving the establishment of BSTX as a facility
of BOX). BSTX cannot commence operations as a facility of BOX until,
among other things, the BSTX Third Amended and Restated Limited
Liability Company Agreement approved by the Commission as rules of
BOX is adopted. Id. at 10407.
\370\ See supra section II.B for further details on the types of
trading centers that execute trades in NMS stocks. See also Form
ATS-N Filings and Information (for a list of ATSs that trade NMS
stocks and have a Form ATS-N filed with the Commission), available
at https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm.
Some academic studies attribute the fragmented nature of the market
for NMS stocks, in part, to certain provisions of Regulation NMS.
See, e.g., Maureen O'Hara & Mao Ye, Is Market Fragmentation Harming
Market Quality?, 100 J. Fin. 459 (2011); Amy Kwan, Ronald Masulis &
Thomas H. McInish, Trading Rules, Competition for Order Flow and
Market Fragmentation, 115 J. Fin. 330 (2015).
\371\ The six OTC market makers that are classified as
wholesalers for purposes of this release are the OTC market makers
to which the majority of marketable orders originating from retail
brokers were routed as identified from information from retail
broker Rule 606(a)(1) reports from Q1 2022. These market makers also
reported executing a significant percentage of shares routed to them
on their Rule 605 reports. Rule 606(a)(1) requires broker-dealers to
produce quarterly public reports containing information about the
venues to which the broker-dealer regularly routed non-directed
orders for execution, including any payment relationship between the
broker-dealer and the venue, such as any PFOF arrangements. See 17
CFR 242.606(a)(1).
Table 1--NMS Stock Traded Share Volume Percentage of All NMS Stocks by Market Center Type
----------------------------------------------------------------------------------------------------------------
Off-exchange
Market center type Venue cnt Share volume share volume
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Exchanges....................................................... 16 59.7 ..............
NMS Stock ATSs.................................................. 32 10.2 25.2
Wholesalers \a\................................................. 6 23.9 59.4
Other FINRA Members............................................. 232 6.3 15.6
----------------------------------------------------------------------------------------------------------------
This table reports the percentage of all NMS stock executed share volume and the percentage of NMS stock share
volume executed off-exchange for different types of market centers for Q1 2022. Venue Cnt lists the number of
venues in each market center category. Share Volume Pct is the percentage of all NMS stock share volume (on
plus off-exchange) executed by the type of market center. Off-Exchange Share Volume Pct is the percentage of
off-exchange share volume executed by the type of market center. Exchange share volume and total market volume
are based on CBOE Market Volume Data on monthly share volume executed on each exchange and share volume
reported in FINRA Trade Reporting Facilities (TRFs).\b\ NMS Stock ATS, wholesaler and FINRA member share
volume are based on monthly FINRA OTC Transparency data on aggregated NMS stock trading volume executed on
individual ATSs and over-the-counter at Non-ATS FINRA members.\c\ Off-Exchange Share Volume Pct is calculated
by dividing the NMS Stock ATS, wholesaler and FINRA member share volume from the FINRA Transparency Data by
the total TRF share volume reported in CBOE Market Volume Data.
\a\ See supra note 371 for details regarding how FINRA member OTC market makers are classified as wholesalers
for purposes of this release.
\b\ Cboe, U.S. Historical Market Volume Data, available at https://cboe.com/us/equities/market_statistics/historical_market_volume/. Trade Reporting Facilities (TRFs) are facilities through which FINRA members report
off-exchange transactions in NMS stocks, as defined in SEC Rule 600(b)(47) of Regulation NMS. See https://www.finra.org/filing-reporting/trade-reporting-facility-trf.
\c\ FINRA OTC (Non-ATS) Transparency Data Monthly Statistics, available at https://otctransparency.finra.org/otctransparency/OtcData otctransparency/OtcData; FINRA ATS Transparency Data Monthly Statistics, available at https://otctransparency.finra.org/otctransparency/AtsBlocksDownload. The FINRA OTC (Non-ATS) Transparency Data may not
contain all share volume transacted by a wholesaler or FINRA member because FINRA aggregates security-specific
information for firms with ``de minimis'' volume outside of an ATS and publishes it on a non-attributed basis.
Market centers' primary customers are broker-dealers that route
their own orders or their customers' orders for execution. Market
centers may compete with each other for these broker-dealers' order
flow on a number of dimensions, including execution quality. They also
may innovate to differentiate themselves from other trading centers to
attract more order flow. While registered exchanges cater to a broader
spectrum of investors, ATSs and OTC market makers, including
wholesalers, tend to focus more on providing trading services to either
institutional or individual investor orders.
Table 1 displays NMS stock share volume percentage by market center
[[Page 182]]
type for Q1 2022. Exchanges execute approximately 60% of total share
volume in NMS stocks, while off-exchange market centers execute
approximately 40%. The majority of off-exchange share volume is
executed by wholesalers, who execute almost one quarter of total share
volume (23.9%) \372\ and about 60% of off-exchange share volume.\373\
NMS Stock ATSs execute approximately 10% of total NMS stock share
volume and 25% of off-exchange share volume. Other FINRA members,
besides wholesalers and ATSs, execute approximately 15% of off-exchange
share volume.
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\372\ Of the six wholesalers identified in Q1 2022, two
accounted for approximately 66% of wholesalers' total executed share
volume of NMS stocks. One study finds that the concentration of
wholesaler internalization, as measured by the Herfindahl-Hirschman
Index (HHI) of share volume executed across wholesalers, has
increased from 2018 to 2021. See Edwin Hu & Dermot Murphy,
Competition for Retail Order Flow and Market Quality (last revised
Oct. 7, 2022) (unpublished manuscript), available at https://ssrn.com/abstract=4070056 (retrieved from Elsevier database).
\373\ The share volume reported for wholesalers in FINRA OTC
Transparency Data includes both individual investor orders executed
by wholesalers in a principal capacity as well as other orders
executed by wholesalers in a principal capacity, such as
institutional orders executed on their SDPs. It does not include
share volume that they executed in a riskless principal capacity or
share volume that was routed and executed at another market center.
---------------------------------------------------------------------------
There is evidence that the percentage of trading volume executed
off-exchange has been increasing over time. One industry group study
found that volume traded off-exchange as a percent of total volume has
increased since 2018, when off-exchange trading was 36.8% of total
volume.\374\ According to another study by an exchange, an increase in
orders executed by off-exchange venues other than ATSs has been the
driving factor behind this increase in off-exchange trading, which has
been particularly significant for lower-priced stocks.\375\ At the same
time, some have highlighted a decline in liquidity displayed at or near
the NBBO on exchanges.\376\ Industry participants have raised concerns
regarding a ``monopolistic environment,'' in which information off-
exchange becomes sufficiently concentrated and determinative as to
widen spreads on exchange.\377\ For example, a liquidity provider
deciding whether to rest an order on the book would face the
possibility of a wholesaler or other off-exchange market maker gleaning
information from the posted liquidity to determine a price to execute
off-exchange that accounts for the lack of adverse selection risk in
off-exchange flow.\378\ This limits the execution possibilities on
exchange. On the other hand, any posted liquidity (which grants an
option to liquidity demanders or to those engaged in latency arbitrage)
is vulnerable to being ``picked off''--namely executed against exactly
when the price is (in the case of a resting buy order) moving lower or
(in the case of a sell order) moving higher. These dynamics lower the
incentives to post liquidity on exchange.
---------------------------------------------------------------------------
\374\ See SIFMA Insights, Analyzing the Meaning Behind the Level
of Off-Exchange Trading (Sept. 2021), available at https://www.sifma.org/wp-content/uploads/2021/09/SIFMA-Insights-Analyzing-Off-Exchange-Trading-09-2021.pdf. The study found off-exchange
trading to be 44.2% of total YTD trading volume as of Sept. 2021.
\375\ See NYSE Data Insights, Market Volume and Off-Exchange
Trading: More than a Retail Story (June 15, 2020), available at
https://www.nyse.com/data-insights/market-volume-and-off-exchange-trading. In particular, the study found that, for stocks priced
lower than $5, off-exchange trading market share increased from
45.4% in Oct. 2019 to 54.8% in June 2020, and that ATS market share
decreased from 14.2% to 11.5% of consolidated average daily volume
and non-ATS OTC market share increased from 20.5% to 27.8% over the
same time period.
\376\ See, e.g., Gunjan Banerji, Buying or Selling Stocks? It
Isn't Always Easy, Wall St., J., Jan. 2, 2020, showing a greater
than 90% reduction in the number of shares available at the best
prices in the SPDR S&P 500 ETF from 2007 to 2018, as one example of
the overall reduction in market liquidity. Furthermore, in a comment
letter to the Commission responding to comments on an SRO proposed
rule change, an exchange found that the COVID crisis lead to a
further substantial decrease in the depth of liquidity at the NBBO,
as the average displayed quote size declined by 69% from Jan. to
Mar. 2020 for S&P 500 stocks. See Letter from John Ramsay, Chief
Market Policy Officer, Investors Exchange LLC to Ms. Vanessa
Countryman, Secretary, U.S. Securities and Exchange Commission,
dated May 10, 2020 (File No. SR-IEX-2019-15), available at https://www.sec.gov/comments/sr-iex-2019-15/sriex201915-7169827-216633.pdf.
\377\ See Hitesh Mittal & Kathryn Berkow, The Good, The Bad &
The Ugly of Payment for Order Flow (May 3, 2021), available at
https://bestexresearch.com/the-good-the-bad-the-ugly-of-payment-for-order-flow/.
\378\ Mitigating this information asymmetry is that off-exchange
trades also print to a consolidated post-trade tape, though with
latency compared with on-exchange trades.
---------------------------------------------------------------------------
Exchanges (via their rules) and ATSs determine how orders compete
with each other, wherein liquidity suppliers set prices and wait for
execution at their prices by liquidity demanders. This interaction
between liquidity providers and demanders encompasses order-by-order
competition. Unlike exchanges, for which each exchange's rules
determine competition in a non-discretionary fashion, wholesalers
execute or route orders in a discretionary fashion.\379\ While some
orders may be routed to a central limit order book against which
institutional investors may execute (on the discretion of the
wholesaler), institutional investors generally consider order flow
routed to a wholesaler to be ``inaccessible.'' \380\
---------------------------------------------------------------------------
\379\ A study estimates that the volume of individual investor
orders executed by wholesalers accounted for approximately 16% to
17% of consolidated share volume during Q1 2022. See Rosenblatt
Securities, An Update on Retail Market Share in US Equities (June
24, 2022), available at https://www.rblt.com/market-reports/trading-talk-an-update-on-retail-market-share-in-us-equities. However,
wholesalers are not completely focused on individual investor order
flow and some do offer services to institutional order flow. See
infra section VII.B.3 for a discussion of their interaction with
institutional order flow.
\380\ See supra note 37 (citing Jennifer Hadiaris, Cowen Market
Structure: Retail Trading--What's going on, what may change, and
what can you do about it?, Cowen (Mar. 23, 2021), available at
https://www.cowen.com/insights/retail-trading-whats-going-on-what-may-change-and-what-can-institutional-traders-do-about-it/).
Further, wholesalers are also not subject to a statutory or
regulatory requirement to provide fair access. See supra section
III.B.3 for further discussion of requirements that do and do not
apply to wholesalers.
---------------------------------------------------------------------------
As a proxy for expected execution quality, quoted prices are a
dimension on which exchanges compete to attract order flow.
Specifically, exchanges are required to post the best bid and ask
prices available on the exchange at that time,\381\ and broker-dealers
can observe those prices and choose to route orders to the exchange
posting the best prices at a given point in time. However, others who
provide trading services, such as ATSs and OTC market makers, do not
usually compete on this dimension.\382\ In other words, wholesalers
generally do not compete for order flow by posting competitive prices
the way exchanges do. They do not display or otherwise advertise the
prices at which they are willing to internalize individual investor
orders at a given point in time. This suggests that wholesalers attract
order flow by offering retail brokers more than just competitive prices
at a point in time on a specific order. Instead, wholesalers generally
attract order flow by offering to on average execute orders at prices
that are better than displayed prices. Additionally, wholesalers bundle
their market access services with execution services, thereby
vertically fully integrating order handling and execution services for
their retail broker customers.
---------------------------------------------------------------------------
\381\ See Rule 602 of Regulation NMS.
\382\ ATSs typically compete for institutional order flow by
offering innovative trading features such as distinct trading
protocols and segmentation options. They may also compete on fees.
In addition, they could include their ATS access in the broader set
of bundled services that the broker-dealer director of the ATS
offers to their institutional investors.
---------------------------------------------------------------------------
2. Segmentation of Individual Investor Order Flow
Individual investor orders typically carry lower adverse selection
risk, in part because individual investors may
[[Page 183]]
have less information on market conditions than other market
participants and in part because their orders tend to be small. Both of
these factors make individual investor orders less likely to be
followed by orders in the same direction.\383\ The lower adverse
selection risk of individual investor orders makes them more valuable
for segmentation by liquidity providers that want to execute these
orders in a principal capacity, since they are less costly to liquidity
providers such as wholesalers to execute (i.e., have lower price
impacts) than orders with higher adverse selection risk. Due to this
lower cost, wholesalers are able to provide price improvement to these
orders and still earn higher profits, as discussed in supra section
II.D.2.
---------------------------------------------------------------------------
\383\ While this characterization of individual orders is
generally true, there are also individual investors that are highly
sophisticated and informed of market conditions. See infra section
VII.B.5.b for an empirical analysis and discussion of variation in
execution quality based on variation in adverse selection risk of
retail broker order flow.
---------------------------------------------------------------------------
Regulation NMS allows an order to be executed off-exchange,
provided that an off-exchange trading venue executes the order at a
price equal to the NBBO or better.\384\ To the extent that a liquidity
provider is able to segment \385\ low-risk individual investor order
flow, this order flow can be executed against with higher profitability
for the liquidity provider. Since exchanges are limited in their
ability to segment order flow (with the exception of retail liquidity
programs),\386\ the ability of off-exchange venues to segment orders is
one reason why orders are routed off-exchange. Furthermore, off-
exchange trading venues are often more flexible in determining prices
than national securities exchanges.\387\
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\384\ See supra section III.B.2.b.
\385\ See supra section I for a definition of segmentation.
\386\ See infra section VII.B.2.c.
\387\ For example, Rule 612 does not prevent wholesalers, after
they receive an order from a broker, from choosing to execute that
order in a transaction at a sub-penny price. See supra note 148 and
corresponding discussion.
---------------------------------------------------------------------------
The ability to segment is one reason why many individual investor
orders are executed off-exchange. Another reason is potential
efficiency in outsourcing routing services. Maintaining market access
at many venues is costly, so broker-dealers have an incentive to use
the services of other broker-dealers who maintain market access at
most, if not all, market centers. Wholesalers are the dominant
providers of market access for retail brokers and bundle their market
access services with execution services. Yet another reason arises from
economies of scale stemming from the information that can be gleaned
from large quantities of individual orders.\388\ Because of the
profitability in these segmented orders, wholesalers will sometimes pay
for them, a practice known as payment for order flow. For some retail
brokers, this may create an additional incentive for routing to the
wholesalers.
---------------------------------------------------------------------------
\388\ See infra note 406 for a discussion of the informational
advantages that routing can provide to wholesalers.
---------------------------------------------------------------------------
a. Routing and Market Access
Most individual investor orders are non-directed, so individual
investor order routing choices are largely made by retail brokers.
Specifically, retail brokers choose how to access the market in order
to fill their individual investor customers' orders. Many broker-
dealers that handle customer accounts, including many retail brokers,
do not directly access national securities exchanges or ATSs for their
orders, relying on other broker-dealers to facilitate market access for
them.\389\ For example, only members of exchanges or subscribers to (or
owners of) ATSs can directly access those particular market
centers.\390\ As a result, some broker-dealers that are exchange
members or ATS subscribers/owners provide access to other brokers-
dealers by rerouting their customer orders to these market centers. The
broker-dealers (including wholesalers) who provide market access can
choose to compete on a number of dimensions, such as by charging lower
fees or paying for order flow, by facilitating better execution
quality, and by providing other valued services.\391\
---------------------------------------------------------------------------
\389\ Providing market access can mean rerouting customer orders
and it can also involve sponsoring access for the broker to send
customer orders directly to a market center.
\390\ The number of broker-dealers providing access is thus
limited due to the expenses of being an exchange member and ATS
subscriber. In addition, membership on an exchange also gives the
broker-dealer access to exchange-provided order routers that re-
route orders to other exchanges at a per-order fee. Thus, membership
on one exchange can effectively provide access, though not directly,
to all exchanges.
\391\ Although some retail brokers are members of exchanges,
they may still prefer to rely on wholesalers' expertise for the
handling and routing of their customers' orders.
---------------------------------------------------------------------------
Retail brokers may route to wholesalers because the cost of sending
orders to wholesalers is lower than the various alternatives available
to their customers for market access. While some broker-dealers have
SORs,\392\ exchange memberships, and ATS subscriptions, and are thus
able to provide market access to retail brokers, these other broker-
dealers incur costs in handling order flow for retail brokers in the
form of exchange access fees, ATS access fees, and administrative and
regulatory costs such as recordkeeping and the risk management controls
of Rule 15c3-5. While wholesalers could incur some of these marginal
costs as well, they benefit on the margin from individual investor
order flow because they have the option to internalize the most
profitable of that order flow, i.e., the individual investor orders
with the lowest adverse selection risk.\393\ This ability to capture,
identify, and internalize profitable orders from individual investors
allows wholesalers to provide market access to retail brokers at low
explicit cost, either by providing PFOF or by not charging retail
brokers explicitly for market access. This service of obtaining market
access on behalf of retail brokers assists retail brokers by allowing
them to avoid routing expenses (even in cases where the wholesaler
further routes the order instead of internalizing) or costly liquidity
searches, and may increase retail brokers' reliance on wholesalers
beyond any payment they receive for routing their order flow to
wholesalers.
---------------------------------------------------------------------------
\392\ Individual investors and professional traders relying on
displayed screens to access financial markets generally do not have
access to these low-latency (algorithmic, high speed) technologies.
\393\ See infra section VII.B.2.b for further discussion of
wholesaler internalization.
---------------------------------------------------------------------------
Indeed, Table 2 shows that retail brokers who accept PFOF (``PFOF
brokers'') pay less to route their orders to wholesalers than to route
them elsewhere.\394\ In fact, they are paid to route their order flow
to wholesalers for every order type reported in the table. On average,
rates paid by wholesalers for both market and marketable limit orders
are higher than those paid by alternative venues, with wholesalers
paying an average of 13 cents per 100 shares for market orders and 12.6
cents for marketable limit orders across S&P 500 and non-S&P 500 stocks
during Q1 2022. In contrast, exchanges, on average, charged PFOF
brokers when they routed their marketable order flow to exchanges. This
likely indicates that most of the volume that PFOF brokers sent to
exchanges was routed to maker-taker exchanges (where fees are assessed
on marketable orders).\395\ Furthermore,
[[Page 184]]
since retail brokers that do not accept PFOF (``non-PFOF brokers'')
also incur fees when they route marketable orders to exchanges, they
are also incentivized to route their marketable order flow to
wholesalers, who do not charge them explicit costs to route and execute
their orders.
---------------------------------------------------------------------------
\394\ In Table 2, average payment rates reported in Rule 606
reports for PFOF brokers in S&P 500 stocks and non-S&P 500 stocks in
Q1 2022 are broken down by trading venue and order type, with rates
given in cents per 100 shares.
\395\ Furthermore, wholesaler rates for non-marketable orders
are more than double the rates for marketable orders, averaging 27.1
cents per hundred shares compared to 13 cents for market orders and
12.6 cents for marketable limit orders. Additionally, Table 2 shows
that the average payment rates PFOF brokers receive from routing
non-marketable limit orders to wholesalers is greater than the
average rates they receive from routing them to exchanges. This may
be driven by wholesalers passing through exchange rebates for these
orders, for which they may receive higher volume-based tiering rates
compared to retail brokers, back to broker-dealers.
Table 2--Average Rule 606 Payment Rates for Q1 2022 to PFOF Brokers by Trading Venue Type
--------------------------------------------------------------------------------------------------------------------------------------------------------
Non-
Market orders Marketable marketable Other orders
limit orders limit orders
--------------------------------------------------------------------------------------------------------------------------------------------------------
S&P 500........................................ Exchange............................... -5.9 -23.9 30.9 20.8
OTC Market Maker--Wholesaler........... 15.2 21.8 41.1 24.1
Other.................................. 4.5 -0.6 -0.6 7.5
Non-S&P 500.................................... Exchange............................... -14.9 -15.3 17.9 16.5
OTC Market Maker--Wholesaler........... 12.5 11.8 24.6 10.1
Other.................................. 1.5 -3.7 -4.6 1.5
Combined....................................... Exchange............................... -12.4 -15.7 19.3 17.1
OTC Market Maker--Wholesaler........... 13.0 12.6 27.1 11.9
Other.................................. 1.7 -3.7 -4.5 2.0
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table shows the average payment rates (in cents per 100 shares) made from different types of trading venues in Q1 2022 to 14 retail PFOF brokers
from wholesalers based on their Rule 606 reports. The table breaks out average rates from exchanges, wholesalers, and other trading venues for market
orders, marketable limit orders, non-marketable limit orders, and other orders in S&P 500 stocks and non-S&P 500 stocks. Other venues include any
other venue to which a retail broker routes an order other than a wholesaler or an exchange. The 43 broker-dealers were identified from the 54 retail
brokers used in the CAT retail analysis (see infra note 466). This analysis uses the retail broker's Rule 606 report if it publishes one or the Rule
606 report of its clearing broker if it did not publish a Rule 606 report itself (the sample of 43 broker-dealer Rule 606 reports include some broker-
dealers that were not included in the CAT analysis because some clearing broker Rule 606 reports are included). Some broker-dealers reported handling
orders only on a not held basis and did not have any Rule 606.
Table 3 reflects that wholesalers dominate the business of
providing market access for retail brokers and indicates that PFOF is a
factor in retail broker routing decisions.\396\ Data from Table 3
indicates that orders of individual investors for NMS stocks are
primarily routed to wholesalers, although a small fraction of
individual investor orders are routed to exchanges and other broker-
dealers providing market access or other market centers (i.e., ATSs),
some of which may be affiliated with the broker that received the
original order.
---------------------------------------------------------------------------
\396\ Table 3 summarizes order routing decisions of 43 of the
most active retail brokers about non-directed orders; see infra note
466. Routing choices are summarized separately for 14 PFOF brokers
in equity markets and non-PFOF brokers. Note that some brokers do
not accept PFOF for orders in equities but do accept PFOF for orders
in options. Consistent with Rule 606, routing statistics are
aggregated together in Rule 606 reports based on whether the stock
is listed in the S&P500 index. Rule 606 reports collect routing and
PFOF statistics based on four different order types for NMS stocks:
(1) market orders, resulting in immediate execution at the best
available price; (2) marketable limit orders, resulting in immediate
execution at the best price that is not worse that the order's
quoted limit price; (3) non-marketable limit orders whose quoted
limit price less aggressive than the NBBO, often preventing
immediate execution; and (4) all other orders. See supra note 371
for a summary of the requirements of Rule 606(a)(1) of Regulation
NMS
Table 3--Retail Broker Order Routing in NMS Stocks for Q1 2022, Combining PFOF and Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Non-
Market Marketable marketable Other Total
Venue type (percent) limit limit (percent) (percent)
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Panel A: Non S&P 500 Stocks
----------------------------------------------------------------------------------------------------------------
Other........................... 6.0 4.7 3.1 1.5 3.6
Exchange........................ 0.2 5.5 22.5 0.8 8.5
Wholesaler...................... 93.9 89.8 74.4 97.6 87.9
-------------------------------------------------------------------------------
Total....................... 26.5 12.6 33.6 27.3 100.0
----------------------------------------------------------------------------------------------------------------
Panel B: S&P 500 Stocks
----------------------------------------------------------------------------------------------------------------
Other........................... 6.6 5.9 1.8 1.7 3.6
Exchange........................ 0.2 4.6 25.1 0.8 9.1
Wholesaler...................... 93.3 89.6 73.1 97.5 87.3
-------------------------------------------------------------------------------
Total....................... 30.6 9.6 33.5 26.4 100.0
----------------------------------------------------------------------------------------------------------------
This table aggregates Rule 606 reports from retail brokers and shows the percentage of market orders, marketable
limit orders, non-marketable limit orders, and other orders that retail brokers route to different types of
venues in Q1 2022. Other venues include any other venue to which a retail broker routes an order other than a
wholesaler or an exchange. Order type classifications are based on the order types broker-dealers are required
to include in their Rule 606 reports.
[[Page 185]]
Table 3 aggregates routing information from 43 broker-dealer Rule 606 reports from Q1 2022. The 43 broker-
dealers were identified from the 54 retail brokers used in the CAT retail analysis (see infra note 466). This
analysis uses the retail broker's Rule 606 report if it publishes one or the Rule 606 report of its clearing
broker if it did not publish a Rule 606 report itself (the sample of 43 broker-dealer Rule 606 reports include
some broker-dealers that were not included in the CAT analysis because some clearing broker Rule 606 reports
are included). Some broker-dealers reported handling orders only on a not held basis and did not have any Rule
606 reports. Because Rule 606 only include percentages of where their order flow is routed and not statistics
on the number of orders, the reports are aggregated together using a weighting factor based on an estimate of
the number of non-directed orders each broker-dealer routes each month. The number of orders is estimated by
dividing the number of non-directed market orders originating from a retail broker in a given month (based on
estimates from CAT data) by the percentage of market orders as a percent of non-directed orders in the retail
broker's Rule 606 report (the weight for a clearing broker consists of the aggregated orders from the
introducing brokers in the CAT retail analysis that utilize that clearing broker).
Table 4--Retail Broker Order Routing in NMS Stocks for March 2022
----------------------------------------------------------------------------------------------------------------
Non-
Market Marketable marketable Other Total
Venue type (percent) limit limit (percent) (percent)
(percent) (percent)
----------------------------------------------------------------------------------------------------------------
Panel A: Non-S&P 500 Stocks
Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... 24.1 22.3 4.2 41.6 16.0
Exchange........................ <0.1 25.3 80.8 19.7 39.8
Wholesaler...................... 76.0 52.4 15.0 38.8 44.2
-------------------------------------------------------------------------------
Total....................... 38.4 12.4 44.2 5.0 100.0
----------------------------------------------------------------------------------------------------------------
PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... <0.1 1.2 2.8 0.3 1.1
Exchange........................ 0.2 1.5 5.8 0.2 2.1
Wholesaler...................... 99.7 97.3 91.4 99.5 96.8
-------------------------------------------------------------------------------
Total....................... 24.1 12.7 31.5 31.8 100.0
----------------------------------------------------------------------------------------------------------------
Panel B: S&P 500 Stocks
Non-PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... 24.8 27.0 3.2 23.4 15.4
Exchange........................ <0.1 19.6 83.2 8.2 39.0
Wholesaler...................... 75.2 53.4 13.6 68.3 45.6
-------------------------------------------------------------------------------
Total....................... 39.0 9.2 43.8 8.0 100.0
----------------------------------------------------------------------------------------------------------------
PFOF Brokers
----------------------------------------------------------------------------------------------------------------
Other........................... <0.1 0.5 1.3 0.3 0.6
Exchange........................ 0.2 0.9 3.4 0.3 1.3
Wholesaler...................... 99.8 98.6 95.3 99.5 98.2
-------------------------------------------------------------------------------
Total....................... 28.4 9.7 30.7 31.2 100.0
----------------------------------------------------------------------------------------------------------------
This table aggregates Rule 606 reports from PFOF and non-PFOF retail brokers and separately shows the percentage
of market orders, marketable limit orders, non-marketable limit orders, and other orders PFOF brokers and non-
PFOF brokers route to different types of venues in Q1 2022. PFOF brokers are retail brokers that receive
payments for routing marketable orders to wholesalers. Other venues include any other venue to which a retail
broker routes an order other than a wholesaler or an exchange. Order type classifications are based on the
order types broker-dealers are required to include in their Rule 606 reports.
Table 4 aggregates routing information from PFOF and non-PFOF broker-dealer Rule 606 reports from Q1 2022.
Fourteen retail brokers are identified as PFOF brokers that receive payments for routing orders in NMS stocks
to wholesalers. Non-PFOF brokers are identified as retail brokers that do not receive monetary compensation
when they route orders in NMS stocks to wholesalers. The 43 broker-dealers were identified from the 54 retail
brokers used in the CAT retail analysis (see infra note 466). This analysis uses the retail broker's Rule 606
report if it publishes one or the Rule 606 report of its clearing broker if it did not publish a Rule 606
report itself (the sample of 43 broker-dealer Rule 606 reports include some broker-dealers that were not
included in the CAT analysis because some clearing broker Rule 606 reports are included). Some broker-dealers
reported handling orders only on a not held basis and did not have any Rule 606 reports. Because Rule 606 only
include percentages of where their order flow is routed and not statistics on the number of orders, the
reports are aggregated together using a weighting factor based on an estimate of the number of non-directed
orders each broker-dealer routes each month. The number of orders is estimated by dividing the number of non-
directed market orders originating from a retail broker in a given month (based on estimates from CAT data) by
the percentage of market orders as a percent of non-directed orders in the retail broker's Rule 606 report
(the weight for a clearing broker consists of the aggregated orders from the introducing brokers in the CAT
analysis that utilize that clearing broker).
CAT data analysis indicates that about 80% of the share volume and
about 74% of the dollar volume of individual investor marketable orders
that were routed to wholesalers and executed comes from PFOF
brokers.\397\ Data from Table 4 indicate that, while retail brokers who
accept PFOF from wholesalers tend to send more of their orders to those
wholesalers, wholesalers even dominate the market access services for
non-PFOF brokers, though non-PFOF brokers route a significantly lower
fraction (i.e., 75.2% to 76%) of their market orders to wholesalers,
compared to 99.7% to 99.8% of market orders for PFOF brokers. Moreover,
non-PFOF brokers route 24.1% to 24.8% of their market orders to other
non-exchange market centers, e.g., ATSs,
[[Page 186]]
while PFOF brokers route less than 1% of their market orders to these
market centers. However, regardless of whether the retail broker
accepts PFOF, the order type, or the S&P500 index inclusion of the
stock,\398\ Table 3 shows that retail brokers route over 87% of their
customer orders to wholesalers.
---------------------------------------------------------------------------
\397\ See infra Table 14.
\398\ Rule 606 reports require that broker-dealers separate
their disclosure information for S&P 500 stocks, non-S&P 500 stocks,
and options.
---------------------------------------------------------------------------
This result suggests that, while PFOF is an important factor in
retail brokers routing decisions, wholesalers likely also compare
favorably to other market access centers (including retail brokers
pursuing their own market access) along other dimensions. The routing
behavior in Table 4 may, in part, reflect a tendency of non-PFOF
brokers to route individual investor orders to market centers such as
their own ATSs for mid-point execution and the lack of an affiliated
ATS for PFOF brokers. However, even broker-dealers with their own ATSs
do not route the majority of their individual investor order flow to
those ATSs and typically do not internalize order flow. Further, retail
brokers with membership on multiple exchanges primarily route their
marketable orders to wholesalers. These results could point to a lower
marginal cost of routing to wholesalers relative to other routing and
execution alternatives. Table 5 below shows that wholesalers appear to
compare favorably to exchanges in the execution quality of orders
routed to them, suggesting that execution quality could be another key
factor in the decision of retail brokers to route to wholesalers.\399\
In particular, marketable orders routed to wholesalers appear to have
higher fill rates, lower effective spreads, and lower E/Q ratios.\400\
These orders are also more likely to receive price improvement and,
conditional on receiving price improvement, receive greater price
improvement when routed to wholesalers as compared to exchanges.
---------------------------------------------------------------------------
\399\ See infra section VII.B.4 for a full discussion of Table 5
and section VII.B.5 for a discussion of how the Commission
preliminarily believes that the execution quality of orders routed
to wholesalers could be even better if most of such orders were not
isolated from order-by-order competition.
\400\ The E/Q ratio is the ratio of a stock's effective spread
over quoted spread. A lower value indicates smaller effective
spreads (i.e., trading costs) as a percentage of the quoted spread.
---------------------------------------------------------------------------
In addition, wholesalers may provide additional valuable services
to retail brokers that route order flow to them. Based on staff
experience, the Commission understands that wholesalers are more
responsive to retail brokers that provide them with order flow,
including, for example, following customer instructions not to
internalize particular orders. More broadly, wholesalers appear to
provide retail brokers with a high degree of consistency with regard to
execution quality. More specifically, while wholesalers receive order
flow from retail brokers that contains variation in quoted spreads and
adverse selection risk, wholesalers can target an average level of
price improvement across this heterogeneous order flow, resulting in a
relatively consistent degree of execution quality.
b. Wholesaler Internalization
Wholesalers provide market access for retail brokers and generally
choose to internalize the order flow they receive from these
brokers,\401\ thereby vertically integrating (i.e., bundling) their
market access and execution services. This vertical integration helps
wholesalers achieve a competitive advantage in both market access and
execution services. Wholesalers are distinct from other broker-dealers
that provide market access and execution services, in that they focus
on marketable order flow from individual investors and internalize the
large majority of orders routed to them.
---------------------------------------------------------------------------
\401\ See analysis in infra Table 10.
---------------------------------------------------------------------------
Wholesalers determine which orders to execute internally and which
to reroute to other trading venues, often using a riskless principal
transaction. For example, after receiving an order from a retail
broker, a wholesaler may send a principal marketable order similar to
the retail broker order to an exchange and, upon execution of the
principal order at the exchange, provide the same execution terms to
the original retail broker order. Alternatively, a wholesaler can
achieve the same economic result by rerouting the original order in an
agency capacity as well. In this way, the wholesaler is providing the
market access service, but another market center is providing the
execution service.
Commission analysis shows that wholesalers internalize over 90% of
the executed dollar value in NMS stocks from the marketable order flow
routed to them by retail brokers, which amounts to more than 80% of
share volume.\402\ Results also show that the marketable NMS stock
orders wholesalers choose to internalize have less adverse selection
risk: orders that wholesalers execute in a principal capacity have a
price impact of 0.9 bps, compared to a price impact of 4.6 bps for
those executed via other methods.\403\ These results stem from the
incentives wholesalers face. As dealers, wholesalers will wish to hold
inventory that is not subject to short-term adverse price moves.
Because orders with greater adverse selection risk will, on average, be
followed by adverse price moves, wholesalers will on average
internalize fewer of these orders.\404\
---------------------------------------------------------------------------
\402\ See analysis in infra Table 10.
\403\ Id. See also supra note 365 for a definition and
discussion of price impact as a measure of adverse selection risk.
\404\ See infra Table 10 in section VII.B.5.a for analysis
indicating that individual investor orders wholesalers internalize
have lower adverse selection risk and earn higher economic profits,
as measured by price impacts and realized spreads, than orders
wholesalers effectively reroute.
---------------------------------------------------------------------------
Wholesalers employ algorithms to predict price impact using
information to which only they have access, such as the identity of the
retail broker, and information any market center would have, such as
order characteristics and stock or market characteristics.\405\ Indeed,
Table 12 shows significant variation in average price impacts across
retail brokers. Because wholesalers know which retail brokers sent them
the order, they can use that information in combination with other
information to make internalization and pricing decisions.\406\ The
results in Table 13 support this conclusion, indicating that
wholesalers internalize a higher percentage of individual investor
orders from retail brokers whose customers' orders on average exhibit
lower price impact.
---------------------------------------------------------------------------
\405\ While these provide a few examples of information that
could be used by wholesalers, the Commission lacks information on
what information wholesalers actually use. Further, while the
analysis presented here shows associations between characteristics,
price impacts, and internalization, the analysis cannot determine
that the expected price impact based on a particular characteristic
caused the wholesaler to internalize the order.
\406\ Having aggregate information on retail order flow could
help the wholesaler assess the direction of the market, which could
also be beneficial for business lines beyond the firm's wholesaler
business.
---------------------------------------------------------------------------
c. Exchange Retail Liquidity Programs
Retail liquidity programs provide an on-exchange means of
segmentation. Indeed, the RLPs offered by many registered exchanges are
specifically set up to segment the marketable order flow of individual
investors,\407\ allowing liquidity suppliers to interact with this
order flow without the risk that their orders will trade against the
marketable orders of other market participants that may impose greater
adverse selection risk. The pricing increments, both for quoting and
trading, in RLPs, are usually 0.1 cents,\408\ although some
[[Page 187]]
exchanges have RLP programs that allow liquidity suppliers to quote
only at the midpoint.\409\ RLP programs typically do not charge an
access fee to individual investor orders executed in RLP programs.\410\
Quotes in RLP programs are not displayed.\411\ Instead, the SIP
disseminates a flag indicating the side of the market for which an
exchange has an RLP quote available at a price better than the NBBO
available. However, the SIP does not make known the price or the size
of the RLP quote, which creates opacity in the liquidity available in
RLP programs. The goal of these programs is to compete with wholesalers
and to attract marketable order flow of individual investors to trade
on national securities exchanges.\412\
---------------------------------------------------------------------------
\407\ See, e.g., NYSE Rule 7.44 (concerning RLPs).
\408\ See, e.g., description of NYSE Retail Liquidity program,
available at https://www.nyse.com/publicdocs/nyse/markets/liquidity-programs/RLP_Fact_Sheet.pdf.
\409\ See, e.g., IEX retail liquidity program, available at
https://exchange.iex.io/products/retail-program/.
\410\ See, e.g., NYSE Price List, available at https://www.nyse.com/publicdocs/nyse/markets/nyse/NYSE_Price_List.pdf; NYSE
Arca Trading Fee, available at https://www.nyse.com/publicdocs/nyse/markets/nyse-arca/NYSE_Arca_Marketplace_Fees.pdf; and IEX Exchange
Fee Schedule, available at https://exchange.iex.io/resources/trading/fee-schedule/.
\411\ RLPs operate under an exemption from Rule 612, and are
therefore allowed to use sub-penny pricing. As part of this
exemption, however, they are only eligible for individual investors
to execute against and cannot display quotes. See supra note 152 for
further discussion.
\412\ See supra note 151 regarding the purpose and operation of
RLPs.
---------------------------------------------------------------------------
However, it is the Commission's understanding that the share of
individual investor trading volume executed through RLPs is small. For
example, in 2021, less than 0.2% of consolidated volume executed in
exchange RLP programs.\413\ This low market share could be the result
of several factors. For example, many retail brokers lack direct access
to exchanges offering RLPs and the means of indirect access may be too
costly for RLPs compared to routing to wholesalers. Further,
wholesalers who compete with RLPs lack the incentives to route the
individual investor order flow with lower adverse selection risk to the
RLPs. If only the individual investor order flow with higher adverse
selection risk goes to RLPs, the liquidity providers in RLPs would
widen spreads to reflect the increased adverse selection.\414\ This in
turn, makes RLPs less competitive relative to wholesalers. Thus, even
retail brokers with exchange membership may find wholesalers more
attractive than RLPs for cost or execution quality reasons.
---------------------------------------------------------------------------
\413\ See Rosenblatt Securities, How Can the Buy Side Interact
With Retail Flow? (Feb. 14, 2022) available at https://www.rblt.com/market-reports/how-can-the-buy-side-interact-with-retail-flow.
\414\ Unlike wholesalers, liquidity suppliers in RLP programs
are not aware of the identity of the retail broker that the
individual investor originated from. Therefore, they are not able to
offer tighter spreads to individual investor orders from retail
brokers whose orders on average have lower adverse selection risk.
Instead, liquidity suppliers in RLP need to price their quotes based
on the average expected adverse selection risk of all orders routed
to the RLP. See, e.g., Lawrence R. Glosten & Paul R. Milgrom, Bid,
Ask, and Transaction Prices in a Specialist Market With
Heterogeneously Informed Traders, 14 J. Fin. Econ. 71 (1985).
---------------------------------------------------------------------------
3. Institutional Investor Interactions With Retail Orders
Several wholesalers operate SDPs through which they execute
institutional orders in NMS stocks against their own inventory.\415\
Because wholesalers also execute individual investor orders against
their own inventory, the use of SDPs amounts to an indirect interaction
between institutional and individual investor orders. The trading
volume on SDPs is economically significant. For example, a study found
that in Q1 2022, the SDPs affiliated with the two highest-volume
wholesalers accounted for around 3% of consolidated average daily
trading volume in NMS stocks.\416\ Institutional clients often
communicate their trading interest to SDPs using Immediate or Cancel
Orders (``IOCs'') or respond to Indication of Interest (``IOIs'')
issued by the SDP.
---------------------------------------------------------------------------
\415\ Wholesalers and OTC market makers can execute orders
themselves or instead further route the orders to other venues. An
SDP always acts as the counterparty to any trade that occurs on the
SDP. See Where Do Stocks Trade?, FINRA (Dec. 3, 2021), available at
https://www.finra.org/investors/insights/where-do-stocks-trade for
further discussion.
\416\ See Rosenblatt Securities, Rosenblatt's 2022 US Equity
Trading Venue Guide (May 24, 2022), available at https://www.rblt.com/market-reports/rosenblatts-2021-us-equity-trading-venue-guide-2. The study also found that SDPs accounted for
approximately 10% of off-exchange trading volume in Q1 2022.
---------------------------------------------------------------------------
On an SDP, the single dealer, i.e., the wholesaler, is privy to the
identities of the counterparties, i.e., institutional investors. One
academic paper has found that this information revelation may have
adverse execution consequences for the institutional investor.\417\ On
the other hand, there also may be benefits relative to other trading
venues. The trading interest of investors who submit IOCs to an SDP for
liquidity are only exposed to the single dealer operating a platform.
In contrast, submission of the same order to an exchange or an ATS may
alert many other market participants to the underlying trade interest,
triggering reactions. As such, institutional investors may view SDPs as
an opportunity to tap into a pool of liquidity that reduces their
orders' price impact and avoids triggering significant reactions by
other market participants.
---------------------------------------------------------------------------
\417\ See, e.g., Robert H. Battalio, Brian C. Hatch & Mehmet
Saglam, The Cost of Exposing Large Institutional Orders to
Electronic Liquidity Providers (last revised Nov. 7, 2022)
(unpublished manuscript), available at https://ssrn.com/abstract=3281324 (retrieved from Elsevier database).
---------------------------------------------------------------------------
4. Execution Quality of Individual Investor Marketable Orders in NMS
Stocks
[[Page 188]]
The wholesaler business model relies in part on segmentation and
internalization of marketable order flow of individual investors, which
is characterized by low adverse selection risk. An analysis of the
execution quality of market and marketable limit orders handled by
wholesalers retrieved from Rule 605 reports \418\ and presented in
Table 5 \419\ shows that orders in NMS stocks handled by wholesalers
are associated with lower price impact \420\ compared to those executed
on exchanges, indicating that orders handled by wholesalers on average
have lower adverse selection costs.\421\ This lower adverse selection
cost allows wholesalers to provide these orders with better execution
quality, manifested in lower effective spreads \422\ and E/Q ratios
compared to exchanges. The realized spreads \423\ observed in Table 5
\424\ adjust effective spreads for adverse selection costs (i.e., price
impact).\425\ Thus orders handled by wholesalers have higher realized
spreads, despite the fact that they may execute at better prices than
those received by and executed on exchanges, as observed by their lower
effective spreads in Table 5.
---------------------------------------------------------------------------
\418\ Rule 605 requires market centers to make available, on a
monthly basis, standardized information concerning execution quality
for covered orders in NMS stocks that they received for execution.
See 17 CFR 242.605. Covered orders are defined in 17 CFR
242.600(b)(22) to include orders (including immediate-or-cancel
orders) received by market centers during regular trading hours at a
time when a national best bid and national best offer is being
disseminated, and, if executed, is executed during regular trading
hours, and excludes orders for which the customer requests special
handling for execution (such as not held orders). Rule 605 reports
are required to contain a number of execution quality metrics for
covered orders, including statistics for all NMLOs with limit prices
within ten cents of the NBBO at the time of order receipt as well as
separate statistics for market orders and marketable limit orders.
Under the Rule, the information is categorized by individual
security, one of five order type categories (see 17 CFR
242.600(b)(14)), and one of four order size categories, which does
not include orders for less than 100 shares or orders greater than
or equal to 10,000 shares (see 17 CFR 242.600(b)(11)). As such, Rule
605 does not require reporting for orders smaller than 100 shares,
including odd-lot orders. Rule 605 requires market centers to report
execution quality information for all covered orders that the market
center receives for execution, including orders that are executed at
another venue (i.e., because they are effectively rerouted to
another trading center by the market center).
\419\ The following filters were applied to the Rule 605 data to
remove potential data errors: Observations where the total shares in
covered orders were less than the sum of the canceled shares, share
executed at the market center, and share executed away from the
market center were deleted; Observations with missing order size
code, order type code, total covered shares, or total covered orders
were deleted; Realized and effective spread values are set to
missing values if the total shares executed at and away from the
market center are zero; and Per share dollar realized spreads, per
share dollar effective spreads, and per share dollar price
improvements were winsorized at 20% of the volume weighted average
price of the stock for the month as calculated from NYSE Daily TAQ
data.
\420\ See supra note 365 and accompanying text for a definition
and discussion of price impact. Table 5 estimates the average price
impact associated with marketable orders routed to wholesalers to be
1.2 bps. This means that for a $10 stock the NBBO midpoint would
move up (down) by an average of 0.12 cents in the five minutes
following the execution of marketable buy (sell) order.
\421\ Once implemented, the changes to the current arrangements
for consolidated market data in the MDI Adopting Release, 86 FR at
18621, may impact the numbers in Table 5, including by reducing
those for realized spread, effective spread, and amount of price
improvement. The NBBO will narrow in stocks priced greater than $250
because it will be calculated based off a smaller round lot size.
This narrower NBBO will decrease price improvement statistics in
Rule 605 reports, which is measured against the NBBO. The effects on
effective and realized spreads is more uncertain, because they are
measured against the NBBO midpoint, which may not change if both the
NBB and NBO decrease by the same amount. However, if marketable
orders are more likely to be submitted when there are imbalances on
the opposite side of the limit order book (i.e., more marketable buy
orders are submitted when there is more size on the offer side of
the limit order book than the bid side), then the NBBO midpoint may
change such that it is closer to the quote the marketable order
executes against, which may decrease the effective and realized
spreads in stocks above $250 when the MDI Rules are implemented. It
is uncertain how likely this NBBO midpoint is to change. It is also
uncertain how or to what degree these changes would differ between
exchange and wholesaler Rule 605 reports. If both changed similarly,
then there would not be changes in relative differences between
their reported spread measures. See supra note 356.
\422\ See supra note 366 for a definition and discussion of
effective spreads.
\423\ See supra note 367 and accompanying text for a definition
and discussion of realized spreads as a measure of the economic
profits earned by liquidity providers. See infra note 426 discussing
the limitations of realized spreads for estimating the profits
earned by market makers.
\424\ The exception to this result is market orders executed on
exchanges, which have average higher realized spreads than
wholesaler market orders. However, market orders represent only 0.2%
of the overall marketable orders executed on exchanges and therefore
do not accurately represent exchange realized spreads. More
specifically, marketable limit orders executed on exchanges in Q1
2022 had a share volume of 179.10 billion shares while market orders
executed on exchanges had a share volume of 0.39 billion shares. See
infra Table 5.
\425\ The execution quality information required pursuant to
Rule 605 combines information about orders executed at a market
center with information on orders received for execution at a market
center but executed by another market center; see supra note 407. As
such, the execution quality statistics presented in Table 5 include
orders that are effectively rerouted by wholesalers. Furthermore,
note that Rule 605 does not specifically require market centers to
prepare separate execution quality reports for their SDPs, and as
such these calculations reflect all covered market and marketable
limit orders in NMS stocks received and executed by wholesalers,
including those on SDPs.
---------------------------------------------------------------------------
Realized spreads are a proxy for the potential economic profit that
liquidity suppliers may earn on a trade.\426\ Therefore, the higher
realized spreads earned by wholesalers suggest that the isolation of
individual investor orders routed to wholesalers results in wholesalers
potentially earning higher economic profits relative to a venue where
market makers compete with each other and other market participants to
supply liquidity at the individual order level (e.g., an exchange).
---------------------------------------------------------------------------
\426\ See supra note 367 for the definition of the realized
spread. Realized spreads do not measure the actual trading profits
that market makers earn from supplying liquidity. In order to
estimate the trading profits that market makers earn, we would need
to know at what times and prices the market maker executed the off-
setting position for a trade in which it supplied liquidity (e.g.,
the price at which the market maker later sold shares that it bought
when it was supplying liquidity). If market makers offset their
positions at a price and time that is different from the NBBO
midpoint at the time lag used to compute the realized spread measure
(Rule 605 realized spread statistics are measured against the NBBO
midpoint 5 minutes after the execution takes place), then the
realized spread measure is an imprecise proxy for the profits market
makers earn supplying liquidity. See Conrad and Wahal (2020) (for
discussions showing how realized spreads decline when measured over
time horizons and for further discussions regarding how realized
spreads are affected when measured over different time horizons).
Differences in inventory holding periods of different market makers
could also create differences in the trading profits that market
makers earn that would not be captured in the realized spread
measure if it is estimated over the same time horizon for all market
makers. See Lingyan Yang & Ariel Lohr, The Profitability of
Liquidity Provision (last revised Feb. 18, 2022) (unpublished
manuscript), available at https://ssrn.com/abstract=4033802.
Additionally, realized spread metrics do not take into account any
transaction rebates or fees, including PFOF, that a market maker
might earn or pay, which would also affect the profits they earn
when supplying liquidity. Furthermore, realized spreads also do not
account for other costs that market makers may incur, such as fixed
costs for setting up their trading infrastructure and costs for
connecting to trading venues and receiving market data.
---------------------------------------------------------------------------
Additionally, the results in Table 5 show that approximately 79% of
the executed dollar volume in marketable orders handled by wholesalers
are market orders. The Commission believes that these outcomes reflect
the heavy utilization of market orders for NMS stocks by individual
investors whose orders are primarily handled by wholesalers, contrary
to the heavy utilization of limit orders by other market participants.
Table 5 also highlights significantly higher fill rates, i.e., the
percentage of the shares in an order that execute in a trade, for
marketable orders sent to wholesalers as compared to those sent to
exchanges.\427\ Wholesalers execute the vast majority of orders that
they receive against their own capital, i.e., they internalize the vast
majority of
[[Page 189]]
orders they receive.\428\ Wholesalers expose themselves to inventory
risk when internalizing order flow, but mitigate this risk by
internalizing orders that possess low adverse selection risks.
---------------------------------------------------------------------------
\427\ Marketable orders may not fully execute if there isn't
sufficient liquidity on the exchange to fill the orders within their
limit price and/or if they contain other instructions that limit
their execution, such as if they are designated as IOC orders or
there are instructions not to route the orders to another exchange.
\428\ See analysis in infra Table 10 and corresponding
discussion.
Table 5--Comparison of Rule 605 Execution Quality Statistics Between Exchanges and Wholesalers for NMS Common Stocks and ETFs in Q1 2022
--------------------------------------------------------------------------------------------------------------------------------------------------------
Combined marketable orders Market Marketable limit
-----------------------------------------------------------------------------------------------
WH EX WH EX WH EX
--------------------------------------------------------------------------------------------------------------------------------------------------------
Average Price........................................... $47.89 $58.14 $56.19 $85.45 $30.66 $58.08
Share Volume (billion shares)........................... 106.97 179.49 72.20 0.39 34.77 179.10
Dollar Volume (billion $)............................... $5,122.91 $10,436.02 $4,056.85 $33.53 $1,066.06 $10,402.49
Fill Rate (%)........................................... 69.32% 25.77% 99.79% 58.08% 34.81% 25.77%
Effective Spread (bps).................................. 1.81 2.06 1.47 3.29 3.11 2.06
Realized Spread (bps)................................... 0.61 -0.38 0.39 2.40 1.43 -0.39
Price Impact (bps)...................................... 1.20 2.44 1.08 0.90 1.68 2.45
E/Q ratio............................................... 0.48 1.01 0.40 1.65 0.83 1.01
Pct of Shares Price Improved............................ 83.17% 8.78% 88.99% 15.95% 61.01% 8.75%
Conditional Amount of Price Improvement (bps)........... 2.17 1.50 2.33 1.92 1.24 1.50
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table computes aggregated execution quality statistics for marketable covered orders received by exchanges and wholesalers from Rule 605 reports
for Q1 2022 for NMS common stocks and ETFs. See supra note 418 for a definition of covered orders. Individual wholesaler and exchange Rule 605 reports
are aggregated together at the stock-month level, into two categories, WH and EX, such that aggregate execution quality data is averaged for, (a)
wholesalers (WH) and, (b) exchanges (EX), for each stock during each month.
The following metrics were calculated: Average Price is the stock's average execution price from the Rule 605 data (Dollar Volume/Share Volume), Share
Volume is the total executed shares (in billions) from the Rule 605 data. Dollar Volume is the total executed dollar volume (in billions), calculated
as the executed share volume from the Rule 605 data multiplied by the stock's monthly VWAP price, as derived from NYSE Daily Trade and Quote data
(TAQ). Fill Rate is the weighted average of the stock-month total executed share volume/total covered shares from the Rule 605 data. Effective Spread
is the weighted average of the stock-month percentage effective half spread in basis points (bps). Realized Spread is the weighted average of the
stock-month percentage realized half spread in basis points (bps). Price Impact is the weighted average of the stock-month percentage price impact in
basis points (bps). E/Q ratio is the weighted average of the stock-month ratio of the effective spread/quoted spread. Pct of Shares Price Improved is
the weighted average of the stock-month ratio of shares executed with price improvement/total executed share volume. Conditional Amount of Price
Improvement is the weighted average of the stock-month of the amount of percentage price improvement in basis points (bps), conditional on the
executed share receiving price improvement.
Aggregated effective and realized percentage spreads are measured in half spreads in order to show the average cost of an individual investor order and
are calculated by dividing the aggregated Rule 605 reported per share dollar amount by twice the stock's monthly volume weighed average price (VWAP),
as derived from NYSE Daily Trade and Quote data (TAQ), for trades executed during regular market hours during the month. Percentage price impact is
calculated as the aggregated Rule 605 reported per share dollar effective spreads minus per share dollar realized spreads divided by twice the stock's
monthly volume weighed average price (VWAP), as derived from NYSE Daily Trade and Quote data (TAQ). Percentage amount of price improvement is
calculated as the aggregated Rule 605 reported per share dollar amount of price improvement divided by the stock's monthly volume weighed average
price (VWAP), as derived from NYSE Daily Trade and Quote data (TAQ). Percentage spreads and amount of price improvement percentages are reported in
basis points (bps). The Combined Market and Marketable Limit order type category is constructed for each security-month-order size category by
combining the market and marketable limit order categories and computing the total and share weighted average metrics for the order size category for
each security-month.
The sample includes NMS common stocks and ETFs that are present in the CRSP 1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus.
(2022). The CRSP 1925 US Indices Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022), was used to identify if a stock was a member of the
S&P 500. The stock did not have to be in the CRSP 1925 US Indices Database to be included in the analysis. NMS Common stocks and ETFs are identified,
respectively, as securities in TAQ with a Security Type Code of `A' and `ETF'. For each stock-month-order-type (such that aggregate execution quality
data is averaged for, (a) wholesalers and, (b) exchanges, for each stock during each month) the per dollar share weighted measures from Rule 605
reports are aggregated together by share-weighting across different trading venues and order-size categories within the stock-month-order-type and
venue type (i.e., trading venue Rule 605 reports for exchanges and wholesalers are aggregated into different categories). Percent values are then
calculated for each stock month by dividing by the stock's monthly volume weighed average price (VWAP). These percentage stock-month values are
averaged together into order-type categories (market orders, marketable limit orders, and the combined market and marketable limit order type
category, for both wholesalers and exchanges) based on weighting by the total dollar trading volume for the wholesaler or exchange category in that
stock-month-order type, where dollar trading volume is estimated by multiplying the Rule 605 report total executed share volume, i.e., the share
volume executed at market center + share volume executed away from the market center, for the stock-month-order type by the stock's monthly VWAP. See
supra note 419 for a discussion of filters that were applied to the Rule 605 data in this analysis.
Because segmented orders valued at $200,000 and greater would be
excepted from Proposed Rule 615,\429\ we limit our analysis to Rule 605
order size categories where the average dollar value of orders received
by wholesalers was under $200,000.\430\ Table 6 summarizes Rule 605
data comparing the execution quality of marketable orders (i.e., the
combined market and marketable limit order category in Table 5) under
$200,000 routed to wholesalers and exchanges for different security
types.\431\ In Table 6, the average realized spreads for marketable
orders routed to exchanges are negative for all security types,\432\
while orders routed to wholesalers have positive realized spreads in
all securities, with larger realized spreads in Non-S&P 500 stocks. The
positive realized spreads for marketable orders routed to wholesalers
seem to indicate that the amount of price improvement these orders
receive in the form of lower effective spreads does not fully offset
the lower adverse selection costs they impose on liquidity suppliers
(as measured by lower price impacts) compared to negative realized
[[Page 190]]
spreads for orders routed to exchanges.\433\
---------------------------------------------------------------------------
\429\ See supra section IV.B.5 discussing exceptions to the
Proposed Rule.
\430\ We estimated the average dollar value of the orders
received by wholesalers based on their Rule 605 reports by
multiplying the average order size for a stock-month-order-size-
category (estimated as the number of total covered shares divided by
the number of total covered orders) by the stock's average monthly
VWAP price estimated from NYSE TAQ data.
\431\ Both the wholesaler and exchange average execution metrics
in Table 6 are calculated based on weighting by the total wholesaler
dollar trading volume in that stock-month. This weighting method
calculates averages across stocks similarly for exchanges and
wholesalers when aggregating their Rule 605 reports, which helps
ensure the averages across stocks are comparable between exchanges
and wholesalers.
\432\ A negative average realized spread on exchanges does not
necessarily mean that market makers on exchanges are not earning
trading profits for supplying liquidity on exchanges. The realized
spread observed on exchanges is a mix of liquidity supplied by
market makers and limit orders submitted by other traders who may be
interested in trading but not earning a spread (e.g., limit or
midpoint orders of individual or institutional investors that
potentially don't want to pay the spread to trade). Additionally, as
discussed in supra note 426, the realized spread is a proxy and does
not measure the actual trading profits that market makers earn from
supplying liquidity. It does not include exchange rebates liquidity
suppliers may earn and also makes assumptions about the time and
price at which the liquidity suppliers exit the position. After
accounting for exchange rebates, liquidity suppliers on exchanges
could potentially earn average positive trading profits if they exit
their positions at a different time or price than the estimated NBBO
midpoint at the time horizon used to estimate the realized spread (5
minutes for realized spreads reported in Rule 605). See Conrad and
Wahal (2020) for discussions on how realized spreads vary when
calculated over different time horizons.
\433\ Other studies have also used realized spreads to examine
competition between liquidity suppliers. See, e.g., Roger Huang &
Hans Stoll, Dealer versus auction markets: A paired comparison of
execution costs on NASDAQ and the NYSE, 41 J. Fin. Econ. 313 (1996)
(finding that in 1991 realized spreads for a sample of NASDAQ stocks
were higher than realized spreads for a matched sample of NYSE
stocks and concluding that important explanations for the higher
spreads observed on NASDAQ were the internalization and preferencing
of order flow and the presence of alternative interdealer trading
systems, factors that limited dealers' incentives to narrow
spreads); Jonathan Brogaard & Corey Garriott, High-Frequency Trading
Competition, 54 J. Fin. & Quantitative Analysis 1469 (2019) (looking
at the effects of the entry of new high-frequency traders that
compete to supply liquidity on the Canadian Alpha exchange and
finding that realized spreads decreased for the marketable orders of
non-high-frequency traders after new high-frequency traders entered
the market; the study observed that the reduction in realized
spreads was not attributable to changes in the price impact of the
orders of non-high-frequency traders and that the reduction in
realized spreads was attributable to increased competition among
liquidity suppliers); and Hank Bessembinder & Herbert Kaufman, A
cross-exchange comparison of execution costs and information flow
for NYSE-listed stocks, 46 J. Fin. Econ. 293 (1997) (finding in 1994
that effective bid-ask spreads for trades in NYSE issues completed
on the NYSE are slightly smaller than for trades completed with the
NASD dealer market and the regional stock exchanges but the realized
bid-ask spreads for trades on the NYSE are lower by a factor of two
to three; the authors conclude that this differential is
attributable to the successful 'cream skimming' of uninformed trades
by market makers off of the NYSE exchange; the authors also raise
concerns as to whether the trades being diverted from the NYSE might
have received better execution if they were not diverted and whether
existing rules governing order flow effectively fostered
competition).
---------------------------------------------------------------------------
Table 6 also shows realized spreads adjusted to reflect share-level
PFOF payments paid by wholesalers \434\ and rebates paid by
exchanges.\435\ After these respective costs are netted out, although
wholesaler realized spreads are reduced and exchange realized spreads
increase (i.e., are less negative), wholesaler realized spreads
continue to exceed exchange realized spreads. Adjusting for rebates on
the one hand and PFOF on the other allows us to estimate a marginal
profit to a liquidity supplier in each venue (note that a rebate
substitutes one-for-one with a spread, as does PFOF, and in an
idealized perfect-competition setting both would be zero).
Acknowledging that there may be differences not captured by these
measures, this calculation suggests a higher marginal profit for orders
off-exchange versus on-exchange, and suggests greater on-exchange
competition.\436\ While an accounting measure of profit would need to
take, say, fixed costs into account, fixed costs alone would not
explain the difference as liquidity suppliers on both types of venues
may have similar fixed costs.
---------------------------------------------------------------------------
\434\ Wholesaler realized spreads are adjusted to account for
the PFOF they pay to retail brokers. Because we are not able to
identify the broker-dealer from which the orders originated in Rule
605 reports, we estimate PFOF rates for the Rule 605 data sample by
multiplying the estimated PFOF rates retail brokers receive in Table
2 by 74% in order to adjust for an estimated 26% of the marketable
order flow wholesalers receive coming from retail brokers that do
not accept PFOF, as estimated by the percentage of share volume
received from non-PFOF brokers in infra Table 14. The estimated PFOF
rates are 12 mils for market orders in S&P 500 stocks, 10 mils for
market orders in ETFs and non-S&P 500 stocks, 17 mils for marketable
limit order in S&P 500 stocks, and 9 mils for marketable limit
orders in ETFs and non-S&P 500 stocks. For the Rule 605 data sample,
the wholesalers' PFOF adjusted realized spread is computed by
subtracting the relevant PFOF rate from a stock's average dollar
realized spread for orders routed to wholesalers and then dividing
by twice the stock's average monthly VWAP price estimated from NYSE
TAQ data.
\435\ Estimates of exchange rebates that liquidity suppliers
earn on maker-taker venues and the fees they pay on inverted and
flat fee venues are assumed as follows: exchange rebates to
liquidity suppliers on maker-taker venues are 27 mils; exchange fees
for supplying liquidity on inverted venues are 15 mils; exchange
fees for supplying liquidity on flat fee venues are 7 mils; and
there is no fee on exchanges that do not charge fees and rebates.
Exchange rebates are assumed to be 27 mils based on the average rate
exchanges pay retail brokers for their non-marketable limit orders
in Table 2. Fee rates for inverted and flat fee venues (which charge
fees to both liquidity suppliers and demanders and do not pay
rebates) were estimated based on exchange fee and rebate tables and
were adjusted by 3 mils to account for volume-based tiering (for
inverted venues) or differences in fees supplying liquidity using
displayed vs. non-displayed orders (for flat fee venues). For both
the Rule 605 and CAT data samples (see infra Table 7), a stock's
rebate adjusted exchange realized spread is calculated by adding/
subtracting the exchange rebate/fee to/from the average dollar
realized spread and then dividing by twice the stock's average
monthly VWAP price estimated from NYSE TAQ data.
\436\ One caveat to the difference in transaction costs on and
off-exchange is that, on-exchange execution, to the extent it is
driven by institutional order flow, may be accompanied by
commissions. While this should not affect the interpretation of
realized spreads as marginal profit to liquidity provision, it does
reflect the interpretation as either the transaction cost of the
customer or marginal profit of the liquidity supplier handling
customer order flow.
Table 6--Rule 605 Wholesaler (WH) and Exchange (EX) Execution Quality Comparison for Marketable Orders Under
$200,000 for Q1 2022 by Security Type
----------------------------------------------------------------------------------------------------------------
All NMS stocks S&P 500 Non-S&P 500 ETF
----------------------------------------------------------------------------------------------------------------
Average Price................................... $33.99 $97.03 $13.52 $51.19
WH Share Volume (billion shares)................ 96.51 15.00 62.32 19.18
WH Dollar Volume (billion $).................... $3,280.03 $1,455.40 $842.66 $981.98
EX Share Volume (billion shares)................ 172.08 39.89 86.67 45.52
EX Dollar Volume (billion $).................... $9,025.52 $3,448.64 $1,899.61 $3,677.27
WH Fill Rate (%)................................ 69.06% 73.17% 66.65% 65.03%
EX Fill Rate (%)................................ 27.31% 32.53% 29.56% 17.63%
WH Effective Spread (bps)....................... 2.05 0.72 5.70 0.89
EX Effective Spread (bps)....................... 3.11 1.45 7.86 1.49
WH Realized Spread (bps)........................ 0.72 0.30 1.55 0.64
EX Realized Spread (bps)........................ -0.67 -0.30 -1.97 -0.12
WH Realized Spread Adj PFOF (bps)............... 0.43 0.17 0.86 0.45
EX Realized Spread Adj Rebate (bps)............. -0.001 -0.05 -0.24 0.28
WH Price Impact (bps)........................... 1.33 0.42 4.15 0.25
EX Price Impact (bps)........................... 3.78 1.74 9.83 1.61
WH E/Q Ratio.................................... 0.42 0.35 0.49 0.45
EX E/Q Ratio.................................... 1.00 0.98 1.00 1.01
WH % Pct of Shares Price Improved............... 84.7% 86.7% 82.5% 83.4%
EX % Pct of Shares Price Improved............... 8.8% 10.9% 9.5% 5.2%
WH Conditional Amount of Price Improvement (bps) 2.62 1.49 6.27 1.17
[[Page 191]]
EX Conditional Amount of Price Improvement (bps) 2.36 1.04 5.88 1.28
----------------------------------------------------------------------------------------------------------------
This table compares aggregated execution quality statistics broken out for different security types for
marketable covered orders with average order size under $200,000 received by exchanges and wholesalers as
reported from Rule 605 reports for Q1 2022 for NMS common stocks and ETFs. See supra note 418 for a definition
of covered orders. Individual wholesaler and exchange Rule 605 reports are aggregated together at the stock-
month level into two categories, EX and WH. EX shows aggregated statistics from Rule 605 reports from
exchanges and WH shows aggregated statistics from Rule 605 reports from wholesalers. Marketable orders are
constructed separately for wholesalers and exchanges by combining the Market and Marketable Limit order type
categories in Rule 605 reports for each security-month-order size category and computing the total and share
weighted average metrics from the combined order types for the order size category for each security-month.
See supra Table 5 for the descriptions of the reported metrics: Average Price, Share Volume, Dollar Volume, Fill
Rate, Effective spread, Realized spread, Price Impact, E/Q Ratio, Pct Shares Price Improved, and Conditional
Amount of Price Improvement. WH Realized Spread Adj PFOF is the weighted average of the stock-month percentage
realized half spread in basis points (bps) from wholesaler 605 reports after adjusting for the estimated PFOF
paid by the wholesaler using the methodology described in supra note 434. EX Realized Spread Adj Rebate is the
weighted average of the stock-month percentage realized half spread in basis points (bps) from exchange 605
reports after adjusting for the estimated rebates (access fees) exchanges pay (charge) to liquidity suppliers
using the methodology described in supra note 435.
Percentage spreads are measured in half spreads in order to show the average cost of an individual investor
order and are calculated by dividing the Rule 605 report per share dollar amount by twice the stock's monthly
VWAP, as derived from NYSE Daily Trade and Quote data (TAQ), for trades executed during regular market hours
during the month. Percentage spreads are reported in basis points (bps).
The sample includes NMS common stocks and ETFs that are present in the CRSP 1925 US Stock Database, Ctr. Rsch.
Sec. Prices, U. Chi. Booth Sch. Bus. (2022). The CRSP 1925 US Indices Database, Ctr. Rsch. Sec. Prices, U.
Chi. Booth Sch. Bus. (2022), was used to identify if a stock was a member of the S&P 500. The stock did not
have to be in the CRSP 1925 US Indices Database to be included in the analysis. NMS Common stocks and ETFs are
identified, respectively, as securities in TAQ with a Security Type Code of `A' and `ETF. The exchange and
wholesaler metrics in the table are each reported for the combined marketable order type, which was
constructed for this analysis separately for exchange and wholesalers by combining the Market and Marketable
Limit order type categories in Rule 605 reports at the stock-month-order-size level and computing the total
and share weighted average metrics from the combined order types. For each stock-month, share weighted metrics
(for both exchange and wholesalers) are then calculated by share-weighting across different order-size
categories based on the number of shares executed (at the market center + away) in wholesalers' Rule 605
reports in that order-size category. Order size categories with wholesaler average order dollar values greater
than or equal to $200,000 were excluded. The average order dollar values were determined for each order-size
category stock-month by dividing the wholesaler total number of covered shares in the order size category by
the wholesaler total number of covered orders and then multiplying by the stock-month's average VWAP, as
derived from NYSE Daily Trade and Quote data (TAQ). Stock-month values are averaged together (for both
wholesalers and exchanges) based on weighting by the total wholesaler dollar trading volume in that stock-
month for the combined marketable order type (wholesaler dollar trading volume is estimated by multiplying the
Rule 605 report wholesaler total executed share volume, i.e., the share volume executed at market center +
share volume executed away from the market center, for the stock-month-order type by the stock's monthly
VWAP). This weighting method calculates averages across stocks similarly for exchanges and wholesalers when
aggregating their Rule 605 reports, which helps ensure the averages across stocks are comparable between
exchanges and wholesalers. See supra note 419 for a discussion of filters that were applied to the Rule 605
data in this analysis.
Because Rule 605 requires market centers to report execution
quality statistics only for covered orders that fall within specific
order size and type categories,\437\ a number of order types and sizes
that may be particularly relevant for individual investors are excluded
from the above analyses, including orders for less than 100
shares.\438\ Additionally Rule 605 data does not allow us to
distinguish between orders that wholesalers execute on a principal
basis from those they execute on riskless principal basis, since they
are both reported as being executed at the market center. Furthermore,
it is not possible in Rule 605 data to distinguish between orders that
a wholesaler received from individual investors from those it received
from other types of market participants. For example, wholesaler Rule
605 reports may include both individual investor orders that they
receive, as well as institutional orders they receive on their SDPs.
Lastly, effective and realized spread measures as required to be
reported in Rule 605 reports are calculated using a five-minute time
horizon, which some academic literature argues has become inappropriate
for a high-frequency environment.\439\ Therefore, to supplement the
analyses using Rule 605 data and test for the robustness of the results
\440\ that it generated, CAT data \441\ was analyzed to look at the
execution
[[Page 192]]
quality of marketable orders of individual investors in NMS Common
Stocks and ETFs that were less than $200,000 in value and that executed
and were handled by wholesalers during Q1 2022 (``CAT retail
analysis'').\442\ This was compared to a sample of CAT data examining
the execution quality of executed market and marketable limit orders in
NMS Common Stocks and ETFs received by exchanges that were less than
$200,000 in value over the same time period (``CAT exchange
analysis'').\443\
---------------------------------------------------------------------------
\437\ See supra note 407 for a definition of covered orders and
a discussion of the order type and size categories included in Rule
605 reporting requirements.
\438\ There is evidence that individual investors tend to use
smaller trading sizes. See, e.g., Robert P. Bartlett, Justin McCrary
& Maureen O'Hara, The Market Inside the Market: Odd-Lot Quotes (last
revised Feb. 11, 2022) (unpublished manuscript), available at
https://ssrn.com/abstract=4027099 (retrieved from Elsevier
database); Matthew Healey, An In-Depth View Into Odd Lots, Cboe
(Oct. 2021), available at https://www.cboe.com/insights/posts/an-in-depth-view-into-odd-lots/.
\439\ See, e.g., Maureen O'Hara, High Frequency Market
Microstructure, 116 J. Fin. Econ. 257 (2015) (``O'Hara 2015'');
Maureen O'Hara, Gideon Saar & Zhuo Zhong, Relative Tick Size and the
Trading Environment, 9 Rev. of Asset Pricing Stud. 47 (2019)
(``O'Hara et al.''); Jennifer S. Conrad & Sunil Wahal, The Term
Structure of Liquidity Provision, 136 J. Fin. Econ. 239 (2020)
(``Conrad and Wahal''). Conrad and Wahal suggest that a one-minute
horizon may be appropriate for small stocks, and a 15-second horizon
may be appropriate for large stocks. The following analyses using
CAT data will use a one-minute horizon for calculating the realized
spread; see supra note 50.
\440\ Rule 605 data is publicly available and the consistency of
the results generated by analysis of these data supports the
veracity of the results generated by CAT data, despite the fact that
CAT data is not publicly available.
\441\ This analysis used CAT data to examine the execution
quality of marketable orders in NMS Common stocks and ETFs that
belonged to accounts with a CAT account type of ``Individual
Customer'' and that originated from a broker-dealer MPID that
originated orders from 10,000 or more unique ``Individual Customer''
accounts during Jan. 2022. The number of unique ``Individual
Customer'' accounts associated with each MPID was calculated as the
number for unique customer account identifiers with an account
customer type of ``Individual Customer'' that originated at least
one order during the month of Jan. 2022. The Commission found that
58 broker-dealer MPIDs associated with 54 different broker-dealers
originated orders from 10,000 or more unique Individual Customer
accounts in Jan. 2022. As discussed in supra note 194, the CAT
account type ``Individual Customer'' may not be limited to
individual investors because it includes natural persons as well as
corporate entities that do not meet the definitions for other
account types. The Commission restricted that analysis to MPIDs that
originated orders from 10,000 or more ``Individual Customer''
accounts in order to ensure that these MPIDs are likely to be
associated with retail brokers to help ensure that the sample is
more likely to contain marketable orders originating from individual
investors. NMS Common stocks and ETFs are identified, respectively,
as securities in TAQ with a Security Type Code of ``A'' and ``ETF.''
\442\ Fractional share orders with share quantity less than one
share were excluded from the analysis. The analysis included market
and marketable limit orders that originated from one of the 58
retail broker MPIDs and were received by a market center that was
associated with one of the six wholesalers CRD numbers (FINRA's
Central Registration Depository number) during some point in the
order's lifecycle. Orders that were received by the wholesaler or
executed outside of normal market hours were excluded. Orders were
also excluded if they had certain special handling codes so that
execution quality statistics would not be skewed by orders being
limited in handling by special instructions (e.g., pegged orders,
stop orders, post only orders, etc.) Orders identified in CAT as
Market and Limit orders with no special handling codes or one of the
following special handling codes were included in the analysis: NH
(not held), CASH (cash), DISQ (display quantity), RLO (retail
liquidity order), and DNR (do not reduce). These special handling
codes were identified based on their common use by retail brokers
and descriptions of their special handling codes. The marketability
of a limit order was determined based on the consolidated market
data feed NBBO at the time a wholesaler first receives the order.
Limit orders that were not marketable were excluded. The dollar
value of an order was determined by multiplying the order's number
of shares by either its limit price, in the case of a limit order,
or by the far side quote (i.e., NBO for a market buy order and NBB
for a market sell) of the consolidated market data feed NBBO at the
time the order was first received by a wholesaler, in the case of a
market order. Orders with dollar values greater than or equal to
$200,000 were excluded from the analysis. The analysis includes NMS
Common Stocks and ETFs (identified by security type codes of `A' and
`ETF' in NYSE TAQ data) that are also present in CRSP data. Price
improvement, effective spreads, realized spreads, quoted spreads,
and price impacts were winsorized if they were greater than 20% of a
stock's VWAP during a stock-week. See Table 7 for a detailed
description of the analysis.
\443\ The Commission analysis used CAT data to examine the
execution quality of market and marketable limit orders in NMS
Common Stocks and ETFs that were under $200,000 in value that were
received and executed by exchanges during normal market hours in Q1
2022. The analysis employed filters to clean the data and account
for potential data errors. The analysis is limited to orders
identified in CAT as market and limit orders accepted by exchanges.
Orders were excluded from the analysis if they had certain special
handling codes, such as post or add-liquidity only orders, midpoint
orders, orders that can only execute in opening and closing
auctions, orders with a minimum execution quantity, pegged orders,
or stop order or stop-loss orders. Orders were also required to
execute in normal trades during normal trading hours to be included
in the analysis. Normal trades are identified in CAT data by sale
conditions ``blank, @, E, F, I, S, Y'' which correspond to regular
trades, intermarket sweep orders, odd lot trades, split trades, and
yellow flag regular trades. For orders submitted to exchanges, the
NBBO the exchange records seeing at the time of order receipt is
used to measure the NBBO and NBBO midpoint for calculating
statistics that are based on the time of order receipt (e.g.,
effective spreads, price improvement, quoted spreads, etc.). The
marketability of exchange orders was determined based on the NBBO
observed by the exchange at the time of order receipt. The dollar
value for a market order was calculated as the price of the far side
NBBO quote (NBO for a market buy order and NBB for a market sell)
times the shares in the order. The dollar value for a limit order
was calculated as the price of the limit order times the number of
shares in the order. Orders with dollar values greater than or equal
to $200,000 were excluded from the analysis. The consolidated market
data feed NBBO was used to calculate statistics that use the NBBO or
NBBO one minute after execution (e.g., realized spreads, price
impacts, etc). The analysis includes NMS Common Stocks and ETFs
(identified by security type codes of `A' and `ETF' in NYSE TAQ
data) that are also present in CRSP data. Price improvement,
effective spreads, realized spreads, quoted spreads, and price
impacts were winsorized if they were greater than 20% of a stock's
VWAP during a stock-week. See Table 7 for a detailed description of
the analysis.
---------------------------------------------------------------------------
Table 7, which reports results from CAT data, contains some
statistics that are not available in Rule 605 reports, including
statistics on midpoint executions and sub-penny trades.\444\ In NMS
common stock and ETF orders, wholesalers execute approximately 44% of
shares at prices at or better than the NBBO midpoint. However,
wholesalers also offer less than 0.1 cents price improvement to
approximately 18.6% of shares that they execute. Wholesalers execute
more than 65% of shares at sub-penny prices, with over 40% of shares
being executed at prices with four decimal points (i.e., the fourth
decimal place is not equal to zero).
---------------------------------------------------------------------------
\444\ Certain items in Table 7 may also be affected by the MDI
rules once they are implemented. See supra notes 356 and 421.
---------------------------------------------------------------------------
Results from this analysis are highly consistent with results from
the analysis of Rule 605 data from Table 6. Specifically, wholesalers
display lower price impacts and E/Q ratios, indicating that orders
internalized by wholesalers receive better execution quality than
orders executed on exchanges. Despite this enhanced execution quality,
realized spreads of wholesalers exceed those produced by
exchanges.\445\ This finding remains even after netting out PFOF
payments made by wholesalers \446\ and rebates made by exchanges.\447\
---------------------------------------------------------------------------
\445\ The relative differences between exchanges and wholesalers
in price impacts and realized spreads are even more pronounced with
the CAT data, which (unlike 605 data) include odd lots, exclude
orders greater than $200,000, and measure realized spreads from 1
minute rather than 5 minutes after execution.
\446\ For CAT data, we estimate the PFOF each retail broker
receives based on data from their Q1 Rule 606 reports. For each
month we separately estimate the average per share PFOF rate they
receive from wholesalers based on the order type (market and
marketable limit orders) and security type (S&P500 and non-S&P500
stocks), which we then combine with the same order and stock type in
the CAT data. If a retail broker does not produce a Rule 606 report,
then we use the PFOF rates from its clearing broker's Rule 606
report, if it is available (some retail brokers' websites disclosed
that they share in payments their clearing broker receives for their
order flow). A PFOF rate of 20 cents per 100 shares was used for the
introducing broker-dealers and clearing broker that reported handled
orders on a not held basis and did not disclose PFOF information in
their Rule 606 report but disclosed on their website that they
received PFOF for their order flow. 20 cents per 100 shares was the
PFOF rate that the clearing broker that handles orders on a not held
basis disclosed on their website that they received.
\447\ See supra note 435 for discussion of how exchange rebates
are calculated.
Table 7--Wholesaler CAT Analysis of Exchange Individual Investor Order Execution Quality for Marketable Orders
in NMS Common Stocks and ETFs by Type of Stock
----------------------------------------------------------------------------------------------------------------
Variable All SP500 Non-SP500 ETF
----------------------------------------------------------------------------------------------------------------
Panel A: Wholesaler and Exchange Execution Quality
----------------------------------------------------------------------------------------------------------------
Average Price................................... $29.87 $110.31 $10.52 $53.14
WH Principal Execution Rate..................... 90.44% 93.07% 87.66% 88.12%
WH Share Volume (billion shares)................ 87.11 11.63 63.17 12.31
EX Share Volume (billion shares)................ 281.90 66.98 140.82 74.10
WH Dollar Volume (billion $).................... $2,601.44 $1,282.62 $664.41 $654.41
EX Dollar Volume (billion $).................... $16,194.84 $6,479.89 $3,246.09 $6,468.85
WH Effective Spread (bps)....................... 2.11 0.67 6.23 0.76
EX Effective Spread (bps)....................... 3.18 1.52 8.11 1.42
WH Realized Spread (bps)........................ 0.85 0.42 2.00 0.51
EX Realized Spread (bps)........................ -1.22 -0.28 -3.90 -0.34
WH Realized Spread Adj PFOF (bps)............... 0.49 0.29 0.99 0.36
EX Realized Spread Adj Rebate (bps)............. -0.40 -0.06 -1.54 0.08
[[Page 193]]
WH Price Impact (bps)........................... 1.26 0.25 4.22 0.25
EX Price Impact (bps)........................... 4.40 1.80 12.00 1.75
WH E/Q Ratio.................................... 0.39 0.32 0.50 0.41
EX E/Q Ratio.................................... 1.04 1.01 0.98 1.17
----------------------------------------------------------------------------------------------------------------
Panel B: Wholesaler Price Improvement
----------------------------------------------------------------------------------------------------------------
WH Pct Executed with Price Improvement.......... 89.95% 93.33% 85.43% 87.93%
WH Conditional Amount Price Improvement (bps)... 2.54 1.47 6.16 0.99
WH Pct Shares Executed at Midpoint or Better.... 44.57% 47.37% 39.76% 43.97%
WH Pct Shares Executed at Midpoint.............. 31.69% 32.47% 28.46% 33.44%
WH Pct Shares Executed at NBBO.................. 8.38% 5.86% 10.97% 10.69%
WH Pct Shares Executed Outside NBBO............. 1.67% 0.81% 3.61% 1.38%
WH Pct Shares Executed with <0.1 cent Price 18.64% 16.62% 20.58% 20.64%
Improvement....................................
WH Pct of Shares Executed as Subpenny Prices.... 66.98% 65.10% 64.16% 73.55%
WH Pct of Shares Executed at Subpenny Prices 47.60% 46.82% 47.03% 49.68%
without Midpoint Trades........................
WH Pct of Shares Executed at Subpenny Prices 41.36% 40.80% 41.76% 42.06%
with 4 Decimals................................
----------------------------------------------------------------------------------------------------------------
This table uses CAT data to compare aggregated execution quality statistics for Q1 2022 broken out for different
security types for executed marketable orders with order size under $200,000 in NMS Common Stocks and ETFs
received by wholesalers from individual investors to similar orders received by exchanges. Aggregated
statistics in the table labeled WH are based on analysis of CAT data of executed marketable orders in NMS
Common Stocks and ETFs from individual investors for under $200,000 in value belonging to one of 58 retail
broker MPIDs that were handled by one of 6 wholesalers during normal market hours in Q1 2022 (see supra note
442 for additional discussions on the CAT data used in the CAT retail analysis). Aggregated statistics in the
table labeled EX are based on a corresponding analysis of CAT data of executed marketable orders in NMS Common
Stocks and ETFs receive by exchanges that were under $200,000 in value and received and executed during normal
market hours in Q1 2022 (see supra note 443 for additional discussions on the CAT data used in CAT exchange
analysis).
The following metrics are calculated for all stocks and for each of the stock-types. EX indicates aggregated
statistics for executed marketable orders routed to exchanges and WH indicates aggregated statistics for
executed marketable orders from individual investors that were routed to wholesalers. Average Price is the
average execution price. WH Principal Execution Rate is the percentage of dollar volume of individual investor
trades that a wholesaler executed in a principal capacity. Share Volume is the total executed share volume.
Dollar Volume is the total executed dollar volume. Effective Spread is the weighted average of the percentage
effective half spread in basis points (bps) (measured as average (execution price--NBBO midpoint at time of
order receipt) * average transaction price). Realized Spread is the weighted average of the percentage one
minute realized spread in bps (measured as average (execution price--NBBO midpoint one minute after execution)
* average transaction price). WH Realized Spread Adj PFOF is the estimated realized spread in bps earned by
the wholesaler after adjusting the realized spread for the estimated PFOF they pay to retail brokers (see
supra note 446 for further details on adjusting wholesaler realized spreads for PFOF in CAT data). EX Realized
Spread Adj Rebate is the estimated realized spread in bps earned by exchange liquidity suppliers after
adjusting the realized spread for the estimated exchange rebates they receive or access fees they pay for
supplying liquidity (see supra note 435 for further details on adjusting realized spreads for exchange fees
and rebates). Price Impact is the weighted average of the percentage one-minute price impact spread in bps
(measured as average (NBBO midpoint one minute after execution--NBBO midpoint at time of order receipt)/
average transaction price). E/Q Ratio is the weighted average of the ratio of the effective dollar spread
divided by its quoted spread at the time of order receipt. WH Pct Executed with Price Improvement is the
weighted average of the percentage of share volume that is routed to wholesalers and executed at a price
better than the NBBO. WH Conditional Amount Price Improvement is the weighted average amount of percentage
price improvement given by wholesalers conditional on the order receiving price improvement in bps (measured
for a marketable buy order as average (NBO at time of order receipt--execution price) and measured for a
marketable sell order as average (execution price--NBB at time of order receipt) and then dividing the
difference by the average transaction price). WH Pct Share Executed at Midpoint or Better is the weighted
average of the percentage of shares that are routed to a wholesaler and executed at prices equal to or better
than the NBBO midpoint at the time of order receipt. WH Pct Share Executed at Midpoint is the weighted average
of the percentage of shares that are routed to a wholesaler and executed at a price equal to the NBBO midpoint
at the time of order receipt. WH Pct Shares Executed at NBBO is the weighted average of the percentage of
share volume routed to a wholesaler and executed at the NBBO at the time of order receipt (executed at the NBB
for marketable sell orders and the NBO for marketable buy orders). WH Pct Shares Executed Outside NBBO is the
weighted average of the percentage of share volume routed to wholesalers and executed at prices outside the
NBBO at the time of order receipt (executed at a price less than the NBB for marketable sell orders and a
price greater than the NBO for marketable buy orders). WH Pct Shares Executed with <0.1 cent Price Improvement
is the weighted average of the percentage of shares that are executed with an amount of price improvement less
than 0.1 cents measured against the NBBO at the time of order receipt. WH Pct Shares Executed Subpenny Prices
is the weighted average of the percentage of shares that execute at a subpenny price (a dollar execution price
with a non-zero value in the third or fourth decimal place). WH Pct Shares Executed at Subpenny without
Midpoint Trades is the weighted average of the percentage of shares that execute at a subpenny price (a dollar
execution price with a non-zero value in the third or fourth decimal place), excluding executions with
subpenny prices that occur at the NBBO midpoint. WH Pct Shares Executed at Subpenny Prices with 4 Decimals is
the weighted average of the percentage of shares that execute at a subpenny price where there is a dollar
execution price with a non-zero value in the fourth decimal place. Average transaction prices used in
calculating the metrics are calculated as the total dollar trading volume divided by the total share trading
volume in the category and time period.For the wholesaler (WH) CAT metrics used in the sample, the analysis
includes marketable orders for under $200,000 in value that originate from a customer with a CAT account type
of ``individual'' at one of the 58 retail broker MPIDs and are routed to a wholesaler (see supra note 441 for
more info on CAT account types and retail broker identification methodology and supra note 442 for more
details on how the CAT retail analysis sample was constructed). Fractional share orders with share quantity
less than one share were excluded from the analysis. Orders were also excluded if they had certain special
handling codes. The marketability of a limit order is determined based on the consolidated market data feed
NBBO at the time a wholesaler first receives the order.
For the exchange (EX) CAT metrics, executed market and marketable limit orders received by exchanges during
normal market hours over the same period were used to calculate the exchange execution quality statics (see
supra note 443 for more details on how the CAT exchange sample was constructed). Exchange orders were filtered
if they had certain special handling codes. The marketability of exchange orders was determined based on the
NBBO observed by the exchange at the time of order receipt.
The dollar value of an order was determined by multiplying the order's number of shares by either its limit
price, in the case of a limit order, or by the far-side quote of the NBBO at the time of order receipt, in the
case of a market order. The analysis includes NMS Common Stocks and ETFs (identified by security type codes of
`A' and `ETF' in NYSE TAQ data) that are also present in CRSP data from CRSP 1925 US Stock Database, Ctr.
Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022). The CRSP 1925 US Indices Database, Ctr. Rsch. Sec. Prices,
U. Chi. Booth Sch. Bus. (2022), was used to identify if a stock was a member of the S&P 500. The stock did not
have to be in the CRSP 1925 US Indices Database to be included in the analysis. Time of order receipt is
defined as the time the wholesaler or exchange first receives the order. Wholesaler metrics based on the time
of order receipt are measured against the NBBO from the consolidated market data feed. Exchange metrics based
on time of order receipt are measured against the NBBO the exchange reports observing. Realized spreads for
both exchange and wholesaler metrics are calculated with respect to the NBBO midpoint from the consolidated
market data feed observed one minute after the time of order execution.
Separately, for both the exchange and wholesaler samples, total share volume, total dollar volume, average
transaction price, percentage volume metrics, and share weighted average dollar per share spread, price
impact, and price improvement metrics were calculated at a stock-week-order size category level by aggregating
together execution quality statistics calculated for individual orders. The order-size categories were defined
as orders less than 100 shares, 100-499 shares, 500-1,999 shares, 2,000-4,999, 5,000-9,999 shares, and 10,000+
shares. For each stock-week-order size category, percentage spread, price impact, and price improvement
metrics were calculated by dividing the average dollar per share metric by the average transaction price
calculated for each stock-week-order size category. E/Q ratios were calculated for each stock-week-order size
category by dividing the average dollar per share effective spread by the average dollar per share quoted
spread.
Exchange sample metrics for E/Q ratios and percentage spread, price impact, and price improvement metrics for
each stock-week-order size category were then merged with the corresponding stock-week-order size category in
the wholesaler sample. Weighted averages for both wholesaler and exchange metrics and the wholesaler
percentage volume metrics are then calculated for the security type in the sample by averaging across stock-
week-order size category levels based on their total dollar transaction volume during the sample period in the
wholesaler CAT sample (i.e., for both exchanges and wholesalers, using the stock's total dollar trading volume
in wholesaler executed transactions as the weight when averaging the share weighted average stock-week- size
category values). Weighting the exchange and wholesaler execution metrics by the same weights helps to ensure
the samples are comparable across stocks. Total dollar volume and share volume for the exchange and wholesaler
samples are calculated by summing across all executions in a security type in each sample. The wholesaler
Principal Execution Rate is calculated for a security type in the wholesaler sample by summing the total
dollar volume in trades wholesalers executed in a principal capacity across the security type in the
wholesaler sample and dividing by the total dollar volume in trades in the security type in the wholesaler
sample.
[[Page 194]]
In sum, analyses from Table 6 and Table 7 show that wholesaler
realized spreads exceed exchange realized spreads for comparable
marketable order transactions (e.g., similar stocks and order sizes) on
exchanges. If orders internalized by wholesalers were subject to
competition from multiple liquidity suppliers at the individual order
level,\448\ we would expect realized spreads to be similar to the
realized spreads earned by liquidity providers of similar orders routed
to exchanges.\449\ That is, the wholesaler could respond to the lower
price impact (adverse selection risk) of its internalized orders by
providing large enough price improvement so that its realized spread
(potential profits) matched exchange realized spreads generated by the
larger price impact (adverse selection risk) and smaller price
improvement of orders executed by liquidity suppliers on exchanges.
Since wholesaler price improvement is not commensurate their lower
costs (i.e., smaller price impacts due to lower adverse selection
risk), their realized spreads exceed exchange realized spreads.
---------------------------------------------------------------------------
\448\ The analysis in Table 7 shows that 9.6% of executed dollar
volume from orders routed to wholesalers may be effectively rerouted
and potentially subject to competition at the individual order
level.
\449\ Despite receiving more price improvement, the analyses in
supra Table 5, Table 6, and Table 7 show that individual investor
orders sent to wholesalers still had significantly positive realized
spreads, indicating their price improvement does not fully offset
the lower adverse selection costs they pose. Thus, while the higher
price impact of orders executed on exchanges compresses exchange
realized spreads, one might expect (under competitive conditions)
that the lower price impact of orders internalized by wholesalers
would pressure wholesalers to provide sufficiently high price
improvement such that wholesaler realized spreads would face a
similar compression.
---------------------------------------------------------------------------
Further evidence and granularity regarding the difference between
wholesaler and exchange realized spreads are found in Table 8 and Table
9. Table 8 compares the execution quality between orders routed to
wholesalers and exchanges and provides estimates of effective and
realized spreads as well as price impacts and E/Q ratios for NMS common
stocks and ETFs sorted into buckets based on their average dollar
quoted spread. Realized spreads are also adjusted for per-share PFOF
payments made by wholesalers and rebates paid by exchanges in order to
account for the impact of these costs on potential economic profits.
Differences in realized spreads between exchanges and wholesalers
appear to be largest in stocks with quoted spreads less than 1.1 cents
or stocks with quoted spreads greater than 5 cents (the buckets in
which wholesalers earn the largest realized spreads). This appears to
be partially driven by orders routed to wholesalers receiving the least
price improvement (as measured by the E/Q ratio) in stocks with quoted
spreads less than 1.1 cents and orders routed to exchanges receiving
the most price improvement in stocks with quoted spreads greater than 5
cents.\450\
---------------------------------------------------------------------------
\450\ Results also indicate that, after adjusting for exchange
rebates, average exchange realized spreads are positive for stocks
with average quoted spreads less than 1.1 cents, unlike stocks where
average quoted spreads exceed 1.1 cents, which still have negative
average realized spreads after adjusting for exchange rebates. It is
possible that one-cent minimum tick size on exchanges limits
competition in stocks with quoted spreads less than 1.1 cents,
leading to higher realized spreads for these stocks. Furthermore,
PFOF-adjusted realized spreads are negative for stocks with quoted
spreads less than 1.1 cents, unlike the realized spreads for stocks
with wider quoted spreads, indicating that potential marginal
economic profit is larger for these stocks.
Table 8--Estimates of Wholesaler and Exchange Execution Quality for Marketable Orders Under $200,000 by Quoted
Spread Range
----------------------------------------------------------------------------------------------------------------
Quoted spread bucket
Variable -------------------------------------------------------------------------------
<1.1 cents 1.1-2 cents 2-3 cents 3-5 cent 5+ cents
----------------------------------------------------------------------------------------------------------------
WH Effective Spread (bps)....... 2.74 1.09 1.30 2.00 2.74
EX Effective Spread (bps)....... 3.83 1.48 1.84 2.70 4.54
WH E/Q Ratio.................... 0.48 0.41 0.34 0.34 0.35
EX E/Q Ratio.................... 1.05 1.20 1.10 1.04 0.92
WH Price Impact (bps)........... 1.76 0.73 0.93 1.30 1.43
EX Price Impact (bps)........... 6.11 2.26 2.47 3.56 5.73
WH Realized Spread (bps)........ 0.99 0.36 0.37 0.69 1.31
EX Realized Spread (bps)........ -2.28 -0.78 -0.63 -0.85 -1.20
WH Realized Spread Adj PFOF -0.15 0.12 0.17 0.50 1.22
(bps)..........................
EX Realized Spread Adj Rebate 0.18 -0.21 -0.16 -0.38 -0.98
(bps)..........................
----------------------------------------------------------------------------------------------------------------
This table uses the CAT retail analysis data and CAT exchange analysis data to estimate exchange and wholesaler
effective spreads, price impacts, realized spreads, E/Q ratios and wholesaler and exchange realized spreads
after accounting for exchange rebates and PFOF across all NMS stocks and ETFs for marketable orders under
$200,000 based on the stock's average quoted spread. See supra Table 7 for additional details on how the
sample and metrics are calculated. Stocks are grouped into buckets based off of their time weighted average
quoted spread for a week as measured in NYSE TAQ. Share-weighted percentage metrics are averaged together at
the individual stock-week-order size category level for the exchange and wholesaler sample using the
methodology in Table 7. Weighted averages for both wholesaler and exchange metrics are then calculated for
each quoted spread bucket by averaging across stock-week-order size category levels based on their total
dollar transaction volume during the sample period in the wholesaler CAT sample (i.e., for both exchanges and
wholesalers, using the stock's total dollar trading volume in wholesaler executed transactions as the weight
when averaging the share weighted average stock-week-order size category values). Weighting the exchange and
wholesaler execution metrics by the same weights helps to ensure the samples are comparable across stocks.
Table 9 compares execution quality between wholesalers and
exchanges and provides estimates of the effective and realized spreads
as well as price impacts and E/Q ratios for stocks sorted into buckets
based on their security type and then sub-sorted into buckets based on
their price and, for Non-S&P 500 stocks and ETFs, into liquidity
buckets based on their total share trading volume in a week. Once
again, realized spreads are adjusted for (per-share) PFOF payments made
by wholesalers and rebates paid by exchanges in order to account for
their impact on potential economic profits. The results show that
differences in realized spreads are larger in stocks with lower
liquidity. This suggests that the isolation of individual investor
orders due to wholesaler internalizations may result in larger losses
in potential price improvement for individual investors on their orders
in less liquid stocks.
[[Page 195]]
Table 9--Estimates of Execution Quality for Marketable Orders Under $200,000 by Stock Type, Price Group, and Liquidity Bucket
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
WH EX EX realized
effective effective WH E/Q EX E/Q WH realized EX realized WH realized spread adj
Stock type Price group Liquidity bucket spread spread Ratio Ratio spread spread spread Adj rebate
(bps) (bps) (bps) (bps) PFOF (bps) (bps)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
S&P 500..................................... (1) <$30 .............................. 1.18 2.47 0.45 1.01 0.67 -1.39 -0.14 -0.22
S&P 500..................................... (2) $30-$100 .............................. 0.49 1.32 0.30 1.06 0.12 -0.62 -0.08 -0.18
S&P 500..................................... (3) $100+ .............................. 0.67 1.50 0.31 1.00 0.46 -0.15 0.39 -0.03
Non-S&P 500................................. (1) <$30 Low........................... 56.26 53.61 0.72 0.94 28.98 -0.43 27.66 3.52
Non-S&P 500................................. (1) <$30 Medium........................ 31.70 26.91 0.80 0.96 11.70 -8.69 9.91 -3.77
Non-S&P 500................................. (1) <$30 High.......................... 8.84 10.25 0.65 1.02 2.21 -6.61 0.12 -1.85
Non-S&P 500................................. (2) $30-$100 Low........................... 22.91 23.60 0.54 0.92 11.83 0.12 11.71 0.57
Non-S&P 500................................. (2) $30-$100 Medium........................ 7.81 10.03 0.44 0.95 4.31 -1.03 4.19 -0.59
Non-S&P 500................................. (2) $30-$100 High.......................... 2.64 4.89 0.38 0.97 0.76 -2.48 0.58 -1.99
Non-S&P 500................................. (3) $100+ Low........................... 14.86 17.82 0.42 0.88 11.83 2.41 11.81 2.51
Non-S&P 500................................. (3) $100+ Medium........................ 6.79 10.07 0.36 0.90 5.12 0.35 5.08 0.48
Non-S&P 500................................. (3) $100+ High.......................... 2.43 5.33 0.30 0.90 1.47 -0.56 1.41 -0.41
ETF......................................... (1) <$30 Low........................... 14.98 19.86 0.67 0.97 12.76 8.61 12.49 9.68
ETF......................................... (1) <$30 Medium........................ 11.69 15.23 0.62 0.96 9.52 4.89 9.29 5.96
ETF......................................... (1) <$30 High.......................... 2.79 4.31 0.55 1.04 1.36 -1.39 0.62 0.20
ETF......................................... (2) $30-$100 Low........................... 8.06 10.62 0.59 0.94 6.98 4.62 6.88 5.10
ETF......................................... (2) $30-$100 Medium........................ 4.22 6.70 0.42 0.93 3.83 1.81 3.75 2.25
ETF......................................... (2) $30-$100 High.......................... 0.66 1.43 0.40 1.12 0.51 -0.41 0.36 0.05
ETF......................................... (3) $100+ Low........................... 2.54 4.69 0.39 0.92 2.39 1.05 2.36 1.20
ETF......................................... (3) $100+ Medium........................ 1.21 2.34 0.33 0.98 1.17 0.02 1.15 0.16
ETF......................................... (3) $100+ High.......................... 0.20 0.44 0.39 1.27 0.15 -0.10 0.12 -0.02
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
This table uses the CAT retail analysis data and CAT exchange analysis data to estimate exchange and wholesaler effective spreads, realized spreads, E/Q ratios and wholesaler and exchange
realized spreads after accounting for exchange rebates and PFOF across all NMS stocks and ETFs for marketable orders under $200,000 based on the stock's type, VWAP, and traded share volume.
See supra Table 7 for additional details on how the sample and metrics are calculated. Stocks are broken out into buckets based on their security type, price, and liquidity. Stock type is
based on whether a security is an ETF, or a common stock in the S&P 500 or Non-S&P 500. Price buckets are based on a stock's average VWAP price over a week as estimated from TAQ (see supra
Table 7 for additional details). Stocks within each security type-price bucket, except S&P 500 stocks, are sorted into three equal liquidity buckets based on the stock's total share trading
volume during the week estimated using TAQ data. Share-weighted percentage metrics are averaged together at the individual stock-week-order-size category level for the exchange and
wholesaler sample using the methodology in Table 7. Weighted averages for both wholesaler and exchange metrics are then calculated for each security-type-price-liquidity bucket by averaging
across stock-week-order size category levels based on their total dollar transaction volume during the sample period in the wholesaler CAT sample (i.e., for both exchanges and wholesalers,
using the stock's total dollar trading volume in wholesaler executed transactions as the weight when averaging the share weighted average stock-week-order size category values). Weighting
the exchange and wholesaler execution metrics by the same weights helps to ensure the samples are comparable across stocks.
5. Variation in Wholesaler Execution Quality
The previous section provided evidence that wholesalers earn
greater realized spreads relative to exchanges and these differences
are larger in less liquid stocks. In the following section, we present
additional evidence on the variation in execution quality that
wholesalers provide to individual investor orders.
a. Principal vs. Non-Principal Capacity
Table 10 uses CAT retail analysis to summarize how individual
investor marketable NMS stock order execution quality varies based on
whether the wholesaler executes the order in a principal capacity
(i.e., internalizes the order) or effectively reroutes the order (i.e.,
executes in a riskless principal or handles it in an agency capacity).
This analysis supports the interpretation that wholesalers identify and
tend to internally execute individual investor orders associated with
the lower adverse selection costs.\451\ Internalized orders have a
lower price impact (0.91 bps as compared to 4.63 bps for those
effectively rerouted), and lower effective spreads (1.77 compared to
5.36 for other transactions). Wholesalers also earn higher realized
spreads on the orders they execute as principal (0.86 bps for principal
transactions compared to 0.72 bps earned by those providing liquidity
for the riskless principal or agency transactions), despite executing
them at lower effective spreads.
---------------------------------------------------------------------------
\451\ Certain items in Table 10 may also be affected by MDI
Rules once they are implemented. See supra notes 356 and 421.
Table 10--Wholesaler CAT Analysis of Individual Investor Order Execution
Quality by Wholesaler Execution Capacity
------------------------------------------------------------------------
Effectively
Variable Internalized rerouted
------------------------------------------------------------------------
Average Price........................... $33.48 $14.78
WH Orders (million)..................... 236.95 34.36
WH Trades (millions).................... 251.32 74.36
WH Share Volume (billion shares)........ 70.28 16.83
WH Pct of Executed Share Volume......... 80.68% 19.32%
WH Dollar Volume (billion $)............ $2,352.80 $248.64
WH Pct of Executed Dollar Volume........ 90.44% 9.56%
WH Effective Spread (bps)............... 1.77 5.36
WH Realized Spread (bps)................ 0.86 0.72
WH Price Impact (bps)................... 0.91 4.63
WH E/Q Ratio............................ 0.35 0.70
[[Page 196]]
WH Pct Executed with Price Improvement.. 93.37% 57.65%
WH Conditional Amount Price Improvement 2.45 3.74
(bps)..................................
WH Pct Shares Executed at Midpoint or 46.05% 30.65%
Better.................................
WH Pct Shares Executed at Midpoint...... 32.23% 26.53%
WH Pct Shares Executed at NBBO.......... 5.51% 35.49%
WH Pct Shares Executed Outside NBBO..... 1.12% 6.86%
WH Pct Shares Executed with <0.1 cent 20.38% 2.22%
Price Improvement......................
------------------------------------------------------------------------
The table summarizes execution quality statistics from the CAT retail
analysis based on whether the wholesaler executed the individual
investor NMS stock order in a principal capacity or in another
capacity (i.e., in an agency or riskless principal capacity). The
majority of the other transactions are executed by the wholesaler in a
riskless principal capacity. See supra Table 7 for additional details
on the sample and metrics used in the analysis. Share-weighted
percentage metrics are averaged together at the individual execution
capacity-stock-week-order-size category level for the wholesaler
sample using the methodology in Table 7. Weighted averages for the
metrics are then calculated for each execution capacity by averaging
across execution capacity-stock-week-order size category levels based
on their total dollar transaction volume during the sample period in
the wholesaler CAT sample.
Table 11 provides data on the duration of time to execution for
orders routed to wholesalers. While there is substantial variation in
time to execution for both internalized orders and orders routed to
other market centers, internalized order are executed more quickly,
especially for orders with the slowest execution times (i.e., greater
than or equal to the 75th percentile). The median execution time for
rerouted orders was 24 milliseconds (0.024 seconds), about seven times
longer than the median execution time for internalized orders, which
equaled 3.6 milliseconds (i.e., 0.0036 seconds). The execution time for
the slowest 5% of internalized orders was under 1.3 seconds,
substantially faster than the slowest 5% of rerouted orders, which took
around two minutes to execute.
Table 11--Distribution of Share-Weighted Time-to-Execution
[in milliseconds]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Execution capacity 5th Pctl 10th Pctl 25th Pctl 50th Pctl 75th Pctl 90th Pctl 95th Pctl
--------------------------------------------------------------------------------------------------------------------------------------------------------
Internalized............................ 0.47 0.90 1.56 3.56 8.65 80.69 1,269.03
Effectively rerouted.................... 2.00 4.55 10.38 24.36 2,983.30 35,166.76 119,284.18
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table presents the time-to-execution of orders handled by wholesalers that are either internalized or effectively rerouted. Time-to-execution
statistics are share weighed across observations. See supra Table 7 for additional details on the sample.
b. Adverse Selection Risk
While individual investor NMS stock orders are generally viewed as
possessing less adverse selection risk than orders of other investors,
there is nevertheless variation in adverse selection risk across this
order flow.\452\ Table 12 shows the distribution of the average
percentage price impact across 58 retail broker MPIDs in the CAT retail
analysis in NMS Common Stocks and ETFs.\453\ The results indicate there
is substantial variation in price impact across the order flow from
different retail brokers, with the price impact of the 90th percentile
retail broker's orders being approximately 20 times greater than that
of the 10th percentile retail broker's orders and more than 4 times
greater than the median retail brokers orders.
---------------------------------------------------------------------------
\452\ Certain retail brokers tend to have more sophisticated
customers than other retail brokers. Order flow from these retail
brokers carries greater adverse selection risk, while order flow
from retail brokers with generally less sophisticated customers
carries less adverse selection risk. For the purposes of this
release, the Commission discusses retail brokers as carrying
different levels of adverse selection risk, although this is
actually a description of the order flow of the customer base of
these retail brokers, not the actual retail brokers.
\453\ Certain items in Table 12 may also be affected by the
amendments in the MDI Adopting Release once they are implemented.
See supra notes 356 and 421.
Table 12--Distribution of Individual Retail Broker-Dealer Average Percentage Price Impact (bps) in Quality in NMS Common Stocks and ETFs During Q1 2022
--------------------------------------------------------------------------------------------------------------------------------------------------------
N Mean Std Dev Min 10th Pctl 25th Pctl 50th Pctl 75th Pctl 90th Pctl Max
--------------------------------------------------------------------------------------------------------------------------------------------------------
58................................. 1.07 2.35 -12.34 0.16 0.43 0.83 1.39 3.38 7.00
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table summarizes the distribution of the retail broker MPID's average price impact for the 58 retail broker MPIDs in the CAT retail analysis in
NMS Common Stocks and ETFs. Each Retail Broker MPID's price impact is determined by share weighting their average percentage price impact half spread
within an individual NMS common stock or ETF and then averaging across stocks using the weighting of the dollar volume the retail broker MPID executed
in each security (Dollar Volume weighted). See supra Table 7 for additional details on the sample and metrics used in the analysis. NMS Common stocks
and ETFs are identified, respectively, as securities in TAQ with a Security Type Code of `A' and `ETF'.
Analysis suggests that wholesalers tend to provide lower execution
quality to retail brokers that have higher adverse selection costs
(i.e., price impact). Table 13 sorts the 58 retail broker MPIDs in the
CAT retail analysis
[[Page 197]]
in NMS Common Stocks and ETFs into quintiles based on their price
impact.\454\ The results indicate that the orders of retail brokers in
the higher adverse selection quintiles handled by wholesalers receive
worse execution quality, as measured by higher effective spreads and E/
Q ratios, than the orders of retail brokers in the lower adverse
selection quintiles.\455\ More specifically, the E/Q ratio of the
broker-dealers with the highest price impact (quintile 5) is more than
twice as large as the E/Q ratio of the broker-dealers with the lowest
price impact (quintile 1).
---------------------------------------------------------------------------
\454\ Certain items in Table 13 may also be affected MDI Rules
once they are implemented. See supra notes 356 and 421.
\455\ Several recent working papers also found that price
improvement varies across retail brokers; see Christopher Schwarz et
al., The `Actual Retail Price' of Equity Trades (last revised Sept.
15, 2022) (unpublished manuscript), available at https://ssrn.com/abstract=4189239 (retrieved from Elsevier database) (``Schwarz et
al. (2022)''); and Bradford Lynch, Price Improvement and Payment for
Order Flow: Evidence from A Randomized Controlled Trial (last
revised Oct. 3, 2022) (unpublished manuscript), available at https://ssrn.com/abstract=4189658 (retrieved from Elsevier database)
(``Lynch (2022)''). These studies only included trades that were
initiated by the authors, and do not include other trades that were
handled by the brokers in their samples. In contrast, the
Commission's analysis is based on the data reflecting all orders
routed by 58 brokers.
Table 13--Execution quality in NMS Common Stocks and ETFs for Retail Brokers Sorted Into Quintiles Based on
Their Average Percentage Price Impact (bps)
----------------------------------------------------------------------------------------------------------------
Avg WH Avg WH Avg WH
BD Average price impact quintile Avg WH price principal effective realized Avg WH E/Q
impact (bps) execution rate spread (bps) spread (bps) ratio
----------------------------------------------------------------------------------------------------------------
1............................... -1.04 88.62(%) 2.86 3.90 0.43
2............................... 0.48 86.63(%) 1.87 1.39 0.46
3............................... 0.79 88.65(%) 2.15 1.36 0.48
4............................... 1.32 83.86(%) 3.48 2.17 0.61
5............................... 3.85 64.01(%) 7.24 3.39 0.88
----------------------------------------------------------------------------------------------------------------
This table summarizes how execution quality varies in NMS Common Stocks and ETFs based on a retail broker
MPID's price impact by grouping the 58 retail broker MPIDs in the CAT retail analysis in NMS Common Stocks and
ETFs into quintiles based on their average price impact. Each Retail Broker MPID's price impact is determined
by share weighting its average percentage price impact within an individual NMS common stock or ETF and then
averaging across stocks using the weighting of the dollar volume the retail broker executed in each security
(Dollar Volume weighted). Average price impacts, effective spreads, realized spreads, and E/Q ratios are also
calculated for each retail broker MPID by share weighting within an individual NMS common stock or ETF and
then averaging across stocks using the weighting of the dollar volume the retail broker MPID executed in each
security (Dollar Volume weighted). The E/Q ratio is the share weighted average of the ratio of each
transaction's effective spread divided by its quoted spread at the time of order receipt. Retail broker MPIDs
are sorted into quintiles based on their average percentage price impact (bps) and then averages for each
quintile are determined by equally weighting the average statistic for each retail broker MPID. See supra
Table 7 for additional details on the sample and metrics used in the analysis. NMS Common stocks and ETFs are
identified, respectively, as securities in TAQ with a Security Type Code of `A' and `ETF'. This analysis uses
data from prior to the implementation of the MDI Rules and specific numbers may differ following the
implementation of the MDI Rules. See infra section VII.B.7.
c. Disparate Treatment of Broker-Dealers by PFOF
Although wholesalers provide individual investor orders with price
improvement relative to exchanges, the magnitude of this price
improvement is not uniform across retail brokers. The previous section
provided evidence of variation in execution quality based on adverse
selection risk. There is also evidence that execution quality varies
based on whether the retail broker receives PFOF for NMS stock orders.
Commission analysis in this section shows that the PFOF a wholesaler
pays to a retail broker affects the price improvement wholesalers
provide, and wholesalers provide worse execution quality to broker-
dealers whose customers' orders pose a greater adverse selection risk.
\456\
---------------------------------------------------------------------------
\456\ Schwarz et. al. (2022) do not find a relationship between
the amount of PFOF a retail broker receives and the amount of price
improvement their customers' orders receive. However, they noted
that the variation in the magnitude of price improvement they saw
across retail brokers was significantly greater than the amount of
PFOF the retail broker received, which could indicate their sample
was not large enough to observe a statistically significant effect.
Similarly, the difference we observe between the effective spreads
of PFOF and non-PFOF brokers infra Table 14 is significantly smaller
than the differences observed across broker-dealers in supra Table
13. Lynch (2022) reports a broker deriving high PFOF revenues
provides small price improvements to customer orders, while a broker
deriving low PFOF revenue offers large price improvement.
Importantly, both studies only included trades that were initiated
by the authors and do not include other trades that were handled by
the brokers in their samples, preventing them from examining the
attributes of a typical retail order handled by each broker. As
such, these studies would not observe the variation in price
improvements that reflect differences in the adverse selection risk
associated with the order flow of different brokers, and hence,
would likely conflate the impacts of PFOF with that of adverse
selection risk. That is, these studies cannot control for the
possibility that a wholesaler would offer smaller price improvement
to order flows with higher adverse selection risk. In contrast, the
Commission relies on CAT data to examine the adverse selection risk
at the broker level, which is a determinant of the amounts of price
improvements that a given wholesaler would offer to different
brokers. The regression framework in Table 15 controls for the
adverse selection risk of the retail broker and finds that is has a
negative relationship with the magnitude of price improvement their
customers' orders receive. We also find a negative relationship
between the amount of PFOF a broker-dealer receives and the
magnitude of the price improvement their customers' orders receive
after controlling for the retail broker adverse selection risk.
---------------------------------------------------------------------------
Commission analysis presented in Table 14 compares average
execution quality for PFOF and non-PFOF brokers for marketable orders
of individual investors under $200,000 in NMS Common stocks and ETF
orders that are routed to wholesalers.\457\ Results are divided between
orders that were executed on a principal basis (i.e., internalized) and
those executed via other methods (the majority of which are in a
riskless principal capacity).
---------------------------------------------------------------------------
\457\ Some brokers that do not accept PFOF for orders in
equities accept PFOF for orders in options. Certain items in Table
14 may also be affected by MDI Rules once they are implemented. See
supra notes 356 and 421.
[[Page 198]]
Table 14--Comparison of PFOF and Non-PFOF Broker Execution Quality in NMS Common Stocks and ETFs
----------------------------------------------------------------------------------------------------------------
Principal transactions Other transactions
---------------------------------------------------------------
Non-PFOF PFOF Non-PFOF PFOF
----------------------------------------------------------------------------------------------------------------
Average Price................................... $41.79 $31.35 $23.90 $12.47
WH Share Volume (billion shares)................ 14.32 55.96 3.40 13.43
WH Dollar Volume (billion $).................... $598.44 $1,754.36 $81.23 $167.41
Pct of Executed Dollar Volume................... 23.00% 67.44% 3.12% 6.44%
WH Effective Spread (bps)....................... 1.50 1.86 4.57 5.75
WH Realized Spread (bps)........................ 0.88 0.85 0.83 0.66
WH Realized Spread Adj PFOF (bps)............... 0.88 0.43 0.83 -0.55
WH Price Impact (bps)........................... 0.62 1.01 3.74 5.07
WH E/Q Ratio.................................... 0.30 0.37 0.78 0.67
WH Pct Executed with Price Improvement.......... 90.59% 94.32% 46.89% 62.87%
WH Conditional Amount Price Improvement (bps)... 2.75 2.34 2.31 4.30
----------------------------------------------------------------------------------------------------------------
The table summarizes execution quality statistics from the CAT retail analysis in Common Stocks and ETFs based
on whether the retail broker MPID receives PFOF from wholesalers (PFOF) or does not (Non-PFOF) and whether the
wholesaler executed the individual investor order in a principal capacity or in another capacity (i.e., in an
agency or riskless principal capacity). A broker-dealer MPID was determined to be a PFOF broker if the broker-
dealer reported receiving PFOF on its Q1 2022 606 report, or if the report of its clearing broker reported
receiving PFOF in the event that the broker did not publish a Rule 606 report. Broker-dealers or clearing
brokers that handled orders on a not held basis and did not disclose PFOF information in their Rule 606 report
were classified as PFOF brokers if disclosures on their websites indicated they received PFOF. Twenty-two
MPIDs belonging to 19 retail brokers were classified as receiving PFOF. The majority of the other transactions
are executed by the wholesaler in a riskless principal capacity. See supra Table 7 for additional details on
the sample and metrics used in the analysis. Share-weighted percentage metrics are averaged together at the
individual PFOF-execution capacity-stock-week-order-size category level for the wholesaler sample using the
methodology in Table 7. Weighted averages for the metrics are then calculated for each PFOF-execution capacity
category by averaging across execution capacity-stock-week-order size category levels based on their total
dollar transaction volume during the sample period in the wholesaler CAT sample.
The results in Table 14 show that wholesaler internalized orders
(Principal Transactions) originating from PFOF brokers are associated
with (1) higher effective spreads, (2) higher E/Q ratios, and (3)
slightly smaller price improvement on orders that achieved at least
some price improvement (WH Conditional Amount Price Improvement),
relative to wholesaler internalized orders originating from non-PFOF
brokers. However, the results also show that orders internalized from
non-PFOF brokers also have lower adverse selection risk and similar
realized spreads (before PFOF is paid), indicating the lower adverse
selection risk could help explain differences in the observed execution
quality.
Because the results in Table 14 are averages across broker-dealers,
they cannot disentangle the effects of PFOF on execution quality from
differences in the adverse selection risk of different broker-
dealers.\458\ In order to control for these differences, the Commission
analyzed the effects of PFOF and differences in broker-dealer adverse
selection risk on execution quality in a regression framework that
controls for other factors that could affect the price improvement
provided by wholesalers.
---------------------------------------------------------------------------
\458\ They also cannot disentangle the effects of differences in
the stocks traded by PFOF and non-PFOF brokers.
---------------------------------------------------------------------------
Table 15 displays regression results from Commission CAT retail
analysis of NMS Common stock and ETF orders.\459\ The regression tests
whether there is a statistically significant relationship between
execution quality and the amount of PFOF a broker-dealer receives and
includes several individual stock- and market-level controls \460\ as
well as the retail broker's average price impact and size (as measured
by percent of executed individual investor dollar volume). Four
different measures of execution quality are used for the dependent
variable, including E/Q ratio, effective spread, realized spread, and
price improvement.\461\ The results in Table 15 show that the Table 14
results indicating brokers that receive PFOF receive inferior execution
quality are robust to the inclusion of controls for differences in the
type of order flow coming from different broker-dealers.
---------------------------------------------------------------------------
\459\ Certain items in this Table 15 may also be affected by the
amendments in the MDI Rules once they are implemented. See supra
notes 356 and 421.
\460\ Broker-dealer cents per 100 shares PFOF rates (dollar PFOF
rates) are determined from their Q1 2022 Rule 606 reports (see supra
Table 2) or the Rule 606 reports of its clearing broker reported
receiving PFOF in the event that the broker did not publish a Rule
606 report. A PFOF rate of 20 cents per 100 shares was used for the
introducing broker-dealers and clearing broker that reported handled
orders on a not held basis and did not disclose PFOF information in
their Rule 606 report but disclosed on their website that they
received PFOF for their order flow. 20 cents per 100 shares was the
PFOF rate that the clearing broker that handles orders on a not held
basis disclosed on their website that they received. Twenty-two
MPIDs belonging to 19 retail brokers were classified as receiving
PFOF. Dollar PFOF rates for each retail broker were merged with the
corresponding stock (S&P 500 and non-S&P 500) and order type in the
CAT sample. For the regressions in Table 15, percentage PFOF rates
are estimated in basis points by dividing the PFOF cents per 100
share values from Rule 606 reports (after converting them to dollar
per share values) by the stock-week VWAP for the security in the CAT
sample. Stock-level controls include average share volume, VWAP,
return, average effective spread, average realized spread, and
average quote volatility during a week. Market-level controls
include market volatility, market return, and the market's average
daily trading volume during week.
\461\ The regression also includes variables to control for
differences in execution quality across different wholesalers and
across different order size categories. The analysis examines trades
in Q1 2022 that wholesalers execute in a principal capacity from
market and marketable limit orders from individual investors that
are under $200,000 in value and are in NMS Common stocks and ETFs.
See supra Table 7 for further discussion on the sample. The unit of
observation for the regression is the average execution quality
provided to trades that are aggregated together based on having the
same stock, week, order type, order size category, wholesaler, and
retail broker MPID. The coefficients are estimated by weighting each
observation by the total dollar volume of trades executed in that
observation.
[[Page 199]]
Table 15--Regression Analysis Showing Relationship Between Execution Quality and PFOF in NMS Common Stocks and
ETFs
----------------------------------------------------------------------------------------------------------------
(2) Effective (3) Realized spread (4) Amount price
Variables (1) E/Q ratio spread (bps) (bps) improvement (bps)
----------------------------------------------------------------------------------------------------------------
PFOF Rate.................... 0.0132***.......... 0.217***........... 0.211***........... -0.170***.
[2.82]............. [6.31]............. [7.13]............. [-5.52]
Stock Share Volume........... 0.0379............. -0.0462............ -0.886*............ -0.533**.
[0.51]............. [-0.14]............ [-1.65]............ [-2.53].
Stock VWAP................... -0.000028.......... 0.000233........... -0.000450.......... 0.000014.
[-1.06]............ [0.61]............. [-0.78]............ [0.04].
Stock Return................. -0.000273.......... -0.0200*........... -0.0120............ 0.00840.
[-0.21]............ [-1.93]............ [-0.36]............ [0.84].
VIX.......................... 0.00968***......... 0.0122*............ 0.0607***.......... -0.000256.
[7.29]............. [1.79]............. [2.85]............. [-0.05].
Market Return................ -0.00710**......... 0.00787............ 0.00686............ -0.0150.
[-2.02]............ [0.36]............. [0.15]............. [-0.96].
Market Dollar Volume......... 0.0306***.......... 0.0641***.......... 0.164***........... -0.0390***.
[9.70]............. [3.44]............. [3.07]............. [-2.69].
Stock Avg Effective spread... 0.00700***......... 0.122***........... -0.0455*........... 0.00746.
[3.34]............. [6.07]............. [-1.94]............ [0.52].
Stock Avg Realized spread.... -0.00169*.......... -0.00902........... 0.0730***.......... -0.00552.
[-1.87]............ [-1.45]............ [2.98]............. [-1.48].
Stock Quote Volatility....... 0.457**............ 2.232.............. -1.799............. 4.458**.
[2.09]............. [1.05]............. [-0.65]............ [2.03].
Broker-Dealer Average Price 0.145***........... 0.414***........... 0.316***........... -0.417***.
Impact. [14.74]............ [9.83]............. [8.50]............. [-10.21].
Broker-Dealer Pct Volume..... -2.45e-05.......... -0.00207*.......... -0.00546***........ 0.000124.
[-0.07]............ [-1.76]............ [-3.77]............ [0.12].
Average Trade Qspread........ -0.00720***........ 0.517***........... 0.378***........... 0.392***.
[-10.12]........... [19.78]............ [10.84]............ [21.14].
Wholesaler Fixed Effects..... Yes................ Yes................ Yes................ Yes.
Order Size Category Fixed Yes................ Yes................ Yes................ Yes.
Effects.
Stock Fixed Effects.......... Yes................ Yes................ Yes................ Yes.
Observations................. 13,365,122......... 13,365,122......... 13,365,122......... 12,453,440.
Adjusted R-squared........... 0.279.............. 0.574.............. 0.060.............. 0.594.
----------------------------------------------------------------------------------------------------------------
This table presents the results of a regression analysis examining the effect of retail brokers receiving PFOF
from wholesalers on levels of price improvement and the execution quality of their customers' orders when the
wholesaler internalizes the order on a principal basis.
The analysis examines trades in Q1 2022 that wholesalers execute in a principal capacity from market and
marketable limit orders from individual investors that are under $200,000 in value and are in NMS Common
stocks and ETFs. See supra Table 7 for further discussion on the CAT retail sample. The unit of observation
for the regression is the average execution quality provided to trades that are aggregated together based on
having the same stock, week, order type, order size category, wholesaler, and retail broker MPID. Weighted
regression are performed based on the total dollar value executed by the wholesaler in that observation (i.e.,
total shares executed for all orders that fit within that stock-week-retail broker-wholesaler-order type-order
size category). This means that the regression coefficients capture the effect on execution quality on a per-
dollar basis.
Dependent variables include: the average E/Q ratio of the shares traded; the average percentage effective
spread of the shares traded measured in basis points; the average percentage realized spread of the shares
traded measured in basis points; and the average percentage value of the amount of price improvement measured
in basis points, conditional on the order being price improved. These variables are from the CAT retail
analysis and described in supra Table 7.
Explanatory variables include: PFOF Rate is the retail brokers' PFOF rates in bps (the per share rates were
determined from retail broker Rule 606 reports and divided by the VWAP of the executed shares in the sample to
determine the PFOF rate on a percentage basis, see supra note 460); Broker-Dealer Pct Volume is the retail
broker size (in terms of percentage total executed dollar trading volume in the sample); Stock Share Volume is
the stock's total traded share volume during the week (from TAQ in billions of shares); Stock VWAP is the VWAP
of stock trades during the week (from TAQ); Stock Return is the stock's return during the week (from CRSP 1925
US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022)); VIX is the average value of the
VIX index during the week (from CBOE VIX data); Market Return is the average CRSP value weighted market return
during the week, Market Dollar Volume is the total market dollar trading volume during the week (from CRSP
1925 US Stock Database, Ctr. Rsch. Sec. Prices, U. Chi. Booth Sch. Bus. (2022)); Stock Avg Effective spread is
the stock's share weighted average percent effective half spread during the week measured in basis points
(from TAQ); Stock Avg Realized spread is the stock's share weighted average percent realized half spread
during the week measured in basis points (from TAQ); Stock Quote Volatility is the stock's average 1 second
quote midpoint volatility measured in basis points (from TAQ); Broker-Dealer Average Price Impact is the
retail broker's average price impact over the sample measured in basis points (see supra Table 12 for more
details on how the metric is calculated); Average Trade Qspread is the average percentage quoted half spread
at the time of order submission for orders in that stock-week-retail broker-wholesaler-order type-order size
category measured in basis points; wholesaler fixed effects (i.e., indicator variables for each wholesaler
that control for time-invariant execution quality differences related to each wholesaler); order-size category
fixed effects (i.e., indicator variables for each order-size category that control for time-invariant
execution quality differences related to order-size category); and individual stock fixed effects (i.e.,
indicator variables for each stock that control for time-invariant execution quality differences related to
individual stocks). The order size categories include less than 100 shares, 100-499 shares, 500-1,999 shares,
2,000-4,999, 5,000-9,999 shares, and 10,000+ shares. Brackets include t-statistics for the coefficients based
on robust standard errors that are clustered at the stock level. ***, **, and * indicate the t-statistics for
the coefficients are statistically significant at the 0.01, 0.05, and 0.1 levels, respectively.
This analysis uses data from prior to the implementation of the MDI Rules and specific numbers may be different
following the implementation of the MDI Rules. See supra note 356 and section VII.B.7.
[[Page 200]]
Regression results in Table 15 support the conclusion that
wholesalers provide worse execution quality to brokers that receive
more PFOF.\462\ The coefficients on the PFOF Rate variable indicates
that, all else equal, for the orders wholesalers internalize, execution
quality declines as the amount of PFOF paid to the retail broker
increases. Orders from retail brokers that receive a greater amount of
PFOF have higher E/Q ratios and effective spreads and receive less
price improvement. The regression results (as measured by the
coefficient on the PFOF Rate variable) indicate that, all else equal,
wholesalers earn higher realized spreads on orders for which they pay
more PFOF. Note that PFOF is not taken out of the realized spread
measure, so the realized spread proxies for wholesaler's economic
profits before any fees are taken out.
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\462\ While results from the regression analysis indicate that
orders routed by PFOF-brokers receive reduced execution quality from
wholesalers, there could be ways that PFOF is indirectly passed on
to customers by their retail brokers. However, the Commission lacks
evidence on the extent to which this is occurring.
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Regression results in Table 15 also show that the retail broker's
adverse selection risk (as measured by the coefficient on the Broker-
Dealer Average Price Impact variable) has a statistically significant
effect on the execution quality wholesalers give on trades they
internalize. The positive coefficient indicates that wholesalers
provide worse execution quality to broker-dealers whose customers'
orders pose a greater adverse selection risk.
In sum, Commission analysis indicates that wholesalers deliver
execution quality that varies across broker-dealers based on their
adverse selection risk. Wholesalers also deliver execution quality that
varies based on characteristics of the order (lot size, principal
capacity vs. riskless principal or agency capacity, market vs.
marketable limit, S&P 500 vs. non-S&P 500). The business model of
wholesalers relies on their ability to parse the adverse selection risk
of individual investors' orders based on these numerous characteristics
and to deliver some price improvement while still generating the
potential for high profits for themselves in the form of a high
realized spread. The lack of additional price improvement that could
otherwise be provided to individual investors stems from the isolation
of marketable orders by wholesalers, which results in a lack of order-
by-order competition.
6. Retail Broker Services
Wholesalers do not charge retail brokers for the routing and
execution that they provide, and pay a segment of these brokers PFOF
for the right to handle their order flow. Proposed Rule 615 could
therefore impact retail brokers as well as wholesalers, due to their
interdependence. In order to analyze the economic effects of the
Proposal on retail brokers, we first provide relevant detail of the
retail broker industry.
There are approximately 2,440 retail brokers in the U.S., earning
quarterly revenues of approximately $86.7 billion and handling 228.9
million customer accounts.\463\ Retail brokers provide a range of
services that assist their customers in the purchase of securities,
which include stocks, bonds, mutual funds, ETFs, options, futures,
foreign exchange, and crypto asset securities. Proposed Rule 615,
however, would cover only NMS stocks, and many customer accounts
include assets that include or exclusively contain securities that are
not NMS stocks. The Commission does not know what share of these
accounts contain exclusively NMS stocks, but estimates that
approximately 1,000 retail brokers originated NMS stock orders from
individual investors in 2021.\464\
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\463\ Data are from Q2 2022, FOCUS Part II Schedule SSOI.
\464\ This number is estimated using CAT data for broker-dealers
that originated an order from an ``Individual Customer'' CAT account
type in 2021. This larger sample is refined down to a sample of 54
broker-dealers fort the CAT data analysis presented above, beginning
in supra Table 7. See supra note 441 for a description of how the
sample of 54 brokers was chosen.
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Retail broker services are sometimes divided into two generally
defined categories: ``discount brokers'' and ``full-service'' brokers.
Discount brokers typically provide commission-free trading for online
purchases of stocks and ETFs, but often charge fees for purchases of
other securities. Some discount brokers manage proprietary mutual funds
and ETFs, which earn them revenue (based on the funds' ``expense
ratio'') paid by the investors that purchase these funds. Full-service
brokers (as they are commonly called and as used in this release)
typically charge commissions and advisory fees, frequently as a share
of the client's total assets under management, in exchange for more
detailed financial guidance.
Retail brokers distinguish themselves by the range of securities
that they sell, as well accessibility and functionality of their
trading platform, which can be geared towards less experienced or more
sophisticated investors. Discount brokers can also differentiate
themselves by providing more extensive customer service as well as
tools for research and education on financial markets.
a. PFOF Revenue
Most marketable orders of individual investors are routed by retail
brokers to wholesalers. Wholesalers do not directly charge retail
brokers for their order routing and execution and pay PFOF to some of
these retail brokers in exchange for this order flow. Wholesalers paid
$235 million in PFOF in NMS stocks in Q1 2022.\465\
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\465\ In NMS stocks in Q1 2022, wholesalers paid $94 million in
PFOF for market orders, $53 million for marketable limit orders, $69
million for non-marketable limit orders, and $19 million for other
order types.
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Table 16 below indicates that a single firm received more than 43%
of all PFOF stemming from NMS stock orders during Q1 2022. Furthermore,
the number one and number four firms on this list merged in 2020,
implying that a single firm received slightly more than 55% of all PFOF
stemming from NMS stock orders. Along with this firm, the other three
firms at the top of this list collectively received almost 94% of all
PFOF from NMS stocks.
Table 16--Top Broker-Dealer Recipients of PFOF From NMS Stocks and Total Revenue
----------------------------------------------------------------------------------------------------------------
Total firm PFOF share of Share of total
PFOF received revenue (Q1 2022- revenue PFOF disbursed
(Q1 2022-) ) (percent) (percent)
----------------------------------------------------------------------------------------------------------------
BD1.......................................... $101,509,456 $1,766,885,957 5.7 43.12
BD2.......................................... 35,019,397 403,037,037 8.7 14.88
BD3.......................................... 32,611,006 435,731,084 7.5 13.85
BD4.......................................... 28,919,376 1,876,198,891 1.5 12.28
BD5.......................................... 22,816,637 94,176,227 24.2 9.69
BD6.......................................... 7,810,943 50,207,346 15.6 3.32
[[Page 201]]
BD7.......................................... 4,123,125 64,850,454 6.4 1.75
BD8.......................................... 835,652 10,855,447 7.7 0.35
BD9.......................................... 696,482 9,406,401 7.4 0.30
BD10......................................... 590,124 12,341,917 4.8 0.25
BD11......................................... 268,754 499,731 53.8 0.11
BD12......................................... 145,943 38,249,831 0.4 0.06
BD13......................................... 68,552 19,462,153 0.4 0.03
BD14......................................... 4,122 4,977,874 0.1 0.002
----------------------------------------------------------------------------------------------------------------
This table includes data from Rule 606 reports and lists all PFOF payments stemming from NMS stock orders paid
by wholesalers to broker-dealers. The Commission analyzed Rule 606 reports for the most active 50 broker-
dealers, and the summary payments to the fourteen firms in the table above represent all PFOF payments made by
wholesalers for NMS stock orders during Q1 2022. The table also contains the total revenue earned by these
firms during the same period. The PFOF share of revenue is calculated by dividing PFOF by revenue for each
broker-dealer.
Table 16 also reveals that dependence on PFOF as a source of
revenue is not equally shared among these firms. The average PFOF share
of revenue of these firms is 9.6%. However, setting aside the
disproportionately high PFOF revenue share of 53.8% from the smallest
firm (by revenue) on this list, the average share of revenue stemming
from PFOF falls to 6.5%. This is almost identical to the median PFOF
revenue share of 6.4%.
Besides receiving different overall disbursements of PFOF revenue,
broker-dealers receive different PFOF rates. Table 17 below displays
the distribution of PFOF rates (in cents per 100 shares) paid by
wholesalers to retail brokers.
Table 17--Distribution Across PFOF Brokers of Average Rule 606 Payment Rates From Wholesalers for Q1 2022
[Cents per 100 shares]
----------------------------------------------------------------------------------------------------------------
Non-
Distribution Market orders Marketable marketable Other orders
statistic limit orders limit orders
----------------------------------------------------------------------------------------------------------------
S&P 500......................... Average 40.3 37.8 49.7 43.1
Min 7.0 6.5 6.1 4.8
25th Pct 14.4 14.4 15.0 11.5
Median 15.0 16.0 28.6 16.6
75th Pct 22.0 22.4 32.4 22.2
Max 280.7 247.6 338.0 310.8
Non S&P 500..................... Average 14.7 11.9 18.5 11.6
Min 6.2 3.3 4.6 2.1
25th Pct 11.1 9.4 13.2 8.2
Median 13.7 10.9 18.2 9.9
75th Pct 18.8 14.4 25.1 17.0
Max 22.7 20.9 28.9 18.6
Combined........................ Average 16.2 12.7 20.1 13.2
Min 6.3 3.4 4.6 2.5
25th Pct 11.3 9.9 13.6 8.3
Median 13.8 12.1 21.9 10.4
75th Pct 21.5 15.7 28.3 19.1
Max 36.4 21.0 31.0 27.2
----------------------------------------------------------------------------------------------------------------
This table displays the distribution across retail brokers (that received PFOF from wholesalers) of average PFOF
payment rates from wholesalers for Q1 2022 (cents per 100 shares). The data were obtained by analyzing rule
606 Reports from the 14 BDs that accepted PFOF from wholesalers. The table shows the distribution of PFOF
rates broken down by S&P 500 and non-S&P 500 stocks, across market orders, marketable limit orders, non-
marketable limit orders, and other orders that retail brokers route to different types of venues in Q1 2022.
See supra Table 2 for additional details on the sample.
PFOF rates vary along several dimensions. For marketable orders,
including market and marketable limit orders, the combined median rate
in Table 17 is 12-14 mils, significantly less than the median rate for
the non-marketable orders median rate of 22 mils. In addition,
variation is wider in non-marketable limit orders, with a wider range
between the 25th and 75th percentile compared to market and marketable
limit orders. It is also evident that the maximum values in S&P 500
stocks, all of which are above 200 mils, are far greater than non-S&P
500 stocks, all of which are below 35 mils, and those higher maximum
values may be driven by the fact that two particular firms that get
PFOF rates proportional to the bid-ask spread.
b. Other Revenues
Retail brokers have numerous sources of revenue, including
commissions, account management and advisory fees, interest income, as
well as PFOF. Retail brokers that currently receive PFOF tend to earn a
somewhat larger share of their revenue from interest on margin loans
provided to clients. Lending rates tend to be highest for margin
amounts under $25,000, and fall successively as
[[Page 202]]
the size of the loan increases, with the lowest rates on loans
exceeding $1 million. PFOF brokers earned 12% of their income from
margin interest in 2021, compared to only 1.6% of revenue earned by
non-PFOF brokers during the same period.\466\ Another source of revenue
is securities borrowing, making up 5.1% of revenues for PFOF brokers
and 0.9% of non-PFOF brokers revenue during 2021. In contrast, other
revenue lines are relatively underutilized by PFOF brokers, such as
account supervision fees, which made up 1.3% of revenue for PFOF-
brokers but 26.5% of non-PFOF brokers.
---------------------------------------------------------------------------
\466\ Statistics on broker-dealer revenues are from their FINRA
Supplemental Statement of Income Form for 2021. The sample in this
discussion is limited to 54 retail brokers that were identified in
the CAT analysis in Table 7. 19 of these 54 broker-dealers were
identified as a PFOF broker if they reported receiving PFOF on their
Q1 2022 606 report, or if the report of their clearing broker
reported receiving PFOF in the event that the broker did not publish
a Rule 606 report. Broker-dealers or clearing brokers that handled
orders on a not held basis and did not disclose PFOF information in
their Rule 606 report were classified as PFOF brokers if disclosures
on their websites indicated they received PFOF. The remaining 35
firms comprise the sample of non-PFOF brokers. We use the broad
definition of sales as we preliminarily believe that many firms will
just mark ``sales'' if they have both retail and institutional
activity. However, we note that this may capture some broker-dealers
that do not have retail activity, although we are unable to estimate
that frequency.
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7. Rules Addressing Consolidated Market Data
In 2020, the Commission adopted a new rule and amended existing
rules to establish a new infrastructure for consolidated market
data,\467\ and the regulatory baseline in this proposal includes these
changes to the current arrangements for consolidated market data.
However, as discussed in more detail above, the MDI Rules have not been
implemented, and so they have not yet affected market practice.\468\ As
a result, the data used to measure the baseline below reflects the
regulatory structure in place for consolidated market data prior to the
implementation of the MDI Rules.\469\ Accordingly, this section will
discuss the Commission's assessment of the potential effects that the
implementation of the MDI Rules could have on the baseline estimations.
---------------------------------------------------------------------------
\467\ The MDI Rules expanded the data that will be made
available for dissemination within the national market system (``NMS
data''). See 17 CFR 242.600(b)(59); MDI Adopting Release, 86 FR at
18613.
\468\ For more information about the implementation timeline for
the MDI Rules, see supra section III.B.1.b.i.
\469\ For more information about the regulatory structure for
consolidated market data prior to the implementation of the MDI
Rules, see supra section III.B.1.a.
---------------------------------------------------------------------------
Among other things, the unimplemented MDI Rules update and expand
the content of consolidated market data to include: (1) certain odd-lot
information \470\; (2) information about certain orders that are
outside of an exchange's best bid and best offer (i.e., certain depth
of book data) \471\; and (3) information about orders that are
participating in opening, closing, and other auctions.\472\ The rules
also introduced a four-tiered definition of round lot that is tied to a
stock's average closing price during the previous month.\473\ For
stocks with prices greater than $250, a round lot is defined as
consisting of between 1 and 40 shares, depending on the tier.\474\ The
rules also introduce a decentralized consolidation model under which
competing consolidators, rather than the existing exclusive SIPs, will
collect, consolidate, and disseminate certain NMS information.\475\
---------------------------------------------------------------------------
\470\ See 17 CFR 242.600(b)(59); MDI Adopting Release, 86 FR at
18613. The Commission outlined a phased transition plan for the
implementation of the MDI Rules, including the implementation of
odd-lot order information. See MDI Adopting Release, 86 FR at 18698-
701.
\471\ See MDI Adopting Release, 86 FR at 18625.
\472\ See MDI Adopting Release, 86 FR at 18630.
\473\ See MDI Adopting Release, 86 FR at 18617.
\474\ See id. The Commission adopted a four-tiered definition of
round lot: 100 shares for stocks priced $250.00 or less per share,
40 shares for stocks priced $250.01 to $1,000.00 per share, 10
shares for stocks priced $1,000.01 to $10,000.00 per share, and 1
share for stocks priced $10,000.01 or more per share.
\475\ See MDI Adopting Release, 86 FR at 18637.
---------------------------------------------------------------------------
Given that the MDI Rules have not yet been implemented, they likely
have not affected market practice and therefore data that would be
required for a comprehensive quantitative analysis of a baseline that
includes the effects of the MDI Rules is not available. It is possible
that the baseline (and therefore the economic effects relative to the
baseline) could be different once the MDI Rules are implemented. The
following discussion reflects the Commission's assessment of the
anticipated economic effects of the MDI Rules as described in the MDI
Adopting Release.\476\
---------------------------------------------------------------------------
\476\ See MDI Adopting Release, 86 FR at 18741-18799.
---------------------------------------------------------------------------
The Commission anticipated that, for stocks priced above $250, the
new round lot definition will mechanically narrow NBBO spreads for most
stocks with prices greater than $250.\477\ This could cause statistics
that are measured against the NBBO to change because they will be
measured against the new, narrower NBBO. For example, execution quality
statistics on price improvement for higher priced stocks may show a
reduction in the number of shares of marketable orders that received
price improvement because price improvement will be measured against a
narrower NBBO. In addition, the Commission anticipated that the NBBO
midpoint in stocks priced higher than $250 could be different under the
MDI Rules than it otherwise would be, resulting in changes in the
estimates for statistics calculated using the NBBO midpoint, such as
effective spreads. In particular, at times when bid odd-lot quotations
exist within the current NBBO but no odd-lot offer quotations exist
(and vice versa), the midpoint of the NBBO resulting from the rule will
be higher than the current NBBO midpoint.\478\ More broadly, the
Commission anticipated that the adopted rules will have these effects
whenever the new round lot bids do not exactly balance the new round
lot offers. However the Commission stated that it does not know to what
extent or direction such odd-lot imbalances in higher priced stocks
currently exist, so it is uncertain of the extent or direction of the
change.\479\
---------------------------------------------------------------------------
\477\ An analysis in the MDI Adopting Release showed that the
new round lot definition caused a quote to be displayed that
improved on the current round lot quote 26.6% of the time for stocks
with prices between $250.01 and $1,000, and 47.7% of the time for
stocks with prices between $1,000.01 and $10,000. See MDI Adopting
Release, 86 FR at 18743.
\478\ For example, if the NBB is $260 and the national best
offer is $260.10, the NBBO midpoint is $260.05. Under the adopted
rules a 40 share buy quotation at $260.02 will increase the NBBO
midpoint to $260.06. Using this new midpoint, effective spread
calculations will be lower for buy orders but higher for sell
orders.
\479\ See MDI Adopting Release, 86 FR at 18750.
---------------------------------------------------------------------------
The Commission also anticipated that the MDI Rules could result in
a smaller number of shares at the NBBO for most stocks in higher-priced
round lot tiers.\480\ To the extent that this occurs, there could be an
increase in the frequency with which marketable orders must ``walk the
book'' (i.e., consume available depth beyond the best quotes) to
execute. This would affect statistics that are calculated using
consolidated depth information, such as measures meant to capture
information about whether orders received an execution of more than the
displayed size at the quote, i.e., ``size improvement.''
---------------------------------------------------------------------------
\480\ However, this effect will depend on how market
participants adjust their order submissions. See MDI Adopting
Release, 86 FR at 18746, for further discussion.
---------------------------------------------------------------------------
The MDI Rules may also result in a higher number of odd-lot trades,
as the inclusion of odd-lot quotes that may be priced better than the
current NBBO in consolidated market data may attract more trading
interest from market participants that previously did not
[[Page 203]]
have access to this information.\481\ However, the magnitude of this
effect depends on the extent market participants who rely solely on SIP
data and lack information on odd-lot quotes choose to receive the odd-
lot information and would have traded frequently against odd-lot quotes
had they known about them. The Commission states in the MDI Adopting
Release that it believes it is not possible to observe this willingness
to trade with existing market data.\482\
---------------------------------------------------------------------------
\481\ See MDI Adopting Release, 86 FR at 18754.
\482\ See id.
---------------------------------------------------------------------------
The MDI Rules may have implications for broker-dealers' order
routing practices. For those market participants that rely solely on
SIP data for their routing decisions and that choose to receive the
expanded set of consolidated market data, the Commission anticipated
that the additional information contained in consolidated market data
will allow them to make more informed order routing decisions. This in
turn would help facilitate best execution, which would reduce
transaction costs and increase execution quality.\483\
---------------------------------------------------------------------------
\483\ See MDI Adopting Release, 86 FR at 18725.
---------------------------------------------------------------------------
The MDI Rules may also result in differences in the baseline
competitive standing among different trading venues, for several
reasons. First, for stocks with prices greater than $250, the
Commission anticipated that the new definition of round lots may affect
order flows as market participants who rely on consolidated data will
be aware of quotes at better prices that are currently in odd-lot
sizes, and these may not be on the same trading venues as the one that
has the best 100 share quote.\484\ Similarly, it anticipated that
adding information on odd-lot quotes priced at or better than the NBBO
to expanded core data may cause changes to order flow as market
participants take advantage of newly visible quotes.\485\ However, the
Commission stated that it was uncertain about the magnitude of both of
these effects.\486\ To the extent that it occurs, a change in the flow
of orders across trading venues may result in differences in the
competitive baseline in the market for trading services.
---------------------------------------------------------------------------
\484\ See MDI Adopting Release, 86 FR at 18744.
\485\ See MDI Adopting Release, 86 FR at 18754.
\486\ See MDI Adopting Release, 86 FR at 18745, 18754.
---------------------------------------------------------------------------
Second, exchanges and ATSs have a number of order types that are
based on the national best bid and offer, and so the Commission
anticipated that the changes in the NBBO caused by the new round lot
definitions may affect how these order types perform and could also
affect other orders with which they interact.\487\ The Commission
stated that these interactions may affect relative order execution
quality among different trading platforms, which may in turn affect the
competitive standing among different trading venues, with trading
venues that experience an improvement/decline in execution quality
attracting/losing order flow.\488\ However, the Commission stated that
it was uncertain of the magnitude of these effects.\489\
---------------------------------------------------------------------------
\487\ See MDI Adopting Release, 86 FR at 18748.
\488\ See id.
\489\ See id.
---------------------------------------------------------------------------
Third, the Commission anticipated that, as the NBBO narrows for
securities in the smaller round lot tiers, it may become more difficult
for the retail execution business of wholesalers to provide price
improvement and other execution quality metrics at levels similar to
those provided under a 100 share round lot definition.\490\ To the
extent that wholesalers are held to the same price improvement
standards by retail brokers in a narrower spread environment, the
wholesalers' profits from execution of individual investor orders might
decline,\491\ and to make up for lower revenue per order filled in a
narrower spread environment, wholesalers may respond by changing how
they conduct their business in a way that may affect retail brokers.
However, the Commission stated that is was uncertain as to how
wholesalers may respond to the change in the round lot definition, and,
in turn, how retail brokers may respond to those changes, and so was
uncertain as to the extent of these effects.\492\ To the extent that
this occurs, this may impact wholesalers' competitive standing in terms
of the execution quality offered particularly to individual investor
orders. Where implementation of the above-described MDI Rules may
affect certain numbers in the baseline, the description of the baseline
below notes those effects.
---------------------------------------------------------------------------
\490\ See MDI Adopting Release, 86 FR at 18747.
\491\ Individual investor orders typically feature lower adverse
selection than other types of orders, such as institutional orders.
See supra section II.D.2 and supra section VII.B.2 for discussion of
why it is generally more profitable for liquidity providers to
execute against orders with lower adverse selection risk.
\492\ See MDI Adopting Release, 86 FR at 18748.
---------------------------------------------------------------------------
C. Economic Effects
The Commission preliminarily believes that the introduction of
qualified auctions for NMS stocks would increase competition to supply
liquidity to marketable orders of individual investors. This might
enhance order execution quality for individual and institutional
investors as well as improve price discovery. The magnitude of the
improvements in order execution quality that individual and
institutional investors may experience as a result of this Proposal
might be less than indicated for a variety of reasons (though it may
also be greater), including the implementation of MDI Rules, the effect
of which is not yet in the data. Under the MDI Rules, the availability
of faster consolidated market data with more data on odd-lot
information, auctions information, and depth of book information from
competing consolidators could result in improved execution quality for
customer orders were their broker-dealers who currently utilize SIP
data switch to using the expanded consolidated market data.\493\
Nevertheless, the Commission preliminarily believes that the Proposal
would lead to improvements in individual and institutional investor
order execution quality, as well as improvements in price discovery,
relative to a baseline in which MDI Rules are implemented.
---------------------------------------------------------------------------
\493\ See supra note 421 for further details on how the MDI
Rules adopted in the MDI Adopting Release could affect the NBBO. It
is unclear how benefits in execution quality will change because of
uncertainty regarding how the price improvement wholesalers provide
to individual investors will change as well as uncertainty regarding
how the NBBO midpoint will change for stocks with prices above $250
once the MDI Rules are implemented.
---------------------------------------------------------------------------
The Commission acknowledges considerable uncertainty in the costs
and benefits of this rule because the Commission cannot predict how
different market participants would adjust their practices in response
to this rule. The Proposal would likely cause wholesalers and some
retail brokers to incur significant adjustment costs to their
operations. It is unknown whether the current industry practice of
routing nearly all retail order flow to wholesalers would persist were
the Commission to adopt this rule, because wholesalers might charge for
this service and retail brokers might find it more profitable to
develop their own routing services. On the other hand, wholesalers may
still find the practice of routing to be profitable were there to
remain an information advantage, and due to the proposed exception to
be able to execute a segmented order at a price equal to or better than
NBBO midpoint without exposing it in a qualified auction.
Among the possible effects are a decline in profitability for
wholesalers. Some retail brokers could also experience costs from
wholesalers reducing the amount of PFOF they pay
[[Page 204]]
to retail brokers or from reducing or charging for the order handling
services they offer to retail brokers. Some of these costs could
ultimately be passed on to individual investors, such as through the
resumption of commissions for NMS stock trades being charged by some
retail brokers.\494\ Market participants would also incur compliance
costs, such as exchanges and NMS Stock ATSs incurring costs for
creating qualified auctions, as well as broker-dealer and trading
center compliance costs related to establishing policies and procedures
for identifying and handling segmented orders and originating brokers
that submit segmented orders. NMS plans and their participants
(including the exchanges and FINRA) would incur compliance costs in
order to update the consolidated market data feeds and to broadcast
qualified auction messages. FINRA would incur compliance costs to
update the ADF and to broadcast qualified auction messages.
---------------------------------------------------------------------------
\494\ See infra section VII.C.2.b.ii for a discussion of the
possibility of the return of commission fees.
---------------------------------------------------------------------------
As discussed above, this section measures the economic effects of
the proposed amendments relative to a regulatory baseline that includes
the implementation of the MDI Rules.\495\ Furthermore, this section
reflects the Commission's assessment of the anticipated economic
effects of the proposed amendments, including potentially
countervailing or confounding economic effects from the MDI Rules.\496\
However, given that the MDI Rules have not yet been implemented, they
likely have not affected market practice and therefore data that would
be required for a comprehensive quantitative analysis of the economic
effects that includes the effects of the MDI Rules are not available.
It is possible that the economic effects relative to the baseline could
be different once the MDI Rules are implemented. Where implementation
of the above-described MDI Rules may affect certain numbers, the
description of the economic effects below notes those effects.
---------------------------------------------------------------------------
\495\ See supra section VII.B.7.
\496\ See supra section VII.B.7 for a discussion of the
Commission's anticipated economic effects of the MDI Rules as stated
in the MDI Adopting Release.
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1. Benefits
a. Increased Competition To Supply Liquidity to Marketable Orders of
Individual Investors
The Commission believes that the Proposal would increase
competition among market participants to provide liquidity to
marketable orders of individual investors.\497\ The majority of
individual investors' marketable orders are currently internalized by
wholesalers without competition at the order-by-order level.\498\ The
Commission believes that, by introducing an auction mechanism that
allows market participants to bid for individual investor orders that
would otherwise be internalized by wholesalers, Proposed Rule 615 and
the proposed amendments to Rule 600 would facilitate competition to
provide liquidity to individual investors by drawing additional
liquidity from market participants other than the wholesalers that
handle the majority of individual investor orders.\499\ Marketable
orders internalized by wholesalers feature lower price impacts, i.e.,
have lower adverse selection risk.\500\ Thus, the lower adverse
selection risk of the order flow that would be routed to qualified
auctions would incentivize market participants to trade against this
flow via auction participation, as market participants would find
providing liquidity against this order flow more attractive relative to
the LOB or to individual investor orders with greater adverse selection
that may currently be routed to exchanges.
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\497\ The Proposal would also increase competition among market
participants to supply liquidity to beyond-the-midpoint non-
marketable limit orders of individual investors because these orders
could not be executed at restricted competition trading centers at
prices beyond the midpoint unless they met one of the other
exceptions to Proposed Rule 615. However, as shown below in Table
20, the majority of beyond-the-midpoint non-marketable limit orders
are not internalized. Additionally, Table 20 also shows that the
executed volume of beyond-the-midpoint non-marketable limit orders
submitted by individual investors and routed to wholesalers is
significantly smaller than the volume of marketable limit orders.
Therefore, an increase in competition to supply liquidity to these
orders may be more limited than for the marketable orders of
individual investors. The Commission does not believe that the
Proposal would have a significant effect on the competition to
execute the fractional share portions of individual investor orders
that may qualify for the exception in Proposed Rule 615(b)(5).
\498\ See supra note 454.
\499\ Although the Proposal is predicted to improve execution
quality for individual investors, it is likely that profits for some
market participants would be reduced, including some wholesalers and
some retail brokers. See infra sections VII.C.2.c and VII.C.2.d for
a discussion of these potential costs. Potential costs to other
market participants are discussed elsewhere in infra section
VII.C.2.
\500\ See supra section VII.B.2.b.
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The Commission is mindful of the limitations faced by investors who
lack access to algorithmic trading technologies, e.g., individual
investors and professional traders relying on displayed screens, to
determine when to provide liquidity in qualified auctions. The proposed
100-millisecond minimum auction length would be too short for such
investors to be able to participate in these auctions unless they have
to access algorithmic trading technology.\501\ Additionally, the
Proposal would prohibit exchange RLPs (unless they operated via one of
the exceptions to qualified auctions), which would further constrain
the ability of these market participants to compete to supply liquidity
to segmented orders by limiting their ability to quote at sub-penny
increments.\502\ However, the Commission believes that market
participants with access to algorithmic trading technology, including
SORs used for trading institutional orders, would be able to
participate in qualified auctions and thereby enhance the competition
to provide liquidity to individual investors.
---------------------------------------------------------------------------
\501\ The possibility of adverse price movement (``adverse
fade'' probability) during an auction is discussed in infra section
VII.C.2.b.
\502\ Consequently, these market participants could only compete
to provide liquidity to segmented orders via exchange LOBs or ATSs.
However, quoting on exchanges and ATSs can only take place at 1-cent
price increments and the quoted midpoint. Therefore, if these
participants wanted to provide a more competitive price relative to
qualified auctions, they would be required to quote at the next
better full-penny price or at the midpoint (for a tick-constrained
stock). In contrast, participants of qualified auctions would be
able to compete by providing liquidity at prices that are only 0.1
cents better than the existing auction price. As such, under
qualified auctions, competition to provide liquidity to segmented
order flow at better prices would be incrementally more costly for
investors who lack access to smart order routers, placing these
participants at a disadvantage relative to participants with access
to smart order routers.
---------------------------------------------------------------------------
Competition to supply liquidity through qualified auctions would
further be enhanced by the proposed implementation of a 5 mil (i.e.,
$0.0005) per share auction fee and rebate cap for executed auction
responses and a 5 mil per share rebate cap for segmented orders priced
at $1.00 per share or greater.\503\
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\503\ Qualified auction fee and rebate caps would be limited to
0.05% of the auction response price per share for executed auction
responses and segmented orders priced at less than $1.00 per share
in Proposed Rule 615(c)(4). Additionally, the Proposal would require
that qualified auction fees and rebates be the same for all of its
auction participants, i.e., volume-based tiering, which tends to
advantage large liquidity suppliers who transact in sufficient
volumes to trigger lower fees and/or higher rebates, would not apply
to qualified auction fees and rebates. Under the proposed rule, no
fee could be charged for submission or execution of a segmented
order, or for submission of an auction response. See supra section
IV.C.4.
---------------------------------------------------------------------------
First, the Commission believes that the proposed auction fee and
rebate caps would help ensure that exchanges and ATSs have sufficient
incentives to operate qualified auctions. Using information from the
financial statements of the three major exchange
[[Page 205]]
groups which collectively account for the overwhelming majority of
trading volume on exchanges, the Commission estimates that the average
total net capture \504\ for exchanges is currently around 4 mils for
all trading types.\505\ However, the Commission understands based on
Staff conversations with industry members that the net capture for the
executions of orders during continuous trading hours (but not open or
close auctions) priced at $1.00 per share or greater is likely close to
2 mils. The Commission expects that in response to the 5 mil auction
fee and rebate cap for executed auction responses priced at $1.00 per
share or greater, open competition trading could charge fees of around
5 mils to executed auction responses and provide rebates of
approximately 3 mils to broker-dealer submitting the segmented order to
the qualified auction, and thus maintain a net capture of approximately
2 mils for these transactions. For the executions of orders priced
below $1.00 per share on exchange LOBs, the Commission estimates that
exchanges have an average net capture of around 0.28% of the
transaction value; \506\ thus, for these orders under $1.00, the net
capture may be lower than what they earn on exchange LOB transactions.
However, qualified auction hosts may be able to compensate for this
decline, e.g., by reducing rebates for segmented orders priced at $1.00
per share or greater to 1 mil or otherwise cross-subsidizing segmented
orders priced below $1.00 per share with access fees charged on their
LOB, with the overall goal to at least maintain their overall total net
capture of around 2 mils for trading on their exchange.\507\
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\504\ Net capture refers to the difference between average fees
levied and rebates paid.
\505\ Intercontinental Exchange, the parent firm of NYSE,
reports on page 51 of its 2021 10k filing that its net capture for
U.S. equity transactions was approximately 4.2 mils in 2021. Nasdaq
did not report its net capture in their 10K filing, however Nasdaq
provides information on their investor relations web page which,
when we average the relevant 2021 volumes, indicates that the
average net capture across all Nasdaq platforms for U.S. equity
transactions was 5.9 mils (see Nasdaq 2022/2021 Monthly Volumes,
available at https://ir.nasdaq.com/static-files/465d2157-c476-4546-a9f7-8d7ad0c9be77). Cboe reports in their 2021 Form 10-K filing that
their net capture for U.S. equity transactions was approximately 2
mils.
\506\ The estimate for the 0.28% net capture, which is the
difference between fees received and rebates paid out by the
exchange, is obtained by an analysis of current fee and rebate
schedules based on Rule 19b-4 filings with the Commission for each
of the equity exchanges operating in the United States as of June 1,
2022, as well as a review of the transaction prices that each
exchange posts. This amount is because, for transactions under $1.00
per share, most exchanges set their baseline fee at 0.30% but do not
offer baseline rebates, and some charge fees to both sides of the
transaction leading to more than 0.30% per trade earned by the
exchange.
\507\ The assumption that the exchanges earn an average 2 mil
spread on trading behavior is discussed above in this section. The
Commission believes that it is reasonable to assume that the
exchanges would fund qualified auction rebates through access fees,
either from qualified auctions or the continuous order book. The
Commission believes that it is reasonable to assume that the
exchanges overall would try to continue to earn approximately 2 mils
per transaction under the Proposal, but the Commission acknowledges
that there is some uncertainty regarding this assumption and seeks
public comment.
---------------------------------------------------------------------------
Second, the proposed 5 mil auction fee and rebate cap for executed
auction responses priced at $1.00 per share or greater would likely
result in qualified auction fees and rebates that would be unlikely to
have a significant impact on the price improvement auction bidders
would be able to offer because the 5 mil fee and rebate cap is smaller
than the minimum pricing increment in qualified auctions. Since larger
fees limit the ability of liquidity suppliers to offer better prices,
setting a lower auction fee cap could result in improved execution
quality for the segmented order. Furthermore, the auction rebate cap of
5 mils for segmented orders is likely to limit the competitive bidding
advantage of the broker-dealer submitting the segmented order to the
qualified auction. The maximum rebate of 5 mils is smaller than the
minimum pricing increment in the auction, which limits the ability of
the broker-dealer submitting the segmented order to use the rebate to
subsidize the price improvement they offer in their qualified auction
bids.
Third, the Commission believes that the caps on qualified auction
fees and rebates would incentivize open competition trading centers to
compete more on the basis of execution quality, rather than fees and
rebates, in order to attract segmented orders. The 5 mil rebate cap for
segmented orders priced at $1.00 per share or greater would result in
rebates that are significantly lower than the rebates that are
currently offered by most exchanges in these stocks. Academic
literature has shown that the presence of high liquidity fees and
rebates on some market centers may impact broker-dealer routing
decisions based on where they can receive the highest rebate (or pay
the lowest fee), rather than where they can receive better execution
quality on behalf of their customers.\508\ In contrast, with the 5 mil
rebate cap, the effect of rebates on qualified auction participants for
stocks with prices greater than $1.00 may be sufficiently small as to
have a minimal impact on overall market structure or behavior.\509\
This would limit the degree to which open competition trading centers
could use rebates to attract segmented orders to their qualified
auctions and help incentivize them to compete more on the basis of the
execution quality of their auctions.
---------------------------------------------------------------------------
\508\ See, e.g., Robert H. Battalio, Shane A. Corwin & Robert
Jennings, Can Brokers Have It All? On the Relation Between Make-Take
Fees and Limit Order Execution Quality, 71 J. Fin. 2193 (2016).
\509\ All but two exchanges do not offer a rebate for
transactions priced below $1.00 per share. Thus, for these
transactions, the proposed auction fee and rebate cap for executed
auction responses would likely not result in lower rebates.
---------------------------------------------------------------------------
In addition, the Commission believes that proposed minimum price
increments under Proposed Rule 615(c)(3) \510\ would further enhance
competition to supply liquidity to marketable individual investor
orders through qualified auctions, as smaller price increments are
likely to encourage greater amounts of price improvement. However,
lowering the price increment beyond that proposed may increase the
possibility of market participants seeking to gain execution priority
by pricing their auction responses in economically small increments.
Thus, the size of the proposed price increment that has been chosen for
qualified auctions is intended to increase price improvement while
still reducing the likelihood of participants using economically
insignificant price increments.
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\510\ Under proposed Rule 615(c)(3), segmented orders and
auction responses must be priced in an increment of no less than
$0.001 (or 0.1 cent) if their prices are $1.00 or more per share, in
an increment of no less than $0.0001 (or 0.01 cent) if their prices
are less than $1.00 per share, or at the midpoint of the NBBO. See
supra section IV.C.3.
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b. Improvements to Segmented Order Execution Quality
The Proposal likely would reduce transaction costs for individual
investors due to improved competition to supply liquidity to individual
investor orders.\511\ By making marketable order flow from individual
investors that is currently internalized by wholesalers and executed at
prices less favorable than midpoint accessible to other market
participants in qualified auctions, the Proposal would allow additional
market participants an opportunity to compete to directly trade with
these individual investor orders.\512\ The Commission estimates that
the potential benefit to individual investors from this increased
competition, the
[[Page 206]]
competitive shortfall rate, would range between an average of 0.86 bps
to 1.31 bps for marketable orders that met the definition of a
segmented order.\513\ Based on Commission estimates that between 7.3%
to 10.1% of total executed dollar volume would be segmented orders that
would be eligible to be included in qualified auctions, the Commission
preliminarily estimates that this could potentially result in a total
average annual savings in individual investor transaction costs, i.e.,
a total competitive shortfall, ranging between $1.12 billion to $2.35
billion dollars.\514\ The Commission acknowledges that there is
considerable uncertainty in these estimates.\515\ Additionally, these
estimates account only for potential changes in individual order
transaction costs and assumes that the PFOF wholesalers currently pay
to retail brokers would be converted into additional price improvement
for the individual investor order. Furthermore, the estimates do not
account for the potential return of commission fees charged by retail
brokers.\516\ As discussed in further detail below,\517\ the
Commissioner does not believe that retail brokers will respond to the
loss of PFOF revenue by resuming commission fees, but even in the event
that total PFOF revenue disappears ($940 million, based on Q1 2022
data) \518\ and PFOF brokers charge commission fees to fully replace
this revenue, this cost increase to traders would still be less than
the estimated $1.12 billion to $2.35 billion annual gain in price
improvement estimated by the Commission.
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\511\ See supra section VII.C.1.a for discussion of improvements
in competition to supply liquidity to segmented orders in qualified
auctions.
\512\ See infra section VII.C.1.c for discussions of how the
Proposal could also enhance the order execution quality of other
market participants that would be able to compete to supply
liquidity to individual investor orders, including institutional
investors.
\513\ As discussed in supra section VII.B.7, the Commission
believes that the implementation of qualified auctions would lead to
improvements in execution quality relative to a baseline in which
the MDI Rules are implemented, i.e., over and above any improvements
in execution quality that may result from the implementation of the
MDI Rules. Once implemented, the changes to the current arrangements
for consolidated market data in the MDI Adopting Release may impact
the magnitude of the benefit from the proposal for individual
investors, but the effects are uncertain. Trading costs are measured
against the NBBO midpoint and, as discussed in supra note 421, there
is uncertainty regarding how the NBBO midpoint will change for
stocks priced above $250 when the MDI Rules are implemented. It is
also uncertain how or to what degree changes in trading costs would
differ between trades executed at exchanges and wholesalers. Since
the benefit is measured based on the differences in exchange and
wholesaler realized spreads, if both realized spread measures
changed similarly, then there would not be changes in relative
differences between their reported spread measures and the estimated
benefit would not change.
\514\ See infra Table 19. The Commission preliminarily believes
that, in order for a wholesaler to effectively compete against other
bidders in qualified auctions, the wholesaler would have to reduce
the PFOF it is paying to the retail broker in order to bid more
aggressively to potentially win the qualified auction. This would
result in the reduction in PFOF instead going to the customer as
additional price improvement, which would be reflected in the
competitive shortfall calculation. The competitive shortfall
estimates do not include costs that may arise in the form of
potential increases in (or the return of) commissions retail brokers
charge to individual investors or other reductions in the services
that retail brokers currently offer, both of which may occur if the
Proposal reduces the PFOF paid to retail brokers or results in
wholesalers charging retail brokers for their order handling
services. See infra section VII.C.2.b for a discussion of costs to
individual investors and infra section VII.C.2.d for a discussion of
costs to retail brokers.
\515\ The Commission is uncertain about these estimates because
the Commission does not know with certainty how different market
participants would adjust their practices in response to this rule.
There is also uncertainty in these estimates because of limitations
in using the realized spreads to measure the trading profits earned
by liquidity suppliers. See supra note 426 for additional
discussions on the limitations of realized spreads.
\516\ Most retail brokers have continued to charge commission
fees for (human) broker-assisted orders, including those that
dropped online trade commission fees.
\517\ See infra section VII.C.2.b.ii.
\518\ However, all PFOF revenue might not disappear because
wholesalers may continue to pay PFOF for non-marketable limit
orders, which may not be affected by the Proposal and may be based
on exchange rebates that wholesalers pass through to retail brokers
(see supra note 395). The annualized PFOF revenue from non-
marketable limit orders is estimated to be approximately $275
million, based on Q1 2022 data. See supra note 465 for additional
information on PFOF revenue in Q1 2022.
---------------------------------------------------------------------------
As shown by analyses in Table 6, Table 7 and Table 8, the realized
spreads earned from supplying liquidity to individual investor
marketable orders routed to wholesalers are greater than realized
spreads for comparable marketable order transactions (e.g., similar
stocks and order sizes) on exchanges, indicating that the additional
price improvement that these individual investor orders receive does
not fully offset the lower adverse selection risk associated with these
orders.\519\ The Commission estimates the competitive shortfall rate,
i.e., the potential additional price improvement (and reduction in
transaction costs) that the marketable orders of individual investors
would receive from having their order being exposed to greater
competition among liquidity suppliers in qualified auctions, as the
difference in the realized spreads between marketable orders executed
on exchanges and individual investor marketable orders that were
executed after being routed to wholesalers,\520\ after adjusting for
exchange rebates that are currently paid to liquidity suppliers on
exchanges, as well as for fees (5 mils) that would potentially be
charged to liquidity suppliers in qualified auctions.\521\
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\519\ See supra sections VII.B.4 and VII.B.5 for discussions of
the differences in realized spreads between individual investor
marketable orders routed to wholesalers compared to marketable
orders routed to exchanges.
\520\ This included marketable orders that the wholesalers
internalized and also marketable orders that were routed to
wholesalers and then executed on a riskless principal or rerouted to
another venue and executed on an agency basis. The Commission does
not adjust wholesaler realized spreads for the PFOF they pay to
retail brokers because PFOF, while a cost to wholesalers, is not a
cost to investors. See supra note 514 for further discussions on the
assumed effects of PFOF for purposes of this analysis.
\521\ The realized spreads after adjusting for potential
exchange rebates to liquidity suppliers are estimated and discussed
in supra section VII.B.4. In estimating the competitive shortfall
rate we also deduct a 5 mil fee from the exchange adjusted realized
spreads to account for the potential fees charged to liquidity
suppliers in qualified auctions. The Commission acknowledges that
realized spreads are a proxy for the trading profits earned by
liquidity suppliers. See supra note 426 for further discussion on
the limitations of realized spreads.
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To illustrate the logic behind this calculation, it is useful to go
through the following thought experiment. Pick a stock, a day, and a
range of order size that is executed by wholesalers. Based on Rule 605
data or CAT data, one can calculate the transaction costs that retail
investors incur for this stock, on this day, and for this range of
order size. The question is: what would be the transaction costs for
those orders if they were sent to competitive auctions? Although such
auctions as those being proposed here do not exist, the marginal profit
required to incentivize provision of liquidity on exchanges' order
books can serve as a proxy. This marginal profit to liquidity provision
can be estimated as the on-exchange realized spread (for a given stock,
on a given day, and within a given range of order size) plus the
estimated rebate that exchanges pay the liquidity providers. The
estimated transaction cost for the auction equals the estimated
marginal profit of liquidity providers on exchange order books plus the
maximum 5 mil fee (a lower fee would result in a higher competitive
shortfall). The competitive shortfall is the difference between the
current transaction cost of retail investors off-exchange wholesalers
and the estimated transaction cost in the auction. Equivalently, one
can view this as the difference in marginal profits to liquidity
provision on and off-exchange (where spreads are adjusted by the
auction fee rather than by PFOF).
Competitive shortfall rates are calculated using three different
estimates of exchange rebates. The first Rebate Base method is
calculated based on Commission estimates of average exchange rebates
paid to liquidity suppliers on maker-taker exchanges (i.e., exchanges
that pay a rebate to orders supplying liquidity and charge a
[[Page 207]]
fee for orders demanding liquidity) and fees charged to liquidity
suppliers on inverted exchanges (i.e., exchanges that charge a fee for
orders supplying liquidity and pay a rebate for orders demanding
liquidity) and flat fee exchanges (i.e., exchange that don't pay
rebates, but may charge fees for orders both demanding and supplying
liquidity).\522\ The other two methods, which are calculated to see how
the competitive shortfall rates vary based on differences in estimates
of exchange fees and rebates, are calculated by varying the exchange
fees and rebates estimated in the Rebate Base method by 25%. The Rebate
High method estimates higher rebates and lower fees for supplying
liquidity and assumes exchange rebates on maker-taker venues are 25%
greater than in the Rebate Base method and exchange fees on inverted
and flat fee exchanges are 25% lower than in the Rebate Base
method.\523\ The Rebate Low method estimates lower rebates and higher
fees for supplying liquidity and assumes exchange rebates on maker-
taker venues are 25% lower than in the Rebate Base method and exchange
fees on inverted and flat fee exchanges are 25% higher than in the
Rebate Base method.\524\
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\522\ The estimated exchange rebates for orders supplying
liquidity used to calculate the competitive shortfall exchange base
method are the same as those used to calculate the Realized Spread
Rebate differential in supra Table 6. See supra note 435 for a
discussion of how these estimates of exchange rebates were
determined. A 5 mil fee is then further deducted to account for the
potential fee charged to liquidity suppliers in qualified auctions.
\523\ The Rebate High method is calculated assuming that
exchange rebates to liquidity suppliers on maker-taker exchanges are
34 mils; that exchange fees for supplying liquidity on inverted
exchanges are 11 mils; and that exchange fees for supplying
liquidity on flat fee exchanges are 5 mils. A 5 mil fee is then
further deducted to account for the potential fee charged to
liquidity suppliers in qualified auctions.
\524\ The Rebate Low method assumes that rebates on maker-taker
exchanges are 25% lower and fees on inverted and flat fee exchanges
are 25% higher. For our adjustments we assume: exchange rebates to
liquidity suppliers on maker-taker exchanges are 20 mils; exchange
fees for supplying liquidity on inverted exchanges are 19 mils;
exchange fees for supplying liquidity on flat fee exchanges are 9
mils. A 5 mil fee is then further deducted to account for the
potential fee charged to liquidity suppliers in qualified auctions.
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The estimates of the overall average competitive shortfall rates
and the competitive shortfall rates for different types of NMS stocks
are presented below in Table 18.\525\ This analysis incorporates the
contrasting levels of adverse selection risk (price impact) and price
improvement provided to orders internalized by wholesalers and executed
on exchanges. Ultimately, the increased price improvement of
wholesalers does not match the lower price impact of individual
investor orders, causing wholesaler realized spreads to exceed exchange
realized spreads, and competitive shortfall rates to be positive. In
order to ensure robustness of the results and to account for potential
limitations of the coverage of Rule 605 reports,\526\ the analysis
estimates competitive shortfall rates using data from Rule 605 reports,
as well as data from CAT. All CAT and Rule 605 estimates of the
competitive shortfall rates are positive in all three methods, which
indicates that the realized spreads earned by wholesalers on the
marketable orders of individual investors tend to be higher than
realized spreads earned by liquidity suppliers on exchanges after
adjusting for exchange rebates. However, the average competitive
shortfall rates calculated using data from Rule 605 reports tend to be
lower than those estimated from CAT data. Rule 605 estimated
competitive shortfall rates using the Rebate Base, Low, and High
methods are 0.58 bps, 0.77 bps, and 0.38 bps, respectively, while CAT
estimated competitive shortfall rates using the Rebate Base, Low, and
High methods are 1.08 bps, 0.86 bps, and 1.31 bps, respectively. The
differences appear to be mainly driven by differences between the
exchange realized spreads calculated using Rule 605 and CAT data.
Exchange realized spreads calculated using CAT data tend to be lower
than those calculated using Rule 605 data, with CAT data estimating an
average exchange realized spread of -1.22 bps for all stocks and Rule
605 data estimating an average exchange realized spread of -0.67 bps.
This difference could be driven by the CAT data having broader coverage
of marketable orders than Rule 605 data.\527\ The analysis in Table 7
supports this by showing that sample from CAT data contains over $16
trillion in trading volume from marketable orders routed to exchanges
in Q1 2022, while Table 6 shows that the sample from Rule 605 data is
smaller, containing over $9 trillion in trading volume from marketable
orders routed to exchanges.\528\ Given the broader coverage of the CAT
exchange data, the Commission believes that the estimates derived from
sample from the CAT data provide a more complete estimate of the
realized spreads for marketable orders executed on exchanges than the
sample from the Rule 605 data. Therefore, the Commission believes that
the range of the estimated competitive shortfall rate from the CAT
data, 0.86 bps to 1.31 bps may be a more representative measurement of
the realized spread difference between individual investor marketable
orders executed by wholesaler and marketable orders executed on
exchanges.\529\
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\525\ Competitive shortfalls are calculated using the same
methodology for calculating realized spreads that is described in
Table 6 and Table 7, but the amount for exchange rebates adjustments
may be different depending on the rebate method used. Additionally,
the competitive shortfall deducts a 5 mil fee from the exchange
adjusted realized spreads to account for the potential fees charged
to liquidity suppliers in qualified auctions, which is not included
in the realized spread differential calculations.
\526\ See supra section VII.B.4 discussing limitations of Rule
605 coverage.
\527\ The different time horizons used for the calculation of
the realized spreads could also contribute to the observed
difference in realized spreads between the samples, with the CAT
sample calculating realized spreads at the one minute horizon and
Rule 605 data calculating spreads at the 5 minute horizon. However,
Conrad and Wahal (2020) examined realized spreads at different
horizons and found that realized spreads measured at the 5 minute
horizon tended to be lower than realized spreads measured at the 1
minute horizon, which indicates that the different time horizons may
not be a significant driver of the difference in realized spreads
between the two samples.
\528\ Note that the samples in Table 6 and Table 7 are filtered
to be limited to orders under $200,000 in value. However, the
trading volume for the CAT sample is still larger than the exchange
trading volume for the unfiltered sample from Rule 605 data shown in
Table 5.
\529\ The Commission acknowledges that there is uncertainty in
these estimates. See supra note 515 for additional discussions.
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The estimates in Table 18 indicate that the competitive shortfall
rate appears to be higher in non-S&P 500 stocks than in S&P 500 stocks
and ETFs, with non-S&P 500 competitive shortfall rates of 3.07 bps
under the Rebate Base method computed using CAT data, compared to the
competitive shortfall rates of 0.44 bps and 0.34 bps for S&P 500 stocks
and ETFs respectively. These results are consistent with the results
shown in Table 8, which indicate that the differences in realized
spreads between individual investor marketable orders executed at
wholesalers and marketable orders executed at exchanges are larger in
less liquid stocks.\530\ Additionally, the estimates in Table 18
indicate that exchanges' rebates tend to have a larger effect on the
competitive shortfall rate for non-S&P 500 stocks, with these types of
stocks showing the greatest variation in the competitive shortfall
rates estimated by the Rebate Low and Rebate High methods.
---------------------------------------------------------------------------
\530\ See supra section VII.B.4 for a discussion of the analysis
in Table 8.
[[Page 208]]
Table 18--Competitive Shortfall Rates Estimates
--------------------------------------------------------------------------------------------------------------------------------------------------------
Data source Stock type All S&P 500 Non-S&P 500 ETF
--------------------------------------------------------------------------------------------------------------------------------------------------------
Rule 605....................................... WH Realized Spread (bps)............... 0.72 0.30 1.55 0.64
Rule 605....................................... EX Realized Spread (bps)............... -0.67 -0.30 -1.97 -0.12
Rule 605....................................... EX Realized Spread Adj Rebate Base -0.001 -0.05 -0.24 0.28
(bps).
Rule 605....................................... EX Realized Spread Adj Rebate High 0.19 0.02 0.25 0.41
(bps).
Rule 605....................................... EX Realized Spread Adj Rebate Low (bps) -0.20 -0.12 -0.73 0.15
CAT............................................ WH Realized Spread (bps)............... 0.85 0.42 2.00 0.51
CAT............................................ EX Realized Spread (bps)............... -1.22 -0.28 -3.90 -0.34
CAT............................................ EX Realized Spread Adj Rebate Base -0.40 -0.06 -1.54 0.08
(bps).
CAT............................................ EX Realized Spread Adj Rebate High -0.18 0.00 -0.90 0.20
(bps).
CAT............................................ EX Realized Spread Adj Rebate Low (bps) -0.63 -0.12 -2.19 -0.05
Rule 605....................................... Competitive Shortfall Rebate Base (bps) 0.58 0.30 1.42 0.26
Rule 605....................................... Competitive Shortfall Rebate High (bps) 0.38 0.23 0.93 0.13
Rule 605....................................... Competitive Shortfall Rebate Low (bps). 0.77 0.37 1.91 0.38
CAT............................................ Competitive Shortfall Rebate Base (bps) 1.08 0.44 3.07 0.34
CAT............................................ Competitive Shortfall Rebate High (bps) 0.86 0.38 2.42 0.22
CAT............................................ Competitive Shortfall Rebate Low (bps). 1.31 0.50 3.71 0.46
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table shows estimates of competitive shortfall rates, wholesaler realized spreads, and exchange realized spreads after adjusting for exchange
rebates. Competitive shortfall is estimated by subtracting realized spreads on marketable orders routed to exchanges after adjusting for exchange
rebates and fees for liquidity suppliers in qualified auctions from realized spreads on marketable orders routed to wholesalers. Estimates are
calculated using three different competitive shortfall estimation methods to account for exchange rebates: (1) Competitive Shortfall Rebate Base
(``Base'') method (see supra note 522); (2) Competitive Shortfall Rebate High (``High'') method (see supra note 523); and (3) Competitive Shortfall
Rebate Low (``Low'') method (see supra note 524).
The competitive shortfall estimates are calculated separately for samples from Rule 605 data and CAT data and are derived from the execution quality
stats for marketable orders under $200,000 described in detail in Table 6 (Rule 605 data) and Table 7 (CAT data). For the sample from Rule 605 data,
the difference in dollar realized spread measures between exchanges and wholesalers are estimated by subtracting the average rebate adjusted exchange
realized spread (using estimated exchange rebate rates from one of the competitive shortfall rebate method estimates) and also deducted a 5 mil fee
(to account for the potential fee charged to liquidity suppliers in qualified auctions) from the adjusted wholesaler average realized spread at the
stock-month-order size category level for the combined market and marketable limit order types with average order size category dollar values less
than $200,000 (average order dollar values were determined for each order-size category stock-month by dividing the total number of covered shares in
the order size category by the total number of covered orders and then multiplying by the stock-month's average VWAP), calculated from Rule 605
reports. The share weighted averages of the wholesaler and exchange realized spread differences are then determined at the individual stock-month
level by share-weighting across different order-size categories based on the number of shares executed (at the market center + away) in wholesalers'
Rule 605 reports in that order-size category. Percentage realized spread differences are then calculated by dividing the dollar realized spread
differentials by the stock-months VWAP as estimated by TAQ. The weighted average of the individual stock-month percentage realized spread
differentials are averaged together based on weighting by the total wholesaler dollar trading volume in that stock-month for the combined marketable
order type (wholesaler dollar trading volume is estimated by multiplying the Rule 605 report wholesaler total executed share volume, i.e., the share
volume executed at market center + share volume executed away from the market center, for the stock-month-order type by the stock's monthly VWAP). A
similar methodology was used to calculate the CAT competitive shortfall measures, but the share weighted volume estimates were calculated up to the
individual stock-week-order-size level and then these values were aggregated together based on a weighted average using the total wholesaler dollar
trade volume executed in that category. The realized spread measures reported are the average wholesaler and exchange adjusted rebates (adjusting for
the exchange rebates reported under this method but not including the 5 mil fee deduction for the qualified auction fees) used to compute the
competitive shortfall rates.
Table 18 estimates the average annual total competitive shortfall
(i.e., the average total annual estimated dollar value of improvements
in individual investor transaction costs) by multiplying the
competitive shortfall rate by an estimate of the total annual dollar
volume of segmented orders that could potentially participate in
qualified auctions. Because the Commission is uncertain about the
volume of orders that would participate in qualified auctions, the
analysis uses three different scenarios to estimate the dollar volume
of individual investor orders that may participate in qualified
auctions.\531\ Under the Base segmented order volume scenario, the
Commission analysis assumes that all individual investor orders under
$200,000 would be exposed in qualified auctions, which is estimated to
constitute 7.8% of total executed dollar volume.\532\ Under the Low
segmented order volume scenario, the Commission analysis assumes that
only individual investor marketable orders under $200,000 would be
exposed in qualified auctions, which is estimated to constitute 7.3% of
total executed dollar volume.\533\ Because some broker-dealers may
submit segmented orders over $200,000 to qualified auctions if it would
result in the order receiving better price improvement,\534\ under the
High segmented order volume scenario, the Commission analysis assumes
that 50% of individual investor orders over $200,000 would also be
exposed in qualified auctions, which is estimated to constitute 10.1%
of total executed dollar volume.\535\ These scenarios include orders
executed by wholesalers at prices at or better than NBBO midpoint,
though should these orders continue to receive this execution via the
exception to the rule then they would not be sent to qualified
auctions. This is appropriate given that these orders are also included
in the analysis examining the execution quality of individual investor
marketable orders routed to
[[Page 209]]
wholesalers.\536\ Therefore, removing these orders from the analysis
would serve to increase the realized spread for wholesalers and thus
increase the competitive shortfall for the remaining percentage of
total executed dollar volume.
---------------------------------------------------------------------------
\531\ The percentage multipliers used in these volume estimates
were estimated from an analysis of CAT data in Jan. 2022. The
analysis found that wholesalers trading in an off-exchange principal
capacity against orders originating from an FDID Individual customer
account type accounted for 12.36% of the total consolidated dollar
volume reported by the SIP during the month. Of these individual
orders, 36.78% of the executed dollar volume originated from orders
with dollar values of $200,000 or greater. Of the remaining orders,
5.90% of the executed dollar volume belonged to orders that were not
market or marketable limit orders.
\532\ The Base Scenario estimate of 7.80% as the percentage of
total dollar volume that could potentially be segmented orders that
could be exposed in qualified auctions is estimated by multiplying
the 12.36% of total executed dollar volume belonging to individual
accounts and executed by wholesalers in a principal capacity by the
63.22% (1-36.78%) of this executed dollar volume from orders that
were less than $200,000.
\533\ The Low Scenario estimate of 7.34% as the percentage of
total dollar volume that could potentially be segmented orders that
could be exposed in qualified auctions is estimated by multiplying
the 12.36% of total executed dollar volume belonging to individual
accounts and executed by wholesalers in a principal capacity by the
63.22% (1-36.78%) of this executed dollar volume from orders that
were less than $200,000. This was then multiplied by 94.1% (1-5.9%)
to account for the assumption that only market and marketable limit
orders would be submitted to qualified auctions.
\534\ Proposed Rule 615 would create an exception in which
segmented orders with a dollar value of $200,000 or greater may be
executed at a restricted competition trading center without being
exposed in a qualified auction. However, the exception still allows
these orders to be submitted to qualified auctions.
\535\ The High Scenario estimate of 10.08% as the percentage of
total dollar volume that could potentially be segmented orders that
could be exposed in qualified auctions is estimated by multiplying
the 12.36% of total executed dollar volume belonging to individual
accounts and executed by wholesalers in a principal capacity by
81.61% (1-36.78%/2), which is the percentage of the remaining
executed dollar volume of orders originating from individual
investor that are less than $200,000 plus 50% of the executed dollar
volume of individual orders that were $200,000 or greater, which
would be submitted to qualified auctions under this scenario.
\536\ Marketable orders that are routed to wholesalers and
executed at the NBBO midpoint or a more favorable price are included
in the analysis in Table 6, Table 7, Table 18, and Table 19, as well
as additional analysis based on the data used in these table.
---------------------------------------------------------------------------
Table 19 estimates the average annual total competitive shortfall
under the three segmented order volume scenarios for each of the three
different competitive shortfall rebate methods. The table presents
estimates for both the sample from Rule 605 data and the sample from
CAT data. The total competitive shortfalls estimated for the Rule 605
sample are smaller than those estimated for the CAT sample. The Rule
605 data sample Rebate Base method estimates total competitive
shortfalls ranging between $800 million and $1.0 billion dollars for
the Low and High segmented order volume scenarios, respectively, while
the CAT data sample Rebate Base method estimates total competitive
shortfalls ranging between $1.5 billion and $1.9 billion dollars. As
discussed above in this section, given the broader coverage of the CAT
exchange data, the Commission believes the estimated competitive
shortfall rates derived from the CAT data are more representative than
those derived from Rule 605 data. The total competitive shortfall
estimated from the CAT data sample using the Rebate High method ranges
between $1.1 billion and $1.5 billion dollars over the different
segmented order volume scenarios, while the estimates from the Rebate
Low method range between $1.7 billion to $2.3 billion dollars. Given
the uncertainty regarding the estimates of average exchange rebates and
the volume of segmented orders that would be exposed to qualified
auctions, the Commission estimates that the average annual total
competitive shortfall, i.e., the total annual average reduction in
individual investor transactions cost, from the Proposal may range
between $1.1 billion dollars and $2.3 billion dollars.\537\
---------------------------------------------------------------------------
\537\ This estimate only accounts for potential changes in
individual order transaction costs and assumes the PFOF that
wholesalers currently pay to retail brokers would be converted into
additional price improvement for the individual investor order. The
competitive shortfall estimates do not include costs that may arise
in the form of potential increases in (or the return of) commissions
retail brokers charge to individual investors or other reductions in
the services that retail brokers currently offer. See supra note 514
for additional details.
Table 19--Total Annual Competitive Shortfall Dollar Values under Different Volume Scenarios
----------------------------------------------------------------------------------------------------------------
Segmented order volume scenario
--------------------------------------------------------
Data source Competitive shortfall Base (7.80% of Low (7.34% of High (10.08% of
scenario total executed total executed Total Executed
dollar volume) dollar volume) Dollar Volume)
----------------------------------------------------------------------------------------------------------------
Rule 605....................... Competitive Shortfall $800 million..... $753 million..... $1.03 billion
Rebate Base (0.58
bps).
Rule 605....................... Competitive Shortfall $530 million..... $499 million..... $684 million
Rebate High (0.38
bps).
Rule 605....................... Competitive Shortfall $1.07 billion.... $1.01 billion.... $1.38 billion
Rebate Low (0.77 bps).
CAT............................ Competitive Shortfall $1.50 billion.... $1.41 billion.... $1.94 billion
Rebate Base (1.08
bps).
CAT............................ Competitive Shortfall $1.20 billion.... $1.12 billion.... $1.54 billion
Rebate High (0.86
bps).
CAT............................ Competitive Shortfall $1.82 billion.... $1.71 billion.... $2.35 billion
Rebate Low (1.31 bps).
----------------------------------------------------------------------------------------------------------------
This table estimates the total annual competitive shortfall dollar amounts by multiplying the competitive
shortfall rates for the different method in Table 18 by an estimate of the total annual dollar trading volume
that could be exposed in qualified auctions under three different scenarios: The Base Volume Scenario
(discussed in supra note 532), the Low Volume Scenario (discussed in supra note 533) and the High Volume
Scenario (discussed in supra note 535 ). The total annual dollar trading volume that could be exposed in
qualified auctions under a scenario is estimated by multiplying the scenario's estimate of the percentage of
executed total dollar volume by four times the Total Executed Dollar Volume in Q1 2022, which equaled $44.54
trillion. Total Competitive Shortfall Dollar Value is estimated by multiplying Competitive Shortfall Rate by
the estimate of the total annual dollar trading volume that could be exposed in qualified auctions under a
scenario.
A proposed exception from being required to send individual
investor orders to qualified auctions under the Proposal is if handling
broker-dealers choose to execute individual investor orders at prices
equal to the NBBO midpoint or better. The analysis in Table 10 presents
evidence that wholesalers execute 46% of the shares they internalize at
prices equal to or better than the midpoint. Analysis of CAT data
indicates that there is often additional midpoint liquidity available
on exchanges and NMS Stock ATSs
Table 20 uses CAT data from March 2022 to examine the non-displayed
liquidity available at the NBBO midpoint on exchanges and NMS Stock
ATSs at a moment in time when a wholesaler internalizes an individual
investor marketable order at a price less favorable (to the customer)
than the NBBO midpoint.\538\ The results indicate that, on
average,\539\ 51% of the shares of individual investor marketable
orders internalized by wholesalers are executed at prices less
favorable than the NBBO midpoint (Wholesaler Pct Exec Shares Worse Than
Midpoint). Out of these individual investors shares that were executed
at prices less favorable than the midpoint, on average, 75% of these
shares could have hypothetically
[[Page 210]]
executed at a better price against the non-displayed liquidity resting
at the NBBO midpoint on exchanges and NMS Stock ATSs. Under the current
market structure, this liquidity is not displayed, so wholesalers may
not have been aware of this liquidity and able to execute the
individual investor marketable orders against it. Currently, if
wholesalers wanted to detect this hidden liquidity, they would have had
to ping each individual exchange or NMS Stock ATS to see if midpoint
liquidity was available on that venue.\540\
---------------------------------------------------------------------------
\538\ More specifically, the analysis uses CAT data to look at
the total shares available at the NBBO midpoint that originate from
hidden midpoint pegged orders on exchanges and NMS Stock ATSs. The
analysis compares the size of an individual investor marketable
order that was internalized in a principal capacity by a wholesaler
at a price less favorable than the NBBO midpoint (measured at the
time the wholesaler received the order) to the total shares of
midpoint liquidity (originating from midpoint peg orders) at the
NBBO midpoint on exchanges and NMS Stock ATSs at the time the
individual investor order is executed in order to hypothetically see
how many additional shares could have gotten price improvement if
they had executed against the hidden liquidity available at the NBBO
midpoint. A midpoint peg order is a type of hidden order whose price
automatically adjusts with the NBBO midpoint. The analysis looks at
midpoint peg orders on exchanges and ATSs during normal market hours
(midpoint peg orders with an Immediate or Cancel or Fill or Kill
modifier are excluded). The total potential shares in orders that
were available at the NBBO midpoint from midpoint peg orders on
exchanges and ATSs was calculated each stock day by adding shares
when midpoint peg orders were received by an exchange or ATS and
subtracting shares in these orders that were canceled or traded.
Shares were also subtracted from the total when a wholesaler
internalized an individual investor marketable order at a price
worse than the NBBO midpoint and shares were available at the
midpoint on exchanges and ATSs that the order could have
hypothetically executed against. This ensures that that analysis is
not overestimating the available midpoint liquidity (i.e., it
ensures that we do not estimate two individual investor 100 share
orders could have executed against the same resting 100 share
midpoint order). The analysis also kept track of the total amount of
dollars of additional price improvement that individual investors
would have received if their orders had hypothetically executed
against the liquidity available at the NBBO midpoint instead of
being internalized by the wholesaler. Note that this analysis might
underestimate the total non-displayed liquidity available at the
NBBO midpoint because it only looks at orders that pegged to the
midpoint and not other orders, such as limit orders with a limit
price equal to the NBBO midpoint.
\539\ As discussed in Table 20, percentages were computed at a
stock-week level and then averaged across stock-weeks by weighting
by the total dollar volume the wholesaler internalized during that
stock-week.
\540\ Pinging for midpoint liquidity at multiple venues could
increase the risk of information leakage or that prices may move,
possibly resulting in some market participants canceling midpoint
orders they posted.
---------------------------------------------------------------------------
These results shed additional light on the availability of
liquidity at the NBBO midpoint for a large share of individual investor
orders that currently receive executions at less favorable prices than
the NBBO midpoint and therefore could potentially execute at a price
equal to the NBBO midpoint under qualified auctions. Under the
Proposal, individual investor marketable orders submitted to qualified
auctions might execute at the NBBO against this hidden liquidity,
assuming the added transparency does not reduce the supply of midpoint
liquidity. The qualified auction message would act as a coordination
mechanism and would make the broker-dealers that handle the orders
resting at the NBBO midpoint on exchanges and NMS Stock ATSs aware
there was a segmented order they could trade against. These broker-
dealers could cancel their midpoint orders resting on exchanges and NMS
Stock ATSs and instead submit them as an auction response priced at the
midpoint in the qualified auction.\541\
---------------------------------------------------------------------------
\541\ If the midpoint liquidity is resting on the LOB of the
open competition center running the qualified auction then it would
be included in the qualified auction without the submitter having to
cancel the order.
---------------------------------------------------------------------------
Table 20 also estimates the additional dollar price improvement
that these individual investor marketable orders would have received if
they had executed against the available midpoint liquidity instead of
being internalized. The total amount of additional price improvement
that all of these individual investor orders would have received was
about 51% of the total dollar price improvement provided by wholesalers
to all of the individual investor marketable orders that they
internalized (i.e. the marketable orders internalized at prices better
or equal to the midpoint plus marketable orders internalized at prices
worse than the midpoint).
In addition, the results in Table 20 also indicate the availability
of NBBO midpoint liquidity is only slightly lower for less liquid (non-
S&P 500 stocks) as liquid (S&P500) stocks. That is, while about 57% of
the shares in individual investor marketable orders in non-S&P500
stocks internalized by wholesalers received executions at less
favorable prices than the NBBO midpoint, there was nevertheless hidden
liquidity available at the NBBO midpoint for about 68% of these non-
S&P500 shares. Thus, the potential for NBBO midpoint execution for
shares in non-S&P500 stocks from qualified auctions is similar to the
overall market. Moreover, the potential additional price improvement
that could have been gained if these individual investor orders had
executed against this NBBO midpoint liquidity is almost 55% of the
total price improvement provided by wholesalers in these stocks. In
general, the potential for qualified auctions under the Proposal to act
as a coordination mechanism and potentially create more opportunities
for hidden liquidity resting at the NBBO midpoint to interact with
segmented orders exists for both liquid and non-liquid stocks.
[[Page 211]]
Table 20--Available Midpoint Liquidity When Wholesaler Internalizes a Retail Trade
----------------------------------------------------------------------------------------------------------------
Wholesaler pct Additional
exec shares Pct shares MP dollar price
Stock type Price group Liquidity bucket worse than price improvement
midpoint improvement Pct
----------------------------------------------------------------------------------------------------------------
All........................... All ................ 51.05 74.60 51.05
SP500......................... All ................ 48.41 72.32 41.43
SP500......................... (1) <$30 ................ 64.36 60.08 50.00
SP500......................... (2) $30-$100 ................ 47.82 60.36 29.29
SP500......................... (3) $100+ ................ 47.69 75.69 43.27
NonSP500...................... All ................ 57.45 68.10 54.51
NonSP500...................... (1) <30 Low............. 73.30 49.52 67.63
NonSP500...................... (1) <$30 Medium.......... 71.30 60.25 82.85
NonSP500...................... (1) <$30 High............ 66.77 52.18 59.74
NonSP500...................... (2) $30-$100 Low............. 63.60 80.69 68.88
NonSP500...................... (2) $30-$100 Medium.......... 57.71 85.24 61.80
NonSP500...................... (2) $30-$100 High............ 50.24 71.79 44.58
NonSP500...................... (3) $100+ Low............. 61.62 84.32 61.49
NonSP500...................... (3) $100+ Medium.......... 55.40 93.29 55.96
NonSP500...................... (3) $100+ High............ 47.15 90.99 45.57
ETF........................... All ................ 49.93 86.06 58.28
ETF........................... (1) <$30 Low............. 66.58 39.75 31.61
ETF........................... (1) >$30 Medium.......... 57.95 54.91 38.35
ETF........................... (1) <$30 High............ 62.24 78.47 88.70
ETF........................... (2) $30-$100 Low............. 61.01 62.00 41.78
ETF........................... (2) $30-$100 Medium.......... 53.94 77.54 46.85
ETF........................... (2) $30-$100 High............ 49.87 84.09 49.56
ETF........................... (3) $100+ Low............. 52.45 72.28 40.13
ETF........................... (3) $100+ Medium.......... 47.51 87.20 45.35
ETF........................... (3) $100+ High............ 46.93 90.28 48.33
----------------------------------------------------------------------------------------------------------------
This table summarizes midpoint liquidity available on exchanges and ATSs during March 2022 when a wholesaler
internalizes an individual investor marketable order less than $200,000 in an NMS common stock or ETF on a
principal basis at a price less favorable than the NBBO midpoint (at the time of the wholesaler receives the
order) from one of the 58 retail broker MPIDs in the CAT retail analysis. Stocks are broken out into buckets
based on their security type, price, and liquidity. Stock type is based on whether a security is an ETF, or a
common stock in the S&P 500 or Non-S&P 500. Price buckets are based on a stock's weekly average VWAP price as
estimated from TAQ. Stocks within each security type-price bucket, except S&P 500 stocks, are sorted into
three equal liquidity buckets based on the stock's total share trading volume during the week estimated using
TAQ data (see supra Table 9 for additional details on the bucket definitions). See supra Table 7 for
additional details on the sample and CAT analysis of wholesaler executions of the orders of individual
investors.
Wholesaler Pct Exec Shares Worse Than Midpoint is the average percentage of individual investor shares that
wholesalers executed on a principal basis at a price less favorable than the NBBO midpoint (measured at the
time the wholesaler receives the order). Pct Shares MP Price Improvement is the average percentage of shares
that the wholesaler executed at a price less favorable than the NBBO midpoint that could have executed at a
better price against resting liquidity available at the NBBO midpoint on exchanges and NMS Stock ATSs at the
time the wholesaler executed the order. Additional Dollar Price Improvement Pct is ratio of the total
additional dollars of price improvement of the sample period that individual investors whose orders were
executed at a price less favorable than midpoint would have received if their orders would have executed
against available midpoint liquidity, divided by the total dollars in price improvement (measured relative the
NBB or NBO at the time of order receipt) that wholesalers provided over the sample period when they
internalized individual investor orders (i.e. the total price improvement for orders wholesalers internalized
at prices less favorable than the midpoint plus the total price improvement for orders wholesalers
internalized at prices more favorable than the midpoint).
Midpoint liquidity is measured based on resting midpoint peg orders on exchanges and NMS Stock ATSs during
normal market hours identified from CAT data. Midpoint peg orders with an Immediate or Cancel or Fill or Kill
modifier are excluded. The total potential shares in orders that were available at midpoint on exchanges and
ATSs at a point in time were calculated keeping a running total each stock day by adding shares when midpoint
peg orders were received by an exchange or NMS Stock ATS and subtracting shares when shares in these midpoint
peg orders were canceled or traded. When a wholesaler executes an order at a price less favorable than the
NBBO midpoint (at the time the wholesaler receives the order), then the executed shares are compared to the
available resting liquidity at the NBBO midpoint. If the NBBO midpoint at the time the order is executed would
provide price improvement over the price the wholesaler would have executed the order at, then the shares
executed by the wholesaler are subtracted from the total resting shares available at the NBBO midpoint, up to
the lesser of the number of shares executed by the wholesaler or the total resting shares available (i.e. the
total resting shares will not drop below zero). These are counted as the total shares that would have received
additional price improvement at the midpoint. This methodology ensures that that analysis is not
overestimating the available midpoint liquidity (i.e. it ensures that we do not estimate two individual
investor 100 share orders could have executed against the same resting 100 share midpoint order). NBBO
midpoints for both time of order receipt and time of execution are estimated from the consolidated market data
feed.
The additional dollars of price improvement individual investors whose orders were executed at a price less
favorable than the midpoint would have received if their orders would have executed against available midpoint
liquidity was calculated as the difference between the price the wholesaler executed the order at and the NBBO
midpoint at the time the wholesaler executed the order (i.e., executed price--NBBO midpoint at the time of
execution for a marketable buy order and midpoint--executed price for a marketable sell order ) times the
number of shares that would have received the additional price improvement.
Weighted averages are calculated for the variables Wholesaler Pct Exec Shares Worse Than Midpoint and Pct Shares
MP Price Improvement using the following methodology. Percentages based on share volume are calculate for each
stock-week (e.g., total shares executed at a price worse than the midpoint during a stock-week divided by the
total shares of individual investor marketable orders executed by a wholesaler in a principal capacity during
the stock-week). Weighted averages are then calculated for each stock-type-price-liquidity bucket by averaging
these stock-week percentages over the month by weighting each stock-week by the total dollar trade volume
internalized by the wholesaler during the stock-week (i.e., using the stock's total dollar trading volume
internalized by the wholesaler as the weight when averaging the stock-week percentage values).
The Additional Dollar Price Improvement Pct is not weighted and is calculated as the ratio of the month's total
additional dollar price improvement orders executed at a price less favorable than the NBBO would have
received if their orders would have executed against available midpoint liquidity, divided by the month's
total dollars in price improvement (measured relative the NBBO at the time of order receipt) that wholesalers
provided when they executed individual investor orders (i.e. the total price improvement for orders
wholesalers internalized at prices less favorable than the midpoint plus the total price improvement for
orders wholesalers internalized at prices more favorable than the midpoint).
c. Improvements to Other Market Participants' Execution Quality
In addition to benefiting individual investors, the Proposal would
improve order execution quality for other key market participants that
compete to supply liquidity to individual investor orders, including
institutional investors. For example, individual investor order flow
that is currently accessed indirectly by institutional investors
through wholesaler SDPs could be accessed directly at better prices
relative to the prices charged by SDPs.\542\ As stated above, in Q1
2022, SDPs associated with the two highest-volume wholesalers accounted
for around 3% of the consolidated NMS stocks volume, while the volume
of shares handled by these two wholesalers accounted for 15.9% of
consolidated share volume in NMS stocks as of Q1 2022.\543\ If
institutional and individual investors could directly interact via
qualified
[[Page 212]]
auctions, then these orders could potentially receive better execution
quality.\544\
---------------------------------------------------------------------------
\542\ See supra section VII.B.3 for further discussions
regarding how institutional investors indirectly interact with
individual investor orders through wholesaler SDPs.
\543\ See supra note 416 and corresponding discussion.
\544\ The direct interaction between individual and
institutional investors in qualified auctions would allow for price
improvement for both groups of investors, the sum of which is
currently received by the wholesaler serving as the intermediary via
its SDP. Thus, the gains to individual and institutional investors
would be an economic transfer from the wholesaler. The impact of the
Proposal on the costs to wholesalers is discussed in infra section
VII.C.2.c.
---------------------------------------------------------------------------
d. Improvements in Pre-Trade Transparency and Price Efficiency
In addition to increasing price improvement and interaction among
market participants, the Proposal would improve pre-trade transparency
and price efficiency. Currently, because most individual investor
orders are internalized by wholesalers, pre-trade transparency related
to these orders is limited, and has very likely declined over time as a
result of the increasing share of trading volume that is executed off-
exchange.\545\ Moreover, the fact that some of the same market-makers
have a large presence both on and off exchange implies a skewed
information advantage, accruing to a subset of market makers. This
subjects on-exchange liquidity providers, which may include individual
investors, to greater adverse selection, which may have manifested in
spreads wider than they would be otherwise, as well as lower
depth.\546\
---------------------------------------------------------------------------
\545\ See supra notes 374 and 375 and accompanying text.
Additionally, market participants have stated that liquidity
displayed at or near the NBBO on exchanges has declined over time.
See supra note 376 and accompanying text.
\546\ See supra section VII.B.1 for further discussion of the
increase in off-exchange trading volume.
---------------------------------------------------------------------------
As a result of the Proposal, price efficiency would be improved as
a result of the dissemination of qualified auction messages, which
would increase transparency regarding the trading interest of
individual investors. Because qualified auction messages would be
included in consolidated market data,\547\ they would not only promote
competition by soliciting potential auction responses from a wide
spectrum of market participants, but would also enhance the pre-trade
transparency of marketable orders of individual investors, which may
lead to improvements in liquidity and price efficiency.\548\ As market
participants would be better able to observe the trading interest of
individual investors using consolidated market data, this would also
allow them to better able to observe institutional trades.\549\ The
overall increase in market participants' ability to observe information
in trades reported in consolidated market data would lessen the highly
skewed information advantage of large market makers on and off-
exchange, reducing adverse selection and potentially improving market
quality.\550\ These improvements would also occur should order flow be
routed directly to the limit order book rather than going to an
auction. They would be reduced to the extent that orders would be
internalized at midpoint or better by wholesalers rather than routed to
an exchange.
---------------------------------------------------------------------------
\547\ The MDI Rules required auction messages to be included in
consolidated market data. See supra section III.B.1. NMS Stock ATSs
operating qualified auctions would need to disseminate qualified
auction messages via FINRA's ADF.
\548\ Evidence shows that increasing pre-trade transparency can
improve liquidity and price efficiency. See, e.g., Ekkehart Boehmer,
Gideon Saar & Lei Yu, Lifting the Veil: An Analysis of Pre-Trade
Transparency at the NYSE, 60 J. Fin. 783 (2005). However, some
evidence suggests that extreme changes, beyond what is proposed
here, can have detrimental effects on market quality. See Ananth
Madhavan, David Porter & Daniel Weaver, Should Securities Markets Be
Transparent?, 8 J. Fin. Mkt. 265 (2005).
\549\ For example, in the most extreme case, if virtually all
individual investor orders are routed to and executed in qualified
auctions, market participants would be able to identify nearly all
other off-exchange transactions as institutional trades. This may
result in additional costs to institutional investors related to
information leakage; see infra section VII.C.2.f for a detailed
discussion.
\550\ The advantage would be lessened though not completely
eliminated, provided that retail brokers route initially through
wholesalers rather than directly to exchanges.
---------------------------------------------------------------------------
Additionally, the execution of more individual investor orders on
exchanges would increase post-trade transparency because it would be
easier to identify which transactions belonged to individual investors
and on which venue they were executed.\551\ The effects of post-trade
transparency would be similar in direction to that of pre-trade
transparency, though perhaps smaller, as the incremental difference in
the transparency is less. Overall, the proposal will likely lead to
increased trading on national market exchanges and on alternative
trading systems satisfying the specified conditions. Evidence suggests
that an increase in trading on lit venues could potentially increase
information efficiency.\552\
---------------------------------------------------------------------------
\551\ Qualified auction messages (which would be disseminated in
consolidated market data) could be matched with trade execution
reports in order to identify which trades belonged to retail orders.
Currently, SIP trade reports for trades executed on exchanges
identify the venue on which the trade occurred. Trade reports for
trades executed off-exchange do not.
\552\ See, e.g., Carole Comerton-Forde & T[amacr]lis
J.Putni[ncedil][scaron], Dark trading and price discovery, 118 J.
Fin. Econ. 70 (2015), who find that high levels of dark trading can
impede price discovery.
---------------------------------------------------------------------------
2. Costs
The Commission recognizes that the Proposal would result in initial
and ongoing compliance costs, as well as other costs to market
participants. The Commission quantifies these costs where possible and
provides qualitative discussion when quantifying costs is not feasible.
a. Compliance Costs
Market participants would incur various initial and ongoing costs
in order to comply with Proposed Rule 615. The Commission estimates in
Table 21 that total initial PRA compliance costs would be approximately
$48.28 million while ongoing annual PRA compliance costs would be
approximately $1.99 million.\553\ Compliance costs would vary across
market participants, including broker-dealers, SROs (including national
securities exchanges and FINRA), and NMS Stock ATSs.
---------------------------------------------------------------------------
\553\ Aggregate PRA compliance costs are calculated by summing
up PRA compliance costs of various components of Proposed Rule 615,
which are detailed below and also discussed in detail above in supra
section VI.D.
Table 21--Summary of PRA Compliance Costs
--------------------------------------------------------------------------------------------------------------------------------------------------------
Implementation
Element Participants costs per Ongoing costs Total implementation costs Total ongoing costs
entity per entity
--------------------------------------------------------------------------------------------------------------------------------------------------------
Administer & regulate auctions -... 10 $79,000 $119,000 $790,000......................... $1,190,000
Rule 615 (c)(1)....................
P&P--Identification of segmented 157 34,000 4,500 $5,301,000....................... $703,000
orders -.
Rule 615 (e)(1), (e)(2)............
Marking segmented orders: In-house - 52 95,500 .............. $4,970,000....................... ................................
.
Rule 615 (e)(2)....................
Marking segmented orders: 3rd party 105 53,000 .............. $5,600,000....................... ................................
-.
Rule 615 (e)(2)....................
[[Page 213]]
One-time technology project costs 182 170,000 .............. 30,940,000....................... ................................
to add ``segmented order'' and
certification marks to existing
marking systems -.
Rule 615 (e)(2), (f)(1)............
Certification that BD identity will 20 33,800 4,500 $675,000......................... $90,000
not be disclosed -.
Rule 615(c)(1)(iii), (e)(3)........
ATS's excluding subscribers -...... 3 3,100 2,700 $9,300........................... $8,000
Rule 615 (d)(1)....................
--------------------------------------------------------------------------------------------------------------------
Total.......................... 176 .............. .............. $48.29 million................... $1.99 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
These estimated compliance costs can be disaggregated into several
components. First, as part of the requirement to provide qualified
auction messages, specified in Proposed Rule 615(c)(1), national
securities exchanges, FINRA and NMS Stock ATSs would have to utilize
various personnel (legal, compliance, information technology, and
business operations) to prepare and implement a system to collect and
provide the information necessary to generate auction messages for
dissemination in consolidated market data. In addition to the 6
national securities exchanges and 3 NMS stock ATSs that the Commission
believes would participate in qualified auctions,\554\ FINRA would also
disseminate qualified auction data and would therefore incur these
compliance costs. Thus, each of these 10 entities (6 exchanges, 3 ATSs,
and FINRA), would each face an estimated initial compliance costs of
$79,000, with total cost calculated at $790,000.\555\ Furthermore, each
of these entities would have to collect and provide auction messages on
an ongoing basis, which the Commission estimates would be $119,000 per
entity annually, totaling $1.19 million (see Table 21 above.) \556\
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\554\ See supra section IV.B.2 and section VII.C.1.a for further
discussion on the incentives for exchanges and ATSs to offer
qualified auctions.
\555\ See supra notes 290 and 296 for a detailed description of
these estimated costs.
\556\ See supra notes 291-292; 295; 297 for a detailed
description of these estimated costs.
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Originating broker-dealers would face various compliance costs,
including identifying and marking segmented orders, as specified in
paragraphs (e)(1) and (e)(2) of Proposed Rule 615. This would involve
utilizing in-house and outside counsel to update and review existing
policies and procedures, as well as an in-house General Counsel and a
Chief Compliance Officer to review and approve updated policies and
procedures. An outside programmer would also be needed to modify
existing technology and coordinate with the broker-dealer's compliance
manager. The Commission estimates that the initial costs to the 157
originating broker-dealers would be approximately $34,000 per broker
and $5.3 million for the industry.\557\ In addition, these originating
brokers would need to provide ongoing annual reviews and update
existing policies, which Commission estimates would cost about $4,500
per broker-dealer and an aggregate cost of $703,000.\558\
---------------------------------------------------------------------------
\557\ See supra notes 301-303 for a detailed description of
these estimated costs.
\558\ See supra notes 304-305 for a detailed description of
these estimated costs.
---------------------------------------------------------------------------
The 157 originating brokers would also incur the cost of adding a
``segmented order'' and certification mark to their existing marking
systems, as specified in Rule 615(e)(2). The Commission predicts that
approximately one third of the 157 originating brokers (i.e., 52 firms)
would choose to perform the necessary systems modifications to identify
and mark segmented orders with in-house staff, which would cost an
estimated $95,500 per firm and $4.97 million for all 52 firms.
Commission estimates that two-thirds of the originating brokers (i.e.,
105 firms) would hire third-party service providers to assist with
these system modifications, which is predicted to cost $53,000 per
broker and $5.6 million for all 105 firms.\559\
---------------------------------------------------------------------------
\559\ See supra notes 312-313 for a detailed description of
these estimated costs.
---------------------------------------------------------------------------
The Commission also estimates that there would be an initial one-
time technology project costs for originating brokers to add the
``segmented order'' and certification marks to the existing marking
systems of all 157 originating brokers as well as 25 routing brokers
(for a total of 182 brokers-dealers), in order to comply with paragraph
(e)(2) of Proposed Rule 615, and the initial one-time cost for routing
broker-dealers to mark segmented orders to comply with paragraph (f)(1)
of Proposed Rule 615 and also mark orders to communicate certifications
when applicable. These costs are estimated to be $170,000 per broker-
dealer, for an aggregate total cost of $30.94 million.\560\
---------------------------------------------------------------------------
\560\ See supra notes 314-315 for a detailed description of
these estimated costs.
---------------------------------------------------------------------------
The ongoing task of marking segmented orders would not require new
resources, but instead would utilize broker-dealers' existing marking
systems. Therefore, the ongoing task of marking segmented orders would
not cause broker-dealers to incur new monetary costs related to
updating their systems to market orders (and is therefore not reported
in Table 21 above).\561\
---------------------------------------------------------------------------
\561\ The Commission estimates that around 2.1 billion orders
would need to be marked annually, and calculates that this would
require between approximately 24,000 and 290,000 total hours, based
on its estimates of the duration of time used to mark each order.
See supra notes 316-320 and corresponding discussion.
---------------------------------------------------------------------------
The Commission estimates that 20 originating broker-dealers would
certify and not make the mandatory identity disclosure, as specified in
paragraph (c)(1) of Proposed Rule 615.\562\ Obtaining this
certification would involve utilizing in-house and outside counsel to
update and review existing policies and procedures, as well as an in-
house General Counsel and a Chief Compliance Office to review and
approve updated policies and procedures. Outside counsel would also be
needed to review the updated policies and procedures. These initial
compliance costs are estimated at $33,800 per broker, totaling $675,000
for all 20 firms.\563\
---------------------------------------------------------------------------
\562\ See supra note 288 and corresponding discussion.
\563\ See supra notes 322-326 for a detailed description of
these estimated costs.
---------------------------------------------------------------------------
These 20 broker-dealers would also incur ongoing costs to review
and update existing policies and procedures, estimated at $4,500 per
broker-dealer and $90,000 for all 20 firms.\564\ The various compliance
costs involved in
[[Page 214]]
obtaining and maintaining originating broker certification (that it has
established, maintained, and enforced written policies and procedures
designed to assure that its identity will not be disclosed), as
specified in paragraphs (c)(1)(iii) and (e)(3) of Proposed Rule 615,
are summarized above in Table 21. It is uncertain how many broker-
dealers would choose to exercise this option. If fewer or greater than
(the Commission's estimate of) 20 firms seek certification to withhold
their identity as the originating broker during a qualified auction,
aggregate compliance costs would be different from those found in Table
21.
---------------------------------------------------------------------------
\564\ See supra notes 327-329 for a detailed description of
these estimated costs.
---------------------------------------------------------------------------
NMS Stock ATSs that participate in qualified auctions would incur
costs in order to comply with the requirements regarding ATS policies
and procedures for excluding subscribers, as specified in proposed Rule
615(d)(1). Compliance costs would initially involve reviewing existing
policies and procedures for consistency with the proposed rule, making
modifications as appropriate, and putting the policies and procedures
in writing. These initial costs, which the Commission expects would
apply to 3 NMS Stock ATSs, are predicted to cost $3,100 per firm, and
$9,300 for all 3 firms.\565\ In addition, these ATSs would face the
ongoing cost of reviewing and updating the relevant existing policies
and procedures, estimated at $2,700 per firm and $8,000 for all 3 firms
(see Table 21 above). Note that these estimated compliance costs are
based on the Commission's assumption that at least some ATSs would
operate qualified auctions. As discussed above, ATSs would have to make
significant adjustments to their business models (especially with
regards to segmenting customer orders and displaying quotes) in order
to meet the requirements to operate a qualified auction.\566\
---------------------------------------------------------------------------
\565\ See supra notes 334-335 for a detailed description of
these estimated costs.
\566\ See discussion in supra section VII.C.1.a.
---------------------------------------------------------------------------
It should be emphasized that the estimated compliance costs
described above and summarized in Table 21 are the Commission's best
estimate for the required technological, operational, and legal
services resources that would be utilized in the initiation and ongoing
operation of qualified auctions.
b. Costs to Individual Investors
i. Greater Variation in Execution Quality
The Commission is cognizant of concerns regarding the possibility
of a decline in execution quality due to the implementation of
qualified auctions. This includes the possibility that a qualified
auction host could decide not to host an auction for a particular
stock.\567\ However, if an order fails to execute in one auction, it
could be directed quickly to other auctions,\568\ and/or the wholesaler
would have the option to internalize the order at the same or better
price at which it was exposed in the first auction. Although it is also
possible that the quotes may move against the order during this time
and the wholesaler would have to route it to an exchange LOB or expose
the order in another qualified auction before it could execute. Also,
wholesalers would have the option to internalize the trade without
exposing it in an auction if the wholesaler were willing to execute the
order at midpoint or better. More generally, however, the Commission
believes that at least one open competition trading center would be
incentivized to operate qualified auctions and serve as the qualified
auction host for every segmented order in order to increase its volume/
market share relative to other trading venues, as well as to
potentially earn revenue from any net capture between the fees and
rebates the qualified auction might charge.\569\
---------------------------------------------------------------------------
\567\ Qualified auction hosts would have the discretion to
determine for which stocks they would run auctions.
\568\ An additional risk is that there could be price slippage
when the order is routed to a different qualified auction.
\569\ See supra notes 503-507 and accompanying discussions for
estimates of net capture rates for fees and rebates related to
qualified auctions.
---------------------------------------------------------------------------
An additional concern is that there could be a general lack of
interest from liquidity suppliers to participate in a qualified
auction. However, in cases where there was insufficient competition
from liquidity providers, then the majority of individual investor
orders could simply be internalized by wholesalers, similar to the
current market, though perhaps at inferior prices compared to what they
might have received under the current market structure. Moreover, while
this occurrence might occur for any individual order, it would be
extremely unlikely at the market level, because marketable order flow
of individual investors has lower adverse selection risk than order
flow routed to exchanges and most liquidity suppliers would profit by
trading with it if the predicted realized spread was large enough.\570\
---------------------------------------------------------------------------
\570\ The Commission is uncertain how liquidity would be
impacted by increased volatility within the context of qualified
auctions. The risk that individual investors may receive worse
prices compared to the current market structure may not be
significantly elevated because wholesalers could still internalize
the trades if they cleared the auctions or route them to the LOB for
execution.
---------------------------------------------------------------------------
A related concern regarding the functioning of qualified auctions
is the possibility of slippage costs. More specifically, there is the
potential that the NBBO could change while the qualified auction was in
process. Since Proposed Rule 615 would require an auction message to be
disseminated once an individual investor order is brought to a
qualified auction, the concern is that these messages would trigger a
response in quoted prices.
The Commission performed an empirical analysis to estimate this
risk by observing the likelihood that that the NBBO spread moves (i.e.,
the ``fading probability'') as the time lag increases (in milliseconds)
from the internalization of an individual investor order in comparison
to the fade probability after NBBO quote movements.\571\ Results from
this analysis \572\ indicate that the probability of the NBBO quotes
adversely moving after the execution of an individual investor order
range from 1.8% at 25 milliseconds after an internalized trade, to 2.8%
at 100 milliseconds--an increase of 1 percentage point. Extending the
duration to 300 milliseconds, the maximum time of the auction as
proposed, increases the likelihood of adverse fading to 4.6%.\573\
---------------------------------------------------------------------------
\571\ The Commission's ``fade analysis'' estimates the
possibility of adverse price movements to individual investors. It's
also possible to consider the likelihood of adverse price movements
(and the resulting increase in trading costs) from the perspective
of the bid winner. However, bidders would be much less exposed to
risk of fade because their connectivity capacities would allow them
to cancel bids should they expect adverse price movements.
Individual investors, however, would have no control over where
their orders are executed: auction vs. internally. Therefore, the
Commission's focus is on the risk of adverse price movements from
the perspective of individual investors.
\572\ The Commission's ``fade analysis'' uses an algorithm from
Boehmer et al. (2021) to identify retail trades. A recent paper by
Barber et al. (2022) finds that the algorithm correctly identifies
only 35% of trades as retail. However, plausibly a significant
fraction of the retail trades unidentified by the algorithm reflects
orders executed on a risk-less principal basis, i.e., executions
that would not be relevant to the order flow targeted by the
Proposal. In addition, the internalized retail trades missed by the
algorithm are likely idiosyncratic across buy and sell orders.
Therefore, aggregation of the data, which was performed as part of
the Commission fade analysis, would likely have minimized any
directional bias that these errors would have otherwise caused.
Therefore, empirical results regarding the estimated risk of adverse
pricing movements are likely to still be consistent despite
limitations in identifying retail trades. See Ekkehart Boehmer et
al., Tracking Retail Activity, 76 J. Fin. 2249 (2021), and Brad M.
Barber et al., A (Sub)penny For Your Thoughts: Tracking Retail
Investor Activity in TAQ (last revised Sept. 30, 2022) (unpublished
manuscript), available at https://ssrn.com/abstract=4202874
(retrieved from Elsevier database).
\573\ Moreover, the substantially lower fade probability of less
than 5% following internalized investor trades relative to the
cross-stock fade probability of more than 16% following a given
quote update is consistent with low adverse selection costs of
currently internalized individual investor orders.
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[[Page 215]]
Auction announcements would differ from SIP trade messages for
trades executed off-exchange, which could potentially result in
different quote movements compared to those observed in the analysis.
Auction announcements would represent announcements of pre-trade
interest as opposed to SIP trade messages being announcements of post-
trade interest, which could lead to different responses by the
liquidity suppliers setting the NBBO.\574\ Additionally, auction
announcements would disclose more information than SIP messages for
off-exchange trades, including, among other things, the direction of
the segmented order, the venue it was on, and, potentially, the
identity of the originating broker.\575\ Disclosure of this information
in qualified auctions, including the originating broker as mandated by
the Proposal (absent a certification from the originating broker that
its identity not be disclosed), would provide potential bidders with
more information about an order than is currently provided by the SIP
trade message, which in turn could lead to increased variation in the
adverse fade that could follow auction announcements. That is, adverse
fade could be reduced when bidders learn that an order stems from an
originating broker with relatively low adverse selection risk, while
announcements of orders from retail brokers with higher adverse
selection risk could trigger greater adverse fade relative to a SIP
trade announcement of an identical order. However, despite the likely
increase in the variation of adverse fade, the average risk of adverse
fade under qualified auctions may be similar to SIP trade announcements
used to generate the estimates reported above. Overall, the results of
the Commission's fade analysis suggest that auction messages would
result in minimal adverse movements in best quotes due to the low
adverse selection risk of individual investors, but, for the reasons
discussed above, there may be greater variability in the risk of
adverse quote movements. Because auction messages would differ from SIP
messages, there is uncertainty regarding their overall effects on the
risk of adverse quote movements.
---------------------------------------------------------------------------
\574\ Although this difference may be limited given the lower
adverse selection risk of segmented orders.
\575\ The SIP trade message would not reveal what venue the
trade took place on, its direction (although it may be able to be
estimated based on the transaction price), or whether the trade
belonged to an individual investor vs another market participant
(although, similar to this analysis, this information may be
inferred based on if the trade executed at a sub-penny price).
---------------------------------------------------------------------------
Fade analysis only estimates the possibility that adverse price
slippage will occur, not the magnitude of the adverse fade. Thus, it is
not possible to directly compare the potential loss to individual
investors due to adverse fading with the gains that could stem from
qualified auctions, which the Commission estimates would range from
0.86 bps to 1.31 bps, or in dollar terms, 0.15 to 0.47 cents per
share.\576\ However, one way to possibly quantify the potential cost of
fading is to consider the price impact of an auction that did not
result in a bid, which might increase the probability that the NBBO
would be worse after a 300 millisecond auction by (the fade analysis's
estimate of) 4.6%. If we assume the quote moved 1 cent, which the
Commission believes is the most frequent movement over a short time
span, then the (expected value of the) potential average higher
transaction cost to the order would face could be 1 cent x 4.6% = 0.046
cents--significantly smaller than the estimated 0.15-0.47 cent per
share gain stemming from qualified auctions.
---------------------------------------------------------------------------
\576\ See supra section VII.C.1.b.
---------------------------------------------------------------------------
A similar analysis could be used to estimate that the adverse fade
that would occur during the course of a successful auction, which would
be a minimum of 100 milliseconds, with the current duration of
wholesaler internalized executions, which have a median duration of
3.54 milliseconds. In other words, even successful qualified auctions
that result in execution after the minimal duration of time will be
(100 milliseconds--3.54 milliseconds) = 96.56 milliseconds slower than
the median wholesaler execution. If we use the fade probability of 2.8%
for 100 milliseconds, then the (expected value of the) adverse fade
cost of a successful auction relative to internalization, assuming 1
cent slippage, would be 1 cent x 2.8% = 0.028 cents. This estimated
cost is significantly below the estimated 0.15-0.47 cent per share gain
stemming from qualified auctions. However, this calculation relies on
the assumption of the minimum length of a qualified auction (100
milliseconds) and the median duration of a wholesaler internalized
order (3.54 milliseconds). This calculation would generate different
results if we assumed longer auction lengths, which would increase the
fade cost of the auction, and longer (or shorter) internalization
execution times. Given that a number of auctions in the options market
have a duration of 100 milliseconds,\577\ the Commission preliminarily
believes that a majority of open competition trading centers may elect
to choose an auction duration of 100 millisecond for their qualified
auctions. Therefore, a significant share of auctions may be
successfully concluded within the 100 millisecond minimum auction
duration, although some orders could take longer to conclude, while
other orders would likely fail to have a successful outcome. Overall,
the Commission believes the Proposal would result in price improvement
for individual investors, although it is possible that variation in
price improvement and overall execution quality might increase.
---------------------------------------------------------------------------
\577\ See supra note 243 for further discussions of the duration
of auctions in the options market.
---------------------------------------------------------------------------
Besides potentially greater volatility stemming from a failed
auction, an additional cost for some orders may arise to the extent
that lower execution quality for some orders currently subsidizes
better execution quality for others. Table 10 shows that wholesalers
execute 13.82% of orders at prices superior to midpoint for the
investor.\578\ On average, unless the orders have systematically
negative price impact, the wholesaler may not be earning a positive
marginal profit on these executions.\579\ This could imply they
currently subsidize the additional price improvement on these trades
with marginal profits earned on other executions. To the extent this
occurs, if wholesalers' marginal profits decline under the Proposal,
then customers could receive less price improvement and experience
higher transaction costs on trades that are currently subsidized.
However, on average, the Commission expects that execution quality for
individual investor orders would likely improve under the
Proposal.\580\
---------------------------------------------------------------------------
\578\ Table 10 indicates that wholesalers executed 46.05% of
shares at midpoint or better and 32.23% of shares at midpoint.
\579\ For these statistics, the NBBO midpoint is measured at the
time the wholesaler receives the order, so it is possible that
quotes may have changed by the time the wholesaler executes the
order. Therefore, it is possible that wholesalers execute some of
these trades at prices worse than the NBBO midpoint at the time of
execution, in which case the wholesaler could still earn a positive
realized spread on these trades even if price impact measured
against the NBBO midpoint at the time of execution was positive.
\580\ See supra section VII.C.1.b.
---------------------------------------------------------------------------
The Commission recognizes that wholesalers may provide consistency
with regard to the execution quality that they deliver to individual
investor orders.\581\ There is the concern that the Proposal would
undermine the wholesaler business model, which in turn could hinder the
ability of
[[Page 216]]
wholesalers to continue to provide consistency in their execution
services. The Commission believes, however, that while bidders in
qualified auctions may not provide as much consistency as wholesalers,
some orders could receive improved execution quality while others would
receive reduced execution quality (relative to wholesalers). Based on
the competitive shortfall analysis presented in section VII.C.1.b
above, the net result would likely be improved execution quality, but
the standard deviation of this execution quality would likely increase.
---------------------------------------------------------------------------
\581\ See discussion in supra section VII.B.2.b.
---------------------------------------------------------------------------
ii. Resumption of Commissions on NMS Stock Orders
An additional concern is that if the Proposal results in a
significant or complete loss of PFOF, then retail brokers would be
forced to start charging commissions again for online NMS stock and ETF
trades.\582\ There are several reasons that retail brokers would be
unlikely to resume charging commissions for these orders. First, the
majority of retail brokers receive relatively little or no PFOF, and
yet they have nevertheless successfully managed to support commission-
free trading through their other revenue-generating lines of
business.\583\ In fact, several retail brokers, including some that do
not accept PFOF, earned record revenues and profits after zero-
commission trading was initiated.\584\ While most brokers had already
reduced commissions to under $10, there was still considerable concern
that the zero commissions would lower profits. Despite these concerns,
industry profit grew in 2020.\585\
---------------------------------------------------------------------------
\582\ Almost all retail brokers continue to charge a commission
fee for human broker-assisted orders.
\583\ CAT analysis shows that PFOF brokers originated about 80%
of the share volume and about 74% of dollar volume of individual
investor marketable orders that were routed to wholesalers and
executed (see Table 14). The Commission notes that trading revenue
for many discount brokers rose to record levels in 2020, shortly
after these discount brokers dropped commissions to zero. It's
unclear how much of this increase was due to individual investors
being incentivized by zero commissions and new trading options such
as fractional share trading, and how much was due to COVID-related
factors that made online trading more appealing, including a shift
towards remote work and a rise in discretionary funds from
government stimulus. See Maggie Fitzgerald & Kate Rooney, E-brokers
Defy Odds by Recording Record Trading Revenue While Dropping
Commissions to Zero, CNBC (Aug. 20, 2020), available at https://www.cnbc.com/2020/08/20/e-brokers-defy-odds-by-recording-record-trading-revenue-while-dropping-commissions-to-zero.html. It's also
important to note that even brokers that do not accept PFOF
experienced increased revenue and profits, despite adopting zero
commissions. See Kenneth Corbin, Fidelity Posts 6th Straight Record
Profit, Barrons (Mar. 9, 2022), available at https://www.barrons.com/advisor/articles/fidelity-earnings-2021-51646853970.
However, the recent increase in individual investor trading volume
did not result in the loss of order-by-order competition. Isolation
of individual investor orders by wholesalers preceded the recent
rise in trade volume and a subsequent decline in trade volume would
not remove the rationale for the Proposal because individual
investor orders will continue to comprise a substantial share of
overall trade volume with the potential for improved execution
quality if order-by-order competition is incorporated into this
market.
\584\ Id.
\585\ Pre-tax income of FINRA-registered broker-dealers rose
from $43,943 million (2019) to $77,212 million (2020), an increase
of 75.7%. This was substantially larger than the 2.7% increase in
profits from 2018 to 2019 ($42,780 million to $43,943 million). See
FINRA, 2021 FINRA Industry Snapshot (2021), available at https://www.finra.org/sites/default/files/2022-02/21_0078.1_Industry_Snapshot_v10.pdf. However, it is possible that
this increase in industry profits was transitory because of the
spike in individual investor trading volume related to COVID.
---------------------------------------------------------------------------
Moreover, the average PFOF payment that brokers receive on a 100
share order is 10-20 cents.\586\ The PFOF for a 1000 share order is
less than the commission fees previously charged by broker-dealers,
which had generally been $5 or more.\587\ Thus, just as the loss of
commission fees was not offset by the receipt of PFOF, the loss of PFOF
might not necessitate the return of commission fees.\588\
---------------------------------------------------------------------------
\586\ See analysis in supra Table 17.
\587\ The average retail order size has declined since the shift
to zero commission trading. See Pankaj K. Jain et al., Trading
Volume Shares and Market Quality: Pre- and Post-Zero Commissions
(last revised Sept. 16, 2022) (unpublished manuscript), available at
https://ssrn.com/abstract=3741470 (retrieved from Elsevier
database). Assuming a PFOF rate of 20 cents per 100 shares, orders
over 2500 shares would have lower per share revenue for the retail
broker under a $5 fixed commission model than a PFOF model, while
orders under 2500 shares would have higher per share revenue.
\588\ Commission fees were reduced to zero for online NMS stock
trades, but not broker-assisted stock trades. Therefore, commission
revenues have continued to exceed PFOF revenues for most PFOF firms,
excluding the two PFOF firms that are online brokers and collect no
commission revenue.
---------------------------------------------------------------------------
Additionally, to the extent that rebates paid for the routing of
segmented orders to qualified auctions are passed through to retail
brokers, it could reduce the likelihood that they resume charging
commissions. The 5 mil cap on rebates that qualified auctions could pay
for the submission of segmented orders under the Proposal is
approximately 40% of the average combined PFOF rate paid by wholesalers
for marketable orders as estimated in Table 2.\589\ If rebates paid by
qualified auction hosts for the submission of segmented orders to the
qualified auction are passed through to retail brokers (assuming the
retail broker does not route the segmented order to the qualified
auction directly), then it could supplement the revenue they may lose
from a reduction in PFOF.\590\ This could reduce the likelihood that
retail brokers resume charging commissions.
---------------------------------------------------------------------------
\589\ The 5 mil rebate would not be earned unless the order was
routed to a qualified auction. If the wholesaler chose instead to
internalize the order at midpoint (and thereby be exempted from the
auction), it would not earn the 5 mil rebate.
\590\ Similarly, if a wholesaler routes a segmented order to a
qualified auction and receives the rebate for the submission of a
segmented order, the wholesaler may indirectly pass the rebate from
the qualified auction through to the retail broker by using the
rebate to subsidize PFOF payments it makes to the retail broker. See
infra section VII.C.2.d.ii for further discussions on retail broker
loss of PFOF revenue.
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iii. Other Possible Costs to Investors
The Commission is aware of other possible increases in trading
costs stemming from the Proposal that might be experienced by some
individual investors. For example, some individual investor orders that
are currently eligible for RLP programs might not meet the proposed
definition of segmented orders and might be excluded from the qualified
auctions, which could reduce the price improvement that they currently
receive via wholesalers or RPLs.\591\
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\591\ These orders could also be internalized by the wholesaler
or executed on an ATS.
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Furthermore, since the Proposal would require that the identity of
the originating retail broker be disclosed (unless the originating
broker certifies that the identity of the originating broker will not
be disclosed to any person that potentially could participate in the
qualified auction or otherwise trade with the segmented order \592\),
orders from retail brokers that do not offer this certification and
that are perceived to have higher adverse selection costs could end up
receiving worse execution quality (i.e., less price improvement) than
they currently experience, but only if wholesalers today do not already
price in such risk when interacting with each retail broker. Customers
of retail brokers that certify they will not disclose their identity
could potentially receive worse execution quality if non-disclosure
signals to market participants that the adverse selection risk of the
order flow are high relative to orders from other
[[Page 217]]
broker-dealers. However, results from supra section VII.B.5.b indicate
that broker-dealers with higher adverse selection risk receive worse
execution quality from wholesalers, so it is unclear whether orders
stemming from certifying broker-dealers would receive inferior
execution quality relative to wholesaler internalization under the
current market structure.
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\592\ Proposed Rule 615 would require the identity of the
originating broker to be disclosed unless it received certification
that it has established, maintained, and enforced written policies
and procedures designed to assure that its identity will not be
disclosed, as specified in proposed Rule 615(e)(3). See supra
section IV.B.4. The impact of this certification is uncertain. Non-
disclosure would likely signal increased adverse selection risk of
the order to market participants. However, results from supra
section VII.B.5.b indicate that broker-dealers with higher adverse
selection risk receive worse execution quality from wholesalers, so
it is unclear whether orders stemming from certified broker-dealers
will receive inferior execution quality relative to wholesaler
internalization under the current market structure.
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Currently, wholesalers may choose not to internalize individual
investor orders with high adverse selection risk but instead pass them
on to other market makers, where they might be pooled with other
individual investor orders. This pooling might cause these orders to
receive greater price improvement from RLP programs or other hidden
liquidity on exchanges or ATSs than they would otherwise receive if
liquidity suppliers knew the identity of the originating broker. It is
therefore possible that the Proposal's requirement to disclose the
identity of the originating broker (absent a certification from the
originating broker that its identity not be disclosed) might result in
such orders receiving reduced execution quality relative to what they
currently receive to the extent they are pooled with orders from retail
brokers with lower adverse selection risk. However, to the extent
individual investor orders with high adverse selection risk orders are
currently rerouted to exchange limit order books, where they may be
effectively pooled with orders from other market participants with
potentially higher adverse selection risk, then it is also possible
that such orders could receive increased price improvement through
execution in qualified auctions relative to what they receive in the
current market structure. In sum, the more wholesalers already price in
the adverse selection risk from each retail broker, the less impactful
is the proposed requirement that retail brokers' identities be
disclosed in the auction.
c. Cost to Wholesalers
The Commission recognizes that the Proposal would significantly
impact the wholesaler market/business model. Wholesalers would have to
compete directly with other liquidity providers on an order-by-order
basis to provide price improvement to segmented orders in order to
execute against such individual investor orders in qualified
auctions.\593\ This would likely result in wholesalers filling fewer
individual investor orders than they do currently and would likely
pressure wholesalers to provide greater price improvement in order to
remain competitive in providing liquidity to segmented orders.\594\
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\593\ A wholesaler would not have to compete on an order-by-
order basis for an individual investor order if it internalized the
individual investor order at a price equal to the midpoint or
better, pursuant to Proposed Rule 615(b)(3).
\594\ As specified in section VII.B, the economic baseline
against which we measure the economic effects of this proposal,
including its potential effects on efficiency, competition, and
capital formation, includes the changes to the current arrangements
for consolidated market data in the MDI Rules; but those amendments
have not been implemented.
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The Commission recognizes that a wholesaler who exposes an order in
a qualified auction would still be able to internalize the order if it
submits the winning bid in the auction. However, because the order
would be subject to competition from other liquidity suppliers,
wholesalers would most likely not submit the winning bids in all of
these auctions and thus would ultimately internalize a smaller share of
order flow than they do now. Additionally, if a wholesaler decided to
internalize an individual investor order at the midpoint or better, the
order would not be required to be brought to a qualified auction.
However, the E/Q ratios presented in Table 9 indicate that, on average,
the execution prices of internalized individual investor orders are
between 30% to 80% worse than the midpoint at the time of order receipt
by the wholesaler. As such, the Commission believes that it would be
unlikely for wholesalers to internalize all segmented order flow priced
at the NBBO midpoint or better, although a fraction of segmented orders
are expected to be internalized at the NBBO midpoint, as they are
today.
Wholesalers could still end up trading with the majority of
marketable orders of individual investors, although more of these
orders might be executed on exchanges. Moreover, qualified auctions
would provide wholesalers with an opportunity to access individual
investor orders initially sent by retail brokers to other wholesalers.
That is, individual investor orders brought by a given wholesaler to a
qualified auction could be filled by another wholesaler that ends up
submitting the winning bid to the qualified auction. More generally,
wholesalers could have competitive advantages in supplying liquidity in
these auctions due to their economies of scale and market making
expertise. Therefore, while institutional investors would likely take
advantage of the opportunity to directly access low-cost order flow
provided by qualified auctions, it is nevertheless possible that
wholesalers would still end up frequently winning qualified auctions
and trading against a significant share of segmented orders. However,
individual investor order flow might end up being more spread out
across wholesalers rather than concentrated among two leading
firms.\595\
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\595\ See supra section VII.B.1.
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The Commission recognizes that retail brokers might consider
routing their orders directly to a qualified auction instead of through
wholesalers, especially if wholesalers discontinue offering PFOF.\596\
Furthermore, retail brokers could also route orders directly to a
national securities exchange, which could result in access fees but
also exchange rebate revenue.\597\ While the Commission is unable to
quantify the net effect of these factors on the overall routing
decisions of retail brokers, it is likely that the overall share of
individual investor order flow initially routed to wholesalers would
decrease, while the share initially routed to exchanges and ATSs
operating qualified auctions would increase.
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\596\ The Proposal would allow retail brokers to route customer
orders directly to a qualified auction with a specified limit price
(such that they would not be bidding on the order). See supra
section IV.A.
\597\ Broker-dealers would always have the option to direct
their orders to open competition trading centers or national
securities exchanges instead of qualified auctions under the
Proposal. Unlike qualified auctions, which would have auction fee
and rebate caps of 5 mils (for orders valued at $1.00 or greater per
share), national securities exchanges would continue to be able to
charge tiered fees and rebate revenue, consistent with the
requirements of Section 19(b) and Rule 19b-4.
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The predicted decline in wholesaler profit margins from
internalization might force wholesalers to reduce or cease paying PFOF,
which in turn, would remove a key incentive for some broker-dealers to
route to wholesalers. PFOF brokers route 97-98% of their market orders
to wholesalers, while non-PFOF brokers route around 71-72% of their
market orders to wholesalers.\598\ PFOF brokers could reduce their
dependence on wholesalers to usage rates similar to non-PFOF brokers if
PFOF ceased.
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\598\ See analysis in supra Table 4.
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Furthermore, the decline in wholesaler revenue and profit could
cause wholesalers to start charging retail brokers for the order
handling services that they provide. This could increase competition in
the market for exchange execution services and cause wholesalers to
lose market share against other providers of routing and execution
services. Alternatively, wholesalers might try to preserve their share
in order-handling services by continuing to not charge for their
routing and execution services to retail brokers (and thereby earn
lower profit margins),
[[Page 218]]
especially if handling marketable order flow provides additional
benefits, either in the qualified auctions or internalized individual
investor orders at the midpoint.\599\ The Commission is unable to
quantify the likelihood that wholesalers would continue to not directly
charge retail brokers to route and execute their orders, but believes
that it is possible that the majority of wholesalers would still not
charge retail brokers for order-handling services.
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\599\ Even if wholesalers do not internalize individual investor
orders, there might still be informational value from handling
individual investor order flow. Wholesalers could be incentivized to
offer free order routing to retail brokers in order to continue
receiving this information, which would include the identity of the
originating broker, the stock being traded and its order size,
direction of the trade, and any handling instructions that may have
been relayed to the broker, as well as the limit price if it's a
limit order. All of this information could help the wholesaler
assess the direction of the market. In addition, the wholesaler
could choose to internalize the order at midpoint (an allowable
exception to qualified auctions), which would provide additional
information on the direction of order flow that other market
participants would not have since there would be no auction message
in this case. Besides receiving a possible informational advantage
of having first look at individual investor orders, wholesalers
could also receive rebate revenue for submitting the order to a
qualified auction as well as SIP revenue, although the Commission
expects the rebate to be under 5 mils in order to be less than the 5
mil auction fee cap. See supra section IV.C.4 for a discussion of
fees and rebates. Finally, wholesalers could choose to internalize
the order if it was exposed in a qualified auction but did not
execute.
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The Commission also recognizes that a decline in wholesaler market
share would not only reduce wholesaler profits but might have spillover
effects on wholesaler costs. For example, a reduction in the volume of
individual investor order flow internalized by wholesalers could
increase wholesaler inventory risk, which in turn could cause
wholesalers to reduce the liquidity they supply as exchange market
makers or to institutional investors via SDPs.
d. Costs to Retail Brokers
i. Potential Initiation of Order Handling Fees by Wholesalers
Currently, wholesalers do not charge retail brokers for routing and
execution services, and pay some retail brokers PFOF for the right to
provide these services. If the implementation of qualified auctions
results in a significant loss of wholesaler profits, wholesalers might
have to begin charging for routing and execution services. If
wholesalers begin charging a fee for routing services, retail brokers
would have to absorb this cost and earn lower profits and/or pass on a
share of this cost to their customers. Retail brokers could also
respond to the initiation of wholesalers routing fees by paying the
compliance costs necessary to serve as an originating broker, or
instead pay fees to brokers that are able to route directly to
qualified auctions.
Retail brokers that certify that their identity would not be
subject to the proposed disclosure requirement would not only face
explicit costs for this certification (as discussed in supra section
VI.B.3) but also would either have to route the order to the qualified
auction themselves or use a routing service that wouldn't trade with
the orders, as mandated by the Proposal. If instead the broker-dealer
used a wholesaler to route its order, the wholesaler would have to
agree not to trade with the order (as mandated by the Proposal). In
response to this restriction, the wholesaler may offer less PFOF (if it
was currently receiving PFOF from the wholesaler) or potentially even
charge a fee for handling the order.
ii. Loss of PFOF Revenue
The Commission recognizes that the implementation of qualified
auctions, as mandated by the Proposal, could lead to a significant
decline or perhaps disappearance of PFOF in the markets for NMS stocks.
PFOF amounted to $235 million in Q1 2022 but was received almost
entirely (93.8%) by four firms.\600\ One concern is that the loss of
PFOF would cause PFOF brokers, and potentially other discount brokers,
to resume charging commissions for online NMS stock trades.\601\ Just
as PFOF brokers led discount brokers into zero-commission trading in
2019, it is possible they too could lead discount brokers back to
charging commissions if they stopped receiving PFOF.
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\600\ See analysis in supra Table 16 and corresponding
discussion.
\601\ See supra section VII.C.2.b.ii for a discussion.
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The Commission is unable to quantify the risk that some discount
brokers would resume charging commissions on NMS stock and ETF trades,
but there are a number of factors that might make this risk low. First,
the majority of PFOF received by retail brokers comes from transactions
in the options market.\602\ The Proposal would not have a significant
effect on the PFOF brokers receive from options transactions because it
applies only to transactions in NMS stocks.\603\ Additionally,
wholesalers may also continue paying retail brokers for segmented non-
marketable limit orders in NMS stocks, which may not need to be exposed
in qualified auctions under the Proposal if their limit price is at the
midpoint or a more favorable price. Therefore, to the extent that
retail brokers do rely on PFOF, they might be able to retain the
majority of the PFOF revenue they currently receive.
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\602\ See supra note 586.
\603\ There are key differences between the options market and
the market for NMS stocks; see supra note 235 for further
discussion. Proposed Rule 615 is designed to achieve policy
objectives that are particular to mandatory auctions in NMS stocks.
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Second, retail brokers might be able to expand existing revenue
lines or develop other lines of business to compensate for the loss of
PFOF revenue from NMS stock transactions. This includes the possibility
of increasing revenue from margin interest and securities lending,
which PFOF brokers currently utilize more heavily than the average
broker-dealer.\604\ Moreover, the retail broker industry did not
experience a drop in profits following the end of commissions.\605\
This includes non-PFOF brokers, who did not choose to make up for lost
commission revenue by charging wholesalers PFOF. The ability to
maintain or increase profits stemmed in part from the sudden increase
in customer accounts, due to, among other factors, increasingly
accessible online trading platforms and the initiation of fractional
share trading.\606\ Fractional share trading began with a single
broker-dealer in late 2019, but has grown dramatically since that time,
with an increasing number of broker-dealers offering this
functionality.\607\ Thus, just
[[Page 219]]
as retail brokers adjusted to the loss of commission revenue, they
could also adjust to the loss of PFOF revenue.
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\604\ See discussion in supra section VII.B.6.b.
\605\ See supra note 505 and corresponding discussion.
\606\ After falling during the 2016-2019 period from $229.2
billion to $197.8 billion, the average daily value of executions
rose in 2020 to $312 billion. See `Order Audit Trail System (OATS)
Activity--Daily Average OATS Events, 2016-2020', available at
https://www.finra.org/sites/default/files/2022-02/21_0078.1_Industry_Snapshot_v10.pdf. Fractional share trading allows
individual investors to trade and enter orders for fractional shares
of a security, e.g., an individual investor could submit an order to
buy 0.2 shares of a stock. Fractional share orders often arise from
retail brokers allowing individual investors to submit orders for a
fixed dollar value. It is the Commission's understanding that retail
or clearing brokers generally trade in a principal capacity against
their customers' fractional share orders and in turn send out
principal round lot sized orders for execution to manage their
inventory risk.
\607\ Evidence suggests that this growth is in great part due to
the rise in direct individual investor participation in equity
markets. See, e.g., Zhi Da, Vivian W. Fang & Wenwei Lin, Fractional
Trading (last revised May 6, 2022) (unpublished manuscript),
available at https://ssrn.com/abstract=3949697 (retrieved from
Elsevier database). See also Rick Steves, Fractional Shares Experts
Weigh In Amid Exploding Retail Trading Volumes, FinanceFeeds (June
7, 2021) available at https://financefeeds.com/fractional-shares-experts-weigh-in-amid-exploding-retail-trading-volumes/, which shows
that trading volume increased substantially (in one case, more than
1,400%) for brokers after they introduced the use of fractional
shares. Furthermore, an analysis using CAT data reveals that more
than 46 million fractional share orders were executed in Mar. 2022,
originating from more than 5 million unique accounts. Over 31
million of these orders were for less than 1 share, and they
originated from more than 3.3 million accounts. The overwhelming
majority (92%) of fractional share orders were attributed to natural
persons, i.e., individual investors. While fractional shares orders
represented only a small fraction (2.1%) of total executed orders,
they represent a much higher fraction (15.3%) of executions received
by individual investors.
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Third, to the extent that rebates paid on segmented orders routed
to qualified auctions are passed through to retail brokers, it could
supplement the revenue they may lose from a reduction in PFOF.\608\ The
5 mil cap on rebates that qualified auctions could pay for the
submission of segmented orders under the Proposal is approximately 40%
of the average combined PFOF rate paid by wholesalers for marketable
orders as estimated in Table 2.
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\608\ Similarly, if a wholesaler routes a segmented order to a
qualified auction and receives the rebate for the submission of a
segmented order, the wholesaler may indirectly pass the rebate from
the qualified auction through to the retail broker by using the
rebate to subsidize PFOF payments it makes to the retail broker.
---------------------------------------------------------------------------
Furthermore, there is reason to believe that adjustment to the loss
of PFOF would be much more manageable for the retail broker industry
than the loss of commissions from online NMS stock and ETF orders. The
average PFOF payment that brokers receive on a 100 share order is 10 to
20 cents,\609\ far less than the commission fees previously charged by
broker-dealers, which had generally been $5 or more.
---------------------------------------------------------------------------
\609\ See analysis in supra Table 17.
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While PFOF payments per order are relatively small, the small group
of retail brokers (10 firms) that earn at least 2% of their revenue
from PFOF on NMS stocks \610\ could be pressured to develop or increase
other revenue lines and/or attract additional customers to make up for
the loss of PFOF. However, the dependence on PFOF for some of the top
recipients of PFOF stemming from NMS stock orders has diminished in
recent years due to mergers between PFOF-dependent firms and firms with
less reliance on PFOF. This includes the single largest recipient of
PFOF, which was purchased by a larger (i.e., higher revenue) retail
broker firm that had a much smaller share of its revenue stemming from
PFOF.\611\ Moreover, the purchasing firm in this merger had a much more
diversified revenue portfolio, including a large collection of
proprietary mutual funds and ETFs under management and a banking unit.
In addition, the third largest recipient of PFOF was purchased in 2020
by a larger, full service broker with no reliance on PFOF. These
mergers should help insulate leading recipients of PFOF from the
financial damage that would result from the loss of PFOF due to
Proposed Rule 615.
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\610\ See analysis in supra Table 16.
\611\ The largest dollar recipient of PFOF received $101.5
million in PFOF from NMS stocks in Q1 2022, equal to 5.7% of its
total revenue. The purchasing firm in this merger received $28.9
million in PFOF in NMS stocks Q1 2022, equal to 1.5% of its total
revenue.
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e. Costs to Exchanges
The Commission is mindful that the increase in competition to
attract and execute orders of individual investors due to the Proposal
could significantly impact costs for some exchanges and ATSs.\612\
These costs would be in addition to the compliance costs estimated in
section VII.D.2.a., and include the potential loss of market share for
some exchanges and ATSs. The Commission believes that most marketable
orders of individual investors would end up being exposed and executed
in qualified auctions hosted by exchanges, which would increase the
overall percentage of individual investor orders executed on exchanges,
and decrease the percentage internalized by wholesalers. The market
share of ATSs is expected to be stable because they do not handle
significant fractions of marketable individual investor orders and thus
are not affected by the proposed introduction of qualified auctions.
The Commission believes that few ATSs would operate qualified auctions,
either because it would be difficult for new ATSs to meet the
requirements to run qualified auctions or because the requirements of
operating a qualified auction would be incompatible with the business
models of most currently operating ATSs.\613\
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\612\ Retail brokers may also choose to directly route their
orders to qualified auctions, and may therefore compete with
wholesalers, ATSs, and exchanges in executing retail orders.
However, the Commission believes that broker-dealers will play a
much more minor role in this competition.
\613\ Of the 32 NMS Stock ATSs, the Commission estimates that
approximately 3 would operate qualified auctions. See supra section
VI.C.4 for further discussions of the estimates of how many NMS
Stock ATSs would operate qualified auction.
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An NMS Stock ATS that wanted to run qualified auctions would face
numerous requirements, including the need to: permit any registered
broker-dealer to become a subscriber; provide equal access among all
subscribers of the NMS Stock ATS and the registered broker-dealer of
the NMS Stock ATS to all services that are related to a qualified
auction operated by the NMS Stock ATS or to any continuous order book
operated by the NMS Stock ATS; \614\ display quotes in the ADF (and
thus in the consolidated market data feed); and reveal the identity of
the trading venue for trades executed on the ATS and report those
trades to the TRF (which would report the trades and identity of the
trading venue to the consolidated market data feed); operate as an
automated trading center pursuant to Regulation NMS Rule 603(b) and
have an average daily share volume of 1.0 percent or more of the
aggregate average daily share volume for NMS stocks.\615\ ATSs would
have to make significant adjustments to their business models
(especially with regards to segmenting customer orders and displaying
quotes) in order to meet these requirements.\616\ Additionally, new
ATSs that could meet the other requirements might find it difficult to
achieve 1% market share of trading volume in four out of six months
without being able to concurrently operate a qualified auction.
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\614\ This would prohibit the ATS from segmenting customer
orders outside of qualified auctions (unless the orders were
executed at midpoint) and require it to charge the same fee to all
subscribers (see supra section IV.C.4), thereby prohibiting them
from charging tiered auction fees or providing tiered rebates.
\615\ See supra section IV.B.2.b.
\616\ The Commission estimates that 3 NMS stock ATSs would
participate in qualified auctions. See supra section VI.C.4.
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The Commission acknowledges that Proposed Rule 615 might improve
the competitive position of higher volume exchanges that offer
qualified auctions and harm the competitive position of lower volume
exchanges that do not. Higher volume exchanges that executed 1% or more
of the average aggregate daily share volume for NMS stocks during 4 of
the last 6 months would be eligible to run qualified auctions for
segmented orders.\617\ Exchanges that offered qualified auctions would
have a competitive advantage in attracting marketable individual
investor order flow because they would be able to segment the
individual investor order flow and allow liquidity suppliers to trade
against this order flow in smaller pricing increments in their
qualified auctions.\618\ Lower volume exchanges that do not meet the
volume thresholds to run qualified auctions would not be able to
segment individual investor order flow, unless they did so under one of
the exceptions, such as offering
[[Page 220]]
liquidity to individual investor orders only at the NBBO midpoint.\619\
Additionally, exchanges not offering qualified auctions would be unable
to execute segmented orders at the finer 0.1 pricing increments that
would be available in the qualified auctions. These factors could all
limit the competitiveness of smaller exchanges.
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\617\ The Commission estimates that six national securities
exchanges would meet the proposed threshold. These include one
exchange each from the NYSE, NASDAQ, and CBOE groups, as well as
MEMX, IEX, and MIAX PEARL.
\618\ See supra section IV.G for discussions on restrictions on
exchanges from operating any separate trading mechanism for
segmented orders other than qualified auctions.
\619\ See supra section IV.B.2.a for a discussion of lower-
volume exchanges.
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There is also the possibility that if a disproportionate share of
order flow is routed to one or more exchanges offering qualified
auctions, these exchanges might become the preferred trading location
for any given stock. This, in turn, could cause a liquidity externality
to develop, making these venues the preferred routing destination for
all orders.\620\ Under such circumstances, while the consolidation of
liquidity on these exchanges might benefit market participants in the
short run, it may also lead to barriers to entry in the market for
trading services, as new entrants would have a harder time attracting
sufficient liquidity away from established liquidity centers. Lower
volume exchanges could also be adversely impacted by the fact that
under the Proposal, exchanges would have to stop offering RLP programs
unless the program resulted in trades only at the NBBO midpoint,
consistent with a proposed exception. This could result in a reduction
in the trading volume and revenues received by lower-volume exchanges
that do not meet the threshold to offer qualified auctions.\621\
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\620\ A liquidity externality could emerge if orders tended to
concentrate in one auction, such that it would become the preferred
routing destination and attract more orders. Orders in more liquid
venues would be more likely to execute at better prices, which in
turn, would provide such venues with a competitive advantage over
less liquid venues.
\621\ The Commission believes that the mandated auction
mechanism largely would remove the need for RLPs run by exchanges
that would meet the criteria to run qualified auctions. However,
exchanges that operate RLPs that do not serve as qualified auctions
host would be negatively impacted by having their RLP services
curtailed. Individual or institutional investors, however, should
not be significantly adversely impacted by the loss of these RLP
services. From the perspective of individual investors, it would be
unnecessary to execute orders through RLPs because any non-directed
retail order would have a chance to be exposed to open competition,
either because the order would be filled on a riskless principal
basis, or because the wholesaler who considers internalizing an
order would first be required to bring it to a qualified auction.
From the perspectives of other market participants, e.g.,
institutional investors, qualified auctions would provide a superior
means, relative to RLPs, for these participants to directly interact
with retail orders. This is the case because (1) unlike RLPs,
qualified auctions require that characteristics of the order are
communicated to bidders, including its price, size, and the name of
the underlying retail broker; and (2) qualified auctions would allow
market participants to interact with a substantially larger and more
persistent pool of segmented retail order flow, relative to that
available through RLPs. However the Commission acknowledges that the
loss of RLP services may adversely impact market participants that
may currently supply liquidity through existing RLPs but would not
be fast enough to submit an auction response to a qualified auction
message.
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The Commission is unable to quantify the likelihood that one or
more exchanges that would be unable to offer qualified auctions would
cease operating. However, the Commission preliminarily believes that
this risk of this is low because the majority of individual investor
marketable orders are not currently routed to exchanges. Therefore,
even if they are not eligible to run qualified auctions under the
Proposal, the reduction in trading volume that these exchanges might
experience is unlikely to be large enough to require them to exit the
market. Even if such an exit were to occur, the Commission does not
believe this would significantly impact competition in the market for
trading services because the market is served by multiple competitors.
Consequently, if one or more lower-volume exchanges were to exit the
market, demand would likely to be swiftly met by existing competitors.
The Commission recognizes that lower-volume exchanges might have unique
business models that are not currently offered by competitors, but
believes that a competitor could create similar business models if
demand were adequate, and if they did not do so, it seems likely new
entrants would do so if demand were sufficient.
f. Costs to Institutional Investors
The Commission recognizes that the Proposal could increase the risk
of information leakage for institutional investors in at least two
ways.
First, the risk of information leakage may increase for those
institutional investors that choose to supply liquidity in qualified
auctions. Specifically, market participants could use auction message
information \622\ to identify the trades in consolidated market data
that correspond to executions of individual investors orders in
qualified auctions, which could allow these market participants to back
out information about the corresponding institutional bids.\623\ For
example, if a market participant observes that a large volume of
individual investor buy orders are filled in qualified auctions, they
could correctly discern that an institutional investor may be providing
a large sell order. However, in response to this concern, institutional
investors could decide to route their orders to ATSs and OTC market
makers, where information about their orders may be better
concealed.\624\ To the extent that concerns over the risk of
information leakage prevent institutional investors from seeking
liquidity through qualified auctions, this could limit the benefits of
the Proposal.
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\622\ Proposed Rule 615(c)(1) specifies that an auction message
announcing the initiation of a qualified auction for a segmented
order must be provided for dissemination in consolidated market
data, including the disclosure that the auction is for a segmented
order, the identity of the open competition trading center, NMS
stock symbol, side (buy or sell), size, limit price, and identity of
the originating broker for the segmented order (unless they
certified that no bidder in the qualified auction knew the identity
of the originating broker). Note that institutional bids in
qualified auctions would not be revealed unless they were the
winning bid and resulted in an execution.
\623\ See, e.g., Liyan Yang & Haoxiang Zhu, Back-Running:
Seeking and Hiding Fundamental Information About Institutional Order
Flows, 33 Rev. Fin. Studies 1484, 1487 (2020) (``. . .information
about retail order flows is equivalent to information about
institutional order flows, by market clearing.'').
\624\ Trades executed off-exchange, including those executed on
ATSs and by OTC market makers, are reported to Trade Reporting
Facilities (TRFs), which are facilities through which members report
transactions in NMS stocks, as defined in SEC Rule 600(b)(47) of
Regulation NMS. See Trade Reporting Facility (TRF), FINRA, https://www.finra.org/filing-reporting/trade-reporting-facility-trf.
However, as a result of the Proposal, it may be easier to identify
institutional trades using TRF data; see infra this section for
further discussion. Furthermore, it may currently be possible to
identify institutional trades in TRF data; see infra note 627 and
corresponding discussion.
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Second, as individual investors' marketable orders would be
increasingly routed to and executed in qualified auctions under the
Proposal, and as these orders would become more easily identifiable
through the information contained in auction messages as described
above, it may become increasingly possible to identify information
about off-exchange institutional trades in TRF data.\625\ In the most
extreme case, if virtually all individual investor orders are routed to
and executed in qualified auctions, market participants may be able to
identify nearly all off-exchange institutional transactions reported in
the TRF data as originating from institutional trades.\626\ In this
way, information leakage might increase even for institutional
investors that choose not to participate in qualified auctions.
---------------------------------------------------------------------------
\625\ See, e.g., Yang & Zhu, supra note 623, for further
discussions on the identifying institutional investor orders.
\626\ For those individual investor orders that would have been
internalized by wholesalers and reported as a trade to the TRF but
are instead executed in qualified auctions, these trades would be
reported as trades executed on the exchange or ATS operating the
qualified auction, rather than reported to the TRF. This would
reduce the number of individual investor trades reported to the TRF.
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However, it is possible that information on institutional order
flow
[[Page 221]]
is already discernable through multiple means. First, there is evidence
that institutional order flow can be inferred by first identifying
individual investor order flow, which can be estimated using sub-penny
trades in TRF data.\627\ In addition, wholesalers already may have the
ability to discern institutional order flow due to their knowledge of
individual investor order flow. Thus, while there is concern over
information leakage for institutional order flow, it may be the case
that much of this information is already identifiable. To the extent
that qualified auctions would result in further information leakage,
the Proposal may result in additional costs for institutional
investors.\628\ However, this effect could be balanced by the increased
price improvement that institutional traders would receive by being
able to interact directly with individual investor order flow in
qualified auctions.
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\627\ See, e.g., Boehmer et al., supra note 572, who use this
methodology to identify individual investor activity. Specifically,
using TRF data, the authors identify transactions as retail buys if
the transaction price is slightly below the round penny and as
retail sells if the transaction price is slightly above the round
penny. Some institutional trades receive sub-penny price improvement
as a result of midpoint trade price ends in a half-penny. Thus,
trades at or near a half-penny are likely to be from institutions
and are not assigned to the retail category.
\628\ For example, in a study of the Swedish equity market, one
academic paper found that a one-standard-deviation increase in the
extent to which HFTs trade in the same direction as large
institutional orders is associated with a $4,480 higher order
execution cost for institutional investors. This result led the
authors to conclude that the detection of large institutional orders
is costly for institutional investors. See Vincent Van Kervel &
Albert J. Menkveld, High-Frequency Trading Around Large
Institutional Orders, 74 J. Fin. 1091 (2019).
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The Proposal may also result in wholesalers reducing the liquidity
they supply to institutional investors via SDPs.\629\ With reduced
wholesaler liquidity provision on SDPs, institutional investors might
have to resort to other sources of liquidity, e.g., exchanges and ATSs
or supplying liquidity to qualified auctions. An appealing feature of
SDPs from an institutional investor perspective is the possibility of
disclosing intended order size without being detected by other market
participants competing for the same liquidity. By switching to other
sources of liquidity, institutions would no longer enjoy this benefit.
Hence, these institutions might find it more costly to locate liquidity
as they need to protect their intended trade sizes to minimize price
impact of trades.\630\
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\629\ See supra section VII.C.2.c.
\630\ However, institutional investor costs could also fall when
they are able to trade against individual investor orders in
qualified auctions. See supra section VII.C.1.c.
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g. Effects on Exchange Limit Order Books (LOBs) Liquidity
There is a possibility that Proposed Rule 615 could cause displayed
LOB liquidity to decrease. The Commission believes that the Proposal
might entice some liquidity provision to be redirected from exchange
LOBs to qualified auctions,\631\ which could have an adverse impact on
quoted LOB depth and the NBBO. More specifically, if liquidity is
diverted to qualified auctions, there is the risk that the NBBO could
widen because some market participants might reduce the frequency or
the size of the orders they submit to the LOB, including orders that
set the NBBO prices.\632\ However, there would be trade-offs regarding
the execution risk and execution price that might limit the incentives
to bid in an auction compared to supplying liquidity in the LOB.\633\
Moreover, the majority of marketable orders of individual investors are
already segmented from exchanges and thus are not currently reaching
exchange LOBs.\634\ Therefore, although LOB liquidity may decline under
the Proposal, there is the potential that the direct effect of
qualified auctions on LOB liquidity may not be significant.
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\631\ The Commission also is proposing to amend rules addressing
minimum pricing increments. See Minimum Pricing Increments Proposal,
supra note 98. The Commission encourages commenters to review that
proposal to determine whether it might affect their comments on this
proposing release.
\632\ The submission of smaller orders might also require
aggregation of odd-lot orders across more price levels to reach a
round lot size, which would cause the NBBO to widen.
\633\ See infra section VII.C.3.a.iii for further discussion on
the trade-offs involved in supplying liquidity to a qualified
auction vs. submitting an order to an LOB.
\634\ See supra section VII.B.2.a for a discussion of estimates
that appear to indicate that over 90% of individual investor
marketable orders are routed to wholesalers and supra section
VII.B.2.b for estimates that wholesalers internalize 90% of executed
dollar volume in individual investor marketable orders that were
routed to them.
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An additional possibility is that if the Proposal results in the
elimination of zero-commission trading, retail trading volume could
decline and the overall pool of liquidity could shrink due to increased
wholesaler inventory risk.\635\ A lower overall liquidity level might
also manifest itself in lower displayed liquidity in exchange LOBs. For
example, the introduction of qualified auctions might induce some (more
sophisticated) individual investors to switch from placing non-
marketable limit orders priced at or outside the NBBO to placing (a)
marketable orders or (b) non-marketable orders priced between the
midpoint and the NBO (NBB) for buy (sell) orders, which may participate
as segmented orders in qualified auctions.\636\ In this sense, the pool
of non-marketable resting orders that would be routed to exchanges
might shrink, potentially reducing the depth at the NBBO.
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\635\ A reduction in retail trading volume as a result of the
Proposal may decrease a wholesaler's ability to manage their
inventory risk associated with their other trading activities, such
as exchange market making or supplying liquidity through their SDPs.
This may cause wholesalers to reduce the liquidity they supply in
their other activities.
\636\ A segmented order in a qualified auction could have the
benefit of an increased likelihood of execution compared to non-
marketable limit orders submitted to a LOB because bidders may
supply liquidity (and potentially earn part of the spread) to orders
submitted to a qualified auction. Non-marketable limit orders
submitted to a LOB would have to wait until an opposite side
marketable order arrived to potentially execute, which could result
in a greater risk of the order not executing. However this increased
likelihood of execution would come at the cost of earning a spread
by using a non-marketable limit order.
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3. Competition
a. The Market for Trading Services in NMS Stocks
As discussed in more detail below, the creation of qualified
auctions under the Proposal would result in most marketable orders of
individual investors being exposed in qualified auctions on exchanges
and ATSs that are eligible to serve as open competition trading
centers.\637\ The Commission estimates that 6 exchanges and 3 ATSs
could operate qualified auctions. Exchanges should have strong economic
incentives to offer qualified auctions because the lower adverse
selection risk of marketable order flow of individual investors makes
it a valuable commodity that would attract trading interest from other
market participants and increase the exchange's trading volume and the
associated revenue it delivers.\638\ For this reason, it is likely that
there would always be at least one
[[Page 222]]
exchange or ATS operating a qualified auction.\639\
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\637\ Proposed Rule 615 covers only NMS stocks. Qualified
auctions would be conducted for ``segmented orders,'' which would be
defined in Proposed Rule 600(b)(91) as an order for an NMS stock for
an account of a natural person, or an account held in legal form on
behalf of a natural person or group of related family members, and
that for such an account, the average daily number of trades
executed in NMS stocks must be less than 40 in each of the preceding
six calendar months. See supra note 194 and corresponding text for a
discussion of a Commission analysis indicating that during the six-
month period (Jan. 1, 2022, to June 30, 2022), slightly more than
99.9% of individual investor accounts averaged 40 or fewer orders
per day that resulted in a trade. Moreover, during the same period,
99% of individual customer accounts averaged 1.86 or fewer orders
per day that resulted in a trade; see analysis in infra Table 22.
\638\ See supra section IV.B.2 for further discussion on the
incentives for exchanges and ATSs to offer qualified auctions.
\639\ In cases where no open competition trading center chose to
operate a qualified auction for a security, the broker-dealer or
wholesaler handling the order would have the option to internalize
the order. See supra section IV.A for further discussion of options
for segmented orders that did not receive an execution in a
qualified auction. However, it's very likely that at least one
exchange or ATS would operate a qualified auction for an order.
Because of the low adverse selection risk associated with segmented
orders, if a single exchange or ATS operated a qualified auction,
the trading facility would likely attract additional order flow to
supply liquidity to segmented orders, which would increase its
trading volume. This could potentially increase the exchange or
ATS's revenue because a portion of SIP revenue is allocated among
facilities based on trading volume (FINRA also rebates SIP revenue
it receives for the TRF back to its members based on their trading
volume).
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Exchanges and ATSs operating qualified auctions would significantly
increase competition among liquidity suppliers to fill marketable
orders of individual investors, since the majority of these orders are
currently internalized by wholesalers without competition on the
individual order basis.\640\ This increase in competition would have a
significant effect on the business model of wholesalers and might
reduce the volume of order flow that they internalize. This would
affect the competitive dynamics between exchanges, wholesalers and ATSs
related to how they compete for both individual and institutional order
flow and could result in more orders being routed to exchanges that run
qualified auctions. Additionally, there would be competitive
implications for how qualified auctions interact with exchange LOBs.
Additional analysis is provided below regarding the expected impact of
the Proposal on competition: (i) in the market to supply liquidity to
individual investor orders, (ii) between exchanges, ATSs, and
wholesalers, and, (iii) between exchange LOBs and qualified auctions.
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\640\ See supra section VII.B.2.b for a discussion of wholesaler
internalization.
---------------------------------------------------------------------------
i. Competition To Supply Liquidity to Individual Investor Orders
Qualified auctions would enhance competition to provide liquidity
to individual investors at the individual order level by drawing
additional liquidity from other market participants besides the
wholesaler handling the individual investor order, including other
wholesalers that could bid in the auctions. Currently, once a
wholesaler receives order flow, another wholesaler is unable to
interact with these orders unless they are rerouted to that other
wholesaler. Routing these orders to qualified auctions would prevent
these orders from being isolated and instead allow them to be exposed
to other market participants, including other wholesalers, that could
bid for the right to execute them.
The lower adverse selection risk of individual investor orders
should incentivize other liquidity providers to participate in
qualified auctions. It is the Commission's understanding that market
participants quote significant liquidity at prices superior to the
NBBO.\641\ This liquidity primarily includes inside-the-NBBO odd-lot
liquidity quoted on exchanges and non-displayed liquidity quoted on
exchanges and ATSs, originating from various market participants,
including institutional investors, market makers, and individual
investors. In addition, some market participants that currently use
marketable orders to demand liquidity from intermediaries might benefit
from participating in qualified auctions, i.e., quote liquidity at
prices better than the NBBO, to satisfy their liquidity needs. Proposed
Rule 615 would provide an opportunity for these participants to
potentially trade with individual orders with lower adverse selection
by redirecting their liquidity provision to open qualified auctions or
to switching from demanding to supplying liquidity through qualified
auctions.
---------------------------------------------------------------------------
\641\ See supra Table 20 and accompanying discussion in supra
section VII.C.1.b for estimates of liquidity available at the NBBO
midpoint on exchanges and NMS Stock ATSs when a wholesaler
internalizes a trade.
---------------------------------------------------------------------------
It would also give institutional investors a chance to directly
interact with individual investor orders with a minimal degree of
intermediation. For example, institutional investors with pressing
liquidity demand typically rely on optimal trade execution algorithms
that split their trades into child orders, which may demand liquidity,
including on SDPs, where they may potentially end up paying the full
spread.\642\ The availability of marketable individual investor order
flow at qualified auctions would likely draw institutional trade
execution algorithms to supply liquidity in qualified auctions, where
they might trade at the quote midpoint or at least inside the NBBO. By
doing so, institutional orders would be filled without paying the full
spread. This would not only increase the competition in liquidity
provision against individual investor orders, but would also reduce
institutional trading costs.
---------------------------------------------------------------------------
\642\ See supra section VII.B.3 for further discussions on how
institutional investors may indirectly interact with individual
investor orders via trading on SDPs.
---------------------------------------------------------------------------
Some auction features would also enhance competition to supply
liquidity to individual investor orders. The Proposal would facilitate
finer price improvements for inside-NBBO orders by allowing a 0.1-cent
quoting increment for shares priced at $1.00 or more per share. This
would enhance competition by improving the ability of market
participants to be able to compete on price in their auction responses,
since they could quote in finer increments than they could on exchange
or ATS LOBs.\643\ An additional source of increased competition to
supply liquidity would stem from the implementation of a 5 mil auction
fee and rebate cap for shares priced at $1.00 and above and 0.05% for
share prices under $1.00. Mandating low, flat fees and rebates in
qualified auctions should promote a level playing field among all
potential market participants that may wish to trade with segmented
orders and therefore serve to increase competition among liquidity
suppliers.\644\
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\643\ See supra section VII.C.1.a for further discussions on how
the auction pricing increment could improve competition among
liquidity suppliers.
\644\ See id. and supra section IV.C.4 for additional
discussions on the auction fee and rebate caps.
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The Commission is uncertain what effect the proposed requirement to
give customer orders priority if auction responses are at the same
price would have overall on the competition to supply liquidity to
individual investor orders. On the one hand, giving priority to
customer orders may encourage more customers, including institutional
investors, to participate in qualified auctions, potentially increasing
competition to supply liquidity to segmented orders. On the other hand,
it could discourage liquidity provision by broker-dealers in qualified
auctions, potentially decreasing competition to supply liquidity to
segmented orders. However, qualified auctions overall would still
enhance competition among broker-dealers to supply liquidity to
individual investor marketable orders, because a significant portion of
these would be exposed to multiple broker-dealers in a qualified
auction instead of being execution in isolated at a wholesaler.
The Commission acknowledges that there could be some limitations on
the increases in competition to supply liquidity to individual investor
orders. The Commission recognizes that there are some institutional
investors that may currently source liquidity from SDPs in order to
avoid triggering reactions by market participants who would observe
institutional trades might avoid qualified auctions and instead
continue to access liquidity via other
[[Page 223]]
methods. Additionally, due to the sub-second duration of the auctions
mandated by the Proposal, participation would require access to
algorithmic trading technology, which could prevent some potential
providers of liquidity from participating in qualified auctions.\645\
In sum, however, the net effect of qualified auctions would be an
increase in competition to supply liquidity to the orders of individual
investors.
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\645\ See supra section VII.C.1.a for further discussion on the
effect of not having access to algorithmic technology on qualified
auction participation.
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ii. Competition Among Exchanges, ATSs, and OTC Market Makers
Proposed Rule 615 would increase competition among wholesalers,
ATSs, and exchanges in attracting and executing order flow of
individual investors.\646\ It is likely that the share of order flow
currently internalized by wholesalers or executed on ATSs that do not
serve as auction hosts would decline. Wholesalers receiving order flow
from retail brokers could still end up internalizing a substantial
portion of orders that they route to qualified auctions. However,
because the orders would be subject to competition from other liquidity
suppliers, wholesalers would likely win a smaller share of auctions
compared to the share of orders that they currently internalize, for
which they do not face competition at the individual order level.
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\646\ Retail brokers might also choose to directly route their
orders to qualified auctions, and might therefore compete with
wholesalers, ATSs, and exchanges in executing individual investor
orders. However, the Commission believes that broker-dealers would
play a much more minor role in this competition.
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The Proposal might improve the competitive position of higher
volume exchanges that offer qualified auctions and harm the competitive
position of lower volume exchanges that do not. Higher volume exchanges
that execute 1% or more of the average daily share volume for NMS
stocks during 4 of the last 6 months would be eligible to run qualified
auctions for segmented orders.\647\ Exchanges that offered qualified
auctions would have a competitive advantage in attracting marketable
individual investor order flow because they would be able to segment
this order flow and allow liquidity suppliers to trade against it in
smaller pricing increments ($0.001) in the qualified auctions that they
host compared to the minimum price increment on national exchanges
($0.01).\648\ The Commission is unable to quantify the likelihood that
one or more exchanges that would be unable to offer qualified auctions
would cease operating. Even if such an exit were to occur, the
Commission does not believe this would significantly impact competition
in the market for trading services because the market is served by
multiple competitors.\649\
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\647\ The Commission estimates that six national securities
exchanges would meet the proposed threshold. These include one
exchange each from the NYSE, NASDAQ, and CBOE groups, as well as
MEMX, IEX and MIAX PEARL.
\648\ Qualified auctions would have a price increment of $0.001
for shares priced at $1.00 or greater and 0.1% for shares under
$1.00, in contrast to national exchanges, which have a minimum price
increment of $0.01.
\649\ See supra VII.B.1 for a discussion of the market for
trading services in NMS stocks. See also supra section VII.C.2.e for
additional discussion on the effects of the Proposal on small and
large exchanges.
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The Proposal would also likely increase competition between
exchanges, ATSs, and OTC market makers to attract institutional order
flow. The requirement to expose segmented orders in qualified auctions
could improve the competitive position of exchanges and ATSs that run
qualified auctions relative to most ATSs \650\ and all OTC market
makers, including SDPs, which would not be allowed to host auctions.
The resulting increase in marketable orders of individual investors
routed to exchanges and ATSs that operate qualified auctions, relative
to other venues, would entice institutional investors to seek to supply
liquidity to marketable individual investor orders through these
auctions.
---------------------------------------------------------------------------
\650\ As discussed in supra section VI.C.4, the Commission
believes that 3 ATSs would operate a qualified auction.
---------------------------------------------------------------------------
The Proposal would likely have an adverse impact on the competitive
positions of wholesaler-affiliated SDPs to attract institutional order
flow by reducing the liquidity available therein to institutional
investors.\651\ Specifically, the Proposal might lead retail brokers to
directly route more of their customer orders to exchanges and ATSs
operating qualified auctions instead of directing their orders to
wholesalers.\652\ In addition, wholesalers receiving orders from retail
brokers that they then route to qualified auctions could lose a
significant share of these auctions to other bidders. These effects
would hamper the ability of wholesaler-operated SDPs and other OTC
market makers to manage their inventory risk by internalizing incoming
individual investor order flow. This might reduce the ability of these
wholesalers and other market makers to provide liquidity to
institutional investors, who might instead rely on other trading
venues, including qualified auctions, to meet their liquidity needs.
The Commission is unable to quantify the extent to which institutional
order flow would migrate to exchanges or ATSs that run qualified
auctions.
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\651\ Institutional investors (or the brokers that represent
them) would be able to bid in qualified auctions in order to
directly interact with individual investor orders. This could give
the execution of institutional orders better terms because
institutional investors would not need to compensate the wholesaler
for the intermediation services provided by their SDPs. As such,
some of the institutional interest would migrate from its SDPs to
qualified auctions due to more competitive pricing in the qualified
auctions. Therefore, the loss of access to liquidity for
institutional investors provided by SDPs would be mitigated by the
ability of institutional traders to supply liquidity to marketable
orders of individual investors in qualified auctions. See supra
section VII.B.3 for further discussions on institutional investors
interactions with SDPs.
\652\ See supra section VII.C.1.a.
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The risk of information leakage from institutional investors'
orders participating in qualified auctions could also impact
competition between exchanges, ATSs and OTC market makers. The
Commission recognizes that concerns over the risk of information
leakage could prevent institutional investors from seeking to provide
liquidity in qualified auctions.\653\ One possible way that leakage
could occur is if a large volume of individual investor buy orders are
filled consecutively at the midpoint, then market participants might
correctly discern that an institutional investor is working a large
sell order. Because the side and venue of an institutional order
executed off-exchange would continue not to be revealed in a TRF trade
print under Proposed Rule 615, ATSs and OTC market makers would remain
competitive in terms of their ability to conceal intended institutional
trades.\654\ Institutional investors would likely weigh the trade-off
between potentially lower trade costs provided by qualified auctions
and the greater concealment of their trading intentions provided by
off-exchange executions. In cases where the latter objective was
paramount, institutional investors could decide to avoid routing some
of their orders to qualified auctions. As such, ATSs and OTC market
makers might remain attractive trading venues for such institutional
orders.
---------------------------------------------------------------------------
\653\ See supra section VII.C.2.f for additional discussions on
how the Proposal could affect information leakage of institutional
investor orders.
\654\ Institutional bids in qualified auctions would also have
some ability to be concealed, because they would not be revealed
unless they were the winning bid. If they do have the winning bid,
the side, venue, and price of the institutional bid would be
revealed, which may provide more information leakage than some
trades on ATSs.
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Overall, however, the increase in marketable order flow on
exchanges and
[[Page 224]]
ATSs that operate qualified auctions, relative to other venues, would
entice institutional investors to supply liquidity to marketable
individual investor orders through these auctions. Due to the enhanced
competition provided by qualified auctions, it is likely that execution
costs of institutional investors' parent orders would be reduced, which
in turn, should further the likelihood that institutional order flow
would be attracted to exchanges and ATSs that operate auctions. The
execution priorities of Proposed Rule 615 would reinforce this effect.
Under paragraph (c)(5)(ii) of the proposed rule, if an institutional
investor and a wholesaler (broker-dealer) were bidding the same price
in a qualified auction, the investor would have execution priority. As
such, all else constant, institutional investors would win qualified
auctions when competing with wholesalers. This would reduce execution
uncertainty from the perspectives of institutional investors who would
consider bidding in qualified auctions on exchanges, as well as reduce
their trading costs as a result of direct interactions with individual
investor order flow. These collective effects would result in less
institutional orders being routed to ATSs and OTC market makers,
including SDPs.
The Proposal would also generate competition between qualified
auctions that are offered on different exchanges and ATSs.\655\ Open
competition trading centers running qualified auctions might compete
with each other by trying to offer the most price improvement in their
auctions.\656\ They might also compete with each other through
innovations in their auctions protocols in order to differentiate
themselves and attract more segmented orders and liquidity suppliers.
Open competition trading centers might also try to compete with each
other on the basis of fees or rebates they charge in their qualified
auctions. However, the Commission believes that this form of
competition might be limited because of the flat 5 mil auction fee and
rebate cap on executed auction responses and the flat 5 mil rebate cap
on segmented orders submitted to auctions.\657\ More specifically,
while providers of qualified auctions could compete by charging a fee
under the 5 mil cap, this discount would provide far less latitude for
attracting orders compared to the 30 mil fee cap on the LOB.\658\
Furthermore, volume-based rebate and fees, which are utilized by many
exchanges in their transaction based fee schedules, would not be
permitted within qualified auctions (but would remain permitted on
exchange LOBs). Therefore, the Commission believes that competition
based on auction fees and rebates would be minimal.
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\655\ The Commission includes ATSs to the degree that they would
offer qualified auctions. See supra section VII.C.1.a.
\656\ See supra section VII.C.1.a.
\657\ See supra section VII.C.1.a for further discussions on the
effects of auction fees and rebates.
\658\ See 17 CFR 242.610(c).
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iii. Competition Between Qualified Auctions and Exchange LOBs
The Commission believes that the Proposal might entice some
liquidity provision from exchanges' LOB to qualified auctions. A core
function of the mandated qualified auction mechanism under Proposed
Rule 615 would be to segment order flow of individual investors,
leading to a concentration of this order flow in qualified auctions. As
a result, some market participants might consider redirecting liquidity
provision from the LOB to qualified auctions. In doing so, market
participants would need to consider the following under the Proposal:
(1) Displayed orders on the LOB would have priority over auction
responses if they were listed at the same price, and a winning auction
response would have priority over hidden orders on the LOB; (2) for
shares priced $1 or greater, LOB quoting is subject to a 1-cent price
increment,\659\ while qualified auctions would accept bids using a 0.1-
cent price increment, allowing auction responses to jump in front of
LOB quotes by quoting at sub-penny prices; and (3) broker-dealers with
knowledge of where a segmented order is to be routed would not be
allowed to submit LOB orders that could have priority to trade with the
segmented order.\660\ To the extent that market participants quoting
visible or hidden liquidity on the LOB prefer to trade against the
individual investor segment of the order flow through qualified
auctions, they might provide liquidity to auctions rather than quote
liquidity on the LOB.
---------------------------------------------------------------------------
\659\ See supra note 146.
\660\ See Proposed Rule 615(f)(2).
---------------------------------------------------------------------------
The Commission is unable to quantify the magnitude of this
potentially redirected liquidity from the LOB to qualified auctions.
However, the Commission recognizes that there would be a trade-off
between adverse selection risk (which would be higher on an exchange
LOB compared to qualified auctions, where individual investor orders
would be segmented) and execution risk (i.e., the risk of non-
execution, which would be higher for auctions). In general, qualified
auctions should provide greater price improvement due to their lower
adverse selection risk. However, redirecting displayed liquidity to
qualified auctions might increase the execution risk and trading costs
associated with the order. There might be less certainty regarding
whether a bid in a qualified auction would execute because it would be
competing against other bids that would not be displayed.\661\
Additionally, bids in qualified auctions would lead to execution only
if the market participant is willing to trade at worse prices that
could lead to winning the auction, which may lower the spread that they
would earn relative to executing their non-marketable limit order on a
LOB.\662\ Thus, the execution risk of submitting a bid in a qualified
auction could be greater than posting an order at or inside the NBBO on
a LOB. However, these risks associated with auctions would be somewhat
offset by the lower adverse selection risk of trading against a
segmented order in a qualified auction. Overall, the Commission
believes that redirection of liquidity from the LOB to qualified
auctions would be limited and would not significantly reduce execution
quality on the LOB.
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\661\ Bids in qualified auctions would not be displayed.
\662\ Additionally, a non-marketable limit order may earn a
greater rebate from supplying liquidity on a maker-taker exchange
LOB compared to in a qualified auction, which would have rebate cap
of 5 mils on executed auction responses.
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In addition, the name-give-up requirement could potentially reduce
wholesaler liquidity on the LOB if a wholesaler handled a segmented
order where the originating broker made the certification under
proposed Rule 615(c)(1)(iii) that the identity of the originating
broker will not be disclosed, directly or indirectly, to any person
that potentially could participate in the qualified auction or
otherwise trade with the segmented order. Some retail brokers may seek
certification to not disclose their identity, which would impose
explicit costs on these broker-dealers (as discussed above in section
VI.C.3). In addition, it could curtail wholesaler activity if a
wholesaler had an order resting on the limit order book and routed a
segmented order originating from a broker that made the certification
under proposed Rule 615(c)(1)(iii) to a qualified auction on the same
exchange. In this case, the wholesaler would likely have to cancel its
resting limit order if it wanted to trade against the segmented order
in the auction, since the limit order book is included in the auctions.
Thus,
[[Page 225]]
certification could impact wholesaler quoting on exchanges.\663\
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\663\ Wholesalers could indirectly pass their costs for this
back to the originating brokers if wholesalers charged them a fee
for handling segmented orders where the originating brokers made the
certification under proposed Rule 615(c)(1)(iii).
---------------------------------------------------------------------------
b. Market Access
Retail brokers choose how to access the market for trading services
in NMS stocks in order to fill their customers' orders. Currently,
retail brokers primarily access this market via wholesaler
internalization, although broker-dealers with exchange memberships or
ATS subscriptions can access the market directly.\664\ Retail brokers
without these memberships or subscriptions must route their order to
wholesalers or to other brokers that either have direct access to
exchanges and ATSs, or have the routing resources to deliver orders to
market centers. The introduction of qualified auctions would likely
reduce the profit that wholesalers earn on internalizing marketable
order flow, which in turn could result in the decision by wholesalers
to start charging a fee for routing services. This would improve the
competitive position of broker-dealers with routing access to qualified
auctions.\665\ Retail brokers might further choose not to route to
wholesalers if they want to avoid the requisite identity disclosure
requirement. It is likely that other routing brokers with access to
qualified auctions would compete to receive order flow from retail
brokers without this access. The Commission is uncertain of the extent
to which routing services would shift away from wholesalers towards
other routing brokers. However, the implementation of qualified
auctions could generally be expected to reduce the benefit of
wholesaler vertical integration and the potential profits they get from
internalizing individual investor orders.\666\
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\664\ See supra section VII.B.2.a for further discussion of
broker-dealer routing and market access.
\665\ The Commission estimates that 182 retail brokers (157
originating brokers and 25 routing brokers) would be able to route
orders to qualified auctions. See supra note 286 and accompanying
text.
\666\ See supra section VII.C.3.a.ii for a discussion of how
Proposed Rule 615 would increase competition among wholesalers,
ATSs, and exchanges in attracting and executing order flow of
individual investors.
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c. The Market for Retail Broker Services
Wholesalers have been able to secure larger profits by accessing
and internalizing the majority of marketable order flow of individual
traders, which carries less adverse selection risk. The Proposal would
require wholesalers to route this order flow to qualified
auctions,\667\ opening these orders to competition with other market
participants. This competition could result in the wholesaler not
winning the auction. In the event that the wholesaler actually wins the
auction, it is likely that the increased competition would cause the
realized spread (i.e., the wholesaler's profit margin) it receives from
internalizing these orders to fall. Declining profit margins could
reduce the financial latitude that wholesalers needed to pay PFOF to
retail brokers.\668\ The Commission also recognizes that the decline or
disappearance of PFOF would impact retail brokers, although this impact
would vary widely across brokers, since only some broker-dealers
receive PFOF, and the amount of PFOF differs across retail brokers that
do receive it. In particular, as discussed in Section VII.B.6.a,\669\
four retail brokers received 94% of all PFOF in 2021, and PFOF
represented only a fraction of these four retail brokers' total
revenues.
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\667\ This would be the case unless the wholesaler internalized
the order under one of exceptions, such as executing it at the
midpoint. If the wholesaler chose to internalize individual investor
orders at midpoint, the marginal profit earned from supplying
liquidity, represented by the wholesaler's realized spread, would be
reduced. Currently, wholesalers have an average realized spread of
0.72 (see Table 6). Midpoint execution, by definition, generates, at
best, a zero realized spread, assuming no adverse price impact.
While the broker-dealer may have other incentives to execute a trade
with a negative realized spread, such as reducing inventory risk or
as part of a hedging strategy, all else equal, a positive realized
spread would always be preferable.
\668\ See supra section VII.B.5.c.
\669\ See supra Table 16 and corresponding discussion for an
analysis of the rate of PFOF across retail brokers.
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The Commission acknowledges that the implementation of qualified
auctions and the likely subsequent reduction in PFOF could pose a
competitive threat to retail brokers that are dependent on PFOF and
lack alternate revenue sources to compensate for this loss of revenue.
If wholesalers reduce PFOF or begin charging a fee for routing
services, PFOF retail brokers would have to absorb this cost and earn
lower profits and/or pass on a share of this cost to their customers.
This would, in particular, depend upon the competition they face. For
instance, if PFOF retail brokers earn economic rents, then they could
absorb some of these costs, which would come out of their profit. If
PFOF retail brokers primarily face competition from other PFOF retail
brokers, then these brokers could pass on the costs to their consumers.
That said, to the extent that PFOF brokers face competition from non-
PFOF brokers, then their ability to pass on costs to their customers,
such as in the form of higher commissions on stock and ETF trades,
could be constrained. More specifically, non-PFOF brokers (which would
not be harmed by the disappearance of PFOF) would be unlikely to resume
charging commissions, which would put competitive pressure on
commission rates that other retail brokers could charge and still
retain customers. In this context, if the ability of smaller retail
brokers to charge commissions is constrained by competition, it could
increase the competitive advantage of larger retail brokers, which
could raise the barriers to entry for new brokers and cause some
smaller retail brokers to exit the market. The Commission is unable to
quantify the likelihood one or more retail brokers would cease
operating.
Another feature of Proposed Rule 615 that could impact competition
in the market for retail brokers is the option that allows an
originating broker to avoid disclosure of its identity by certifying
that its identity will not be disclosed, directly or indirectly, to any
person that potentially could participate in the qualified auction or
otherwise trade with the segmented order, as specified in Proposed Rule
615(c)(1)(iii) and (e)(3).\670\ Broker-dealers carrying the greatest
adverse selection risk could determine that their execution risk is
improved by remaining anonymous, despite the possibility that their
anonymity could signal that they carry above average adverse selection
risk.\671\ However, the Commission estimates that this effect on the
market would be relatively minor due to the modest number of retail
brokers (20 firms) \672\ that would be expected to choose to use this
certification.
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\670\ See supra note 477.
\671\ See discussion in supra section VI.C.3. The Commission's
estimate is based on the number of broker-dealers that are believed
to have sufficiently large number of informed traders.
\672\ See supra section VI.D.3.
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4. Efficiency
The Commission believes the Proposal might have both positive and
negative effects on efficiency. The Proposal might have negative
effects on the efficiency of wholesaler operations and the efficiency
with which marketable individual investor orders are executed, but the
Commission believes both these effects might be minimal. On the other
hand, price efficiency might improve due to an increase in pre-trade
and post trade transparency for the segmented orders
[[Page 226]]
that are exposed in a qualified auction.\673\
---------------------------------------------------------------------------
\673\ See supra section VII.C.1.d for further discussion of how
the Proposal would increase pre-trade transparency and price
efficiency.
---------------------------------------------------------------------------
The Proposal might decrease the overall efficiency of wholesaler
operations, although this effect is likely to be minimal. The success
of wholesalers typically relies in part on significant investment
spending on high frequency trading technology. It also relies on firm-
specific expertise that has been cultivated over time on how to most
effectively utilize this technology. However, if increased competition
due to a mandated qualified auction system reduces the volume and/or
profit margins of wholesalers, it is conceivable that one or more
wholesalers might exit the business of handling and internalizing
individual investor orders.\674\
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\674\ Wholesalers also have other business lines. While a
wholesaler might stop handling and internalizing individual investor
orders, it is possible that the wholesaler may continue to supply
liquidity to individual orders through qualified auctions if one of
its other business lines, such as an exchange market maker or
proprietary trading desk, bids in qualified auctions.
---------------------------------------------------------------------------
Assuming that the market power of the industry's most active
wholesalers is at least partially (if not primarily) due to the
particular efficiencies that these firms provide, the possibility of
exit by one of these firms perhaps poses a risk of overall diminished
efficiency. However, remaining wholesalers (or, alternatively, other
executing brokers or OTC market makers) should be able to provide the
routing and execution services to the customers of the exiting
wholesaler. In fact, Rule 606 reports reveal that broker-dealers
currently route to multiple wholesalers and do not restrict their
routing to a single wholesaler. Moreover, the Commission's view is that
all current wholesalers would likely remain operating, albeit possibly
with reduced profit margins. Net profit margins among wholesalers are
fairly high, averaging 39.9% in Q1 2022, compared to 19.9% for the
broker-dealer industry as a whole.\675\ Finally, the Commission
believes that retail brokers would be able to shift their orders
towards other wholesalers without much difficulty in the event that any
wholesalers chose to exit the business. In fact, retail brokers
regularly re-assess whether their current allocation of trading
interest to liquidity providers, including wholesalers, exchanges, and
ATSs, is optimal. As a result, the Commission does not expect the
Proposal to have a significant adverse effect on the overall efficiency
of wholesaler operations.
---------------------------------------------------------------------------
\675\ Profit margin data are calculated using FOCUS data, and
calculated as [(total revenue-total expenses)/(total revenue)] x
100. See supra Table 16 for the share of revenue stemming from PFOF
for NMS stock orders across PFOF brokers. The two largest
wholesalers in terms of volume earned 44% and 41% profit margins,
respectively.
---------------------------------------------------------------------------
Additionally, the Proposal might reduce the efficiency with which
marketable individual investor orders are executed, but these effects
would likely be minimal. The proposed requirement that wholesalers
expose marketable orders of individual investors to qualified auctions
might reduce the efficiency with which these orders are filled because
the trade execution would become less streamlined as a new layer of
intermediation would be added to the lifecycle of each trade. Even in
cases where originating brokers would route customer orders directly to
qualified auctions, this process could be more complex or time-
consuming for retail brokers than routing order flow to wholesalers
that manage routing, market access and execution services.\676\ Any
additional complexity or reduction in the speed of execution would tend
to reduce the efficiency of order executions. However, the duration of
the qualified auction would be less than or equal to 300
milliseconds,\677\ and the process would be automated, both of which
would serve to limit the complexity and duration of the qualified
auction. Therefore, the Commission believes that the overall efficiency
with which marketable orders of individual investors are executed would
not be significantly affected by the Proposal.
---------------------------------------------------------------------------
\676\ This is assuming that the wholesalers internalize the
routed orders. For those individual investor orders that are re-
routed by wholesalers, it is possible that directly routing orders
to qualified auctions may reduce complexity and time-to-execution
for retail brokers.
\677\ More specifically, once the proposed qualified auction
receives the order and sends out the auction message, the duration
of the auction is 100 to 300 milliseconds.
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5. Capital Formation
The Commission believes that the improvements in execution quality
for individual investors and other market participants \678\ as well as
improvements in price efficiency \679\ that might result from the
Proposal would potentially promote capital formation.
---------------------------------------------------------------------------
\678\ See supra section VII.C.1.b for a discussion of how the
Proposal would improve execution quality for individual investors
and supra section VII.C.1.c for how the Proposal would improve
execution quality for other market participants, including
institutional investors.
\679\ See supra section VII.C.1.d for further discussion of how
the Proposal would increase pre-trade transparency and price
efficiency.
---------------------------------------------------------------------------
As investors would benefit from improved execution quality as a
result of the proposed amendments, these investors would also likely
benefit from lower transaction costs. Higher transaction costs may
hinder customers' trading activity that would support efficient
adjustment of prices and, as a result, may limit prices' ability to
reflect fundamental values. Less efficient prices may result in some
firms experiencing a cost of capital that is higher than if their
prices fully reflected underlying values, and in other firms
experiencing a cost of capital that is lower than if their prices
accurately reflected their underlying value, as a result of the
market's incomplete information about the value of the issuer. This, in
turn, may limit efficient allocation of capital and capital formation.
By improving order execution quality and reducing transaction costs,
the proposed amendments would reduce financial frictions and promote
investor's ability to trade. Furthermore, improvements in price
efficiency as a result of the Proposal would cause firms' prices to
more accurately reflect their underlying values, which may also improve
capital allocation and promote capital formation.
D. Reasonable Alternatives
A central aim of Proposed Rule 615 is to retain the benefits of
segmenting individual investor orders. A second concern that this
proposal addresses involves the nature of the information transmitted
to the market by the originating broker. The first type of reasonable
alternatives discussed below varies by who can segment, the degree of
segmentation, and whether prescriptive changes to routing practices are
required. The discussion addresses these questions with options that
vary along degrees of prescriptive rules, versus relying on market
incentives alone. The Commission also considered additional types of
alternatives, namely: (1) alternative definitions of segmented orders,
(2) alternative auction designs, including the degree to which auction
design is set by rules or determined by open competition centers, (3)
alternative exceptions to the order competition requirement, and (4)
variation in the definition of open competition center. Finally, the
Commission also considered alternatives such as mandating information
barriers within wholesaler business functions, allowing exchanges to
display quotes in retail liquidity programs, and a separate retail NBBO
as well as a disclosure-only alternative. These alternatives could be
used together or in combination with each other and could also be
paired with other elements of the Proposal. Where applicable the
Commission has
[[Page 227]]
specified which alternatives would likely be paired together when
considering the economic impact of the alternative.
1. Variation in Provisions Regarding Segmentation and Routing
a. Trade-at Requirement
The first alternative to the Proposal is that the Commission could
introduce a trade-at prohibition as part of Regulation NMS. A trade-at
prohibition would: (1) prevent a trading center that was not quoting
from price-matching protected quotations and (2) permit a trading
center that was quoting at a protected quotation to execute orders at
that level, but only up to the amount of its displayed size. Orders
would not be able to be executed at a trading center not displaying a
quote unless the orders were executed with at least a minimum amount of
price improvement as established by the Commission. There could be
exceptions for trades at the NBBO midpoint or trades based on a
reference price, such as VWAP trades. This would mean that any trading
center not displaying a quote, including ATSs and wholesalers, could
not execute a trade unless it offered at least the minimum amount of
price improvement over the NBBO. Exchanges would still be able to offer
separate RLP programs in order to segment the marketable orders of
individual investors. However, because quotes in RLPs would not be
displayed, quotes in RLPs would also be restricted from executing
orders unless they offered the minimum amount of price improvement over
the NBBO.\680\
---------------------------------------------------------------------------
\680\ If this alternative were combined with the alternative to
allow exchanges to display quotes in RLPs, then displayed quotes in
RLPs would be able to execute at NBBO without offering price
improvement.
---------------------------------------------------------------------------
The Commission could establish a low value for the minimum amount
of price improvement of 0.1 cent. It could alternatively establish
higher values for a minimum amount of price improvement ranging up to a
full tick size (i.e., 1 cent), with exceptions for midpoint
executions.\681\ If the Commission chose a higher value for the minimum
amount of price improvement, then the economic effects of this
alternative would be larger (i.e., a greater increase in displayed
liquidity, a greater share of orders being routed to exchanges, etc.).
---------------------------------------------------------------------------
\681\ The Commission also is proposing to amend Rule 612
regarding the tick size. See Minimum Pricing Increments Proposal,
supra note 98. The Commission encourages commenters to review that
proposal to determine whether it might affect their comments on this
proposing release.
---------------------------------------------------------------------------
A number of markets have examined the effects of a trade-at rule.
Studies have examined the introduction of a trade-at prohibition in
Canada and Australia. In Canada, results indicate that dark trading
declined and trading on lit venues increased when the trade-at
prohibition was imposed.\682\ There were not significant changes in
overall spreads or volatility. Displayed depth increased, but total
market depth, i.e., hidden plus displayed depth, did not change.\683\
Some measures showed a decline in price efficiency.\684\ Empirical
research has also looked at differences in trader-types and found that
the trade-at prohibition eliminated intermediation of individual
investor orders in dark venues and shifted individual investor orders
onto the lit market with the lowest trading fee.\685\ Findings indicate
that this resulted in individual investors receiving less price
improvement, retail brokers paying higher trading fees to exchanges,
and high-frequency traders earning higher revenues from trading
fees.\686\ Using Australian market data, researchers found that a
trade-at prohibition decreased off-exchange trading and
internalization, with more off-exchange trades executing at the
midpoint.\687\ They also found that the trade-at prohibition increased
quoted spreads.\688\ However, because these countries had different
market structures than the U.S. market in NMS stocks (e.g., less
fragmentation and less trading occurring off-exchange) the effects
observed from the trade-at-prohibitions in these studies may not be
similar if a trade-at-prohibition were applied to NMS stocks in the US.
---------------------------------------------------------------------------
\682\ See Baiju Devani, Lisa Anderson & Yifan Zhang, Inv. Indus.
Regulatory Org. Can., Impact of the Dark Rule Amendments (May 7,
2015), available at https://paperzz.com/doc/8507782/impact-of-the-dark-rule-amendments.
\683\ Id.
\684\ Id.
\685\ See Carole Comerton-Forde, Katya Malinova & Andreas Park,
Regulating Dark Trading: Order Flow Segmentation and Market Quality,
130 J. Fin. Econ. 347 (2018).
\686\ Id.
\687\ See CFA Inst., Trade Rules in Australia and Canada: A
Mixed Bag for Investors (Nov. 2014), available at https://www.cfainstitute.org/-/media/documents/issue-brief/policy-brief-trade-at-rules.ashx.
\688\ Id.
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The U.S. Tick Size Pilot in NMS stocks imposed a trade-at
requirement for one of the test groups (Test Group 3), although there
were a number of exceptions, including for individual investor
orders.\689\ One academic paper that examined the effects of the Tick
Size Pilot, including the effects of the trade-at prohibition,\690\
found that the effects of the trade-at prohibition varied based on
whether the stock was tick-constrained or unconstrained.\691\ The
authors generally found that in tick-constrained stocks the trade-at
prohibition decreased quoted and effective spreads, increased displayed
depth at the NBBO, and increased trading volume. In contrast,
unconstrained stocks did not experience significant changes in spreads
or displayed depth and experienced a decrease in trading volume. Both
tick-constrained and unconstrained stocks experienced an increase in
quote volatility and a decrease in average trade size. Other empirical
research indicates that the trade-at prohibition reduced the volume of
trading off-exchange, with more trading occurring
[[Page 228]]
on inverted exchanges (i.e., those exchanges that pay a rebate for
demanding liquidity and charge a fee for supplying liquidity).\692\
However, the results observed from the trade-at-prohibition in the Tick
Size Pilot may not be similar if a trade-at-prohibition were applied to
all stocks, because the Tick Size Pilot was limited to stocks with
smaller market capitalizations and also involved a simultaneous
increase in the tick size to five cents.\693\
---------------------------------------------------------------------------
\689\ The Tick Size Pilot Program was an NMS plan designed to
allow the Commission, market participants, and the public to study
and assess the impact of wider minimum quoting and trading
increments--or tick sizes--on the liquidity and trading of the
common stocks of certain small-capitalization companies. The Tick
Size Pilot began in Oct. 2016 and ended in Sept. 2018. The Tick Size
Pilot included NMS common stocks that had a market capitalization of
$3.0 billion or less, a closing price of at least $2.00, and a
consolidated average daily volume of one million shares or less
(``Pilot Securities''). The Pilot Securities were divided into one
control group and three test groups. Each test group contained
approximately 400 Pilot Securities and the remaining Pilot
Securities were in the control group. The Pilot Securities assigned
to Test Group One (``TG1'') were quoted in $0.05 per share
increments but continued to trade at the current price increments,
subject to limited exceptions. The Pilot Securities assigned to Test
Group Two (``TG2'') were quoted in $0.05 per share increments like
those in TG1, but were traded in $0.05 per share increments, subject
to certain exceptions, including exceptions that permit executions
that were the (1) midpoint between the national or protected best
bid and the national or best protected offer, (2) retail investor
orders with price improvement of at least $0.005 per share, and (3)
negotiated trades. The Pilot Securities assigned to Test Group Three
(``TG3'') were quoted in $0.05 per share increments and traded in
$0.05 per share increments consistent with TG2. TG3 Pilot Securities
were also subject to a Trade-at Prohibition, which generally
prevented price matching by a trading center that was not displaying
the best price unless an exception applied. The Trade-at Prohibition
had exceptions that were similar to those provided in Rule 611 of
Regulation NMS. Pilot Securities in the control group continued to
quote and trade at the current tick size increment of $0.01 per
share. See Order Approving the National Market System Plan to
Implement a Tick Size Pilot Program, Securities Exchange Act Release
No. 74892 (May 6, 2013), 80 FR 27541.
\690\ See Barbara Rindi & Ingrid M. Werner, U.S. Tick Size Pilot
(Fisher Coll. Bus. Working Paper No. 2017-03-018, Charles A. Dice
Ctr. Working Paper No. 2017-18, last revised Mar. 17, 2019),
available at https://ssrn.com/abstract=3041644 (retrieved from
Elsevier database) (hereinafter ``Rindi and Werner (2019)'').
\691\ Rindi and Werner (2019) defined tick-constrained as a
stock having an average quoted spread of five cents or less during
the time period before the Tick Size Pilot was implemented. They
define an unconstrained stock as one having an average quoted spread
of 10 cents or greater during the time period before the Tick Size
Pilot was implemented.
\692\ See Carol Comerton-Forde, Vincent Gr[eacute]goire & Zhuo
Zhong, Inverted Fee Structures, Tick Size, and Market Quality, 134
J. Fin. Econ.141 (2019).
\693\ Additionally, a number of exceptions applied to the Tick
Size Pilot trade-at prohibition, including an exception for retail
orders.
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Overall, the Commission believes that a trade-at prohibition would
result in more orders being routed from ATSs to exchanges and an
increase in displayed depth on the LOB compared to the Proposal.\694\
However, it is uncertain to what degree total depth would increase
because the increase in displayed depth could mostly come from market
participants choosing to display orders they currently hide on LOBs. If
most of the increase in displayed depth came from market participants
choosing to display orders they currently hide, then total depth in the
LOB (i.e., hidden plus displayed depth) under this alternative may be
similar to total depth in the LOB under the Proposal. However, LOB
depth may increase if OTC market makers that currently internalize
trades off-exchange increased their liquidity supplied to the LOB in
order to be able to trade without offering the minimum amount of price
improvement.\695\ There is also uncertainty about what would happen to
spreads under this alternative. Based on the evidence from implementing
a trade-at rule in other countries, spreads (both quoted and effective)
may not significantly change compared to the Proposal. However, it is
also possible that quoted and effective spreads could decline on
exchanges if more orders from individual investors are routed for
execution to exchange LOBs.\696\ More trading volume (including more
orders from institutional investors) may also shift from ATSs to
exchanges because the trade-at rule may prevent ATSs not displaying
quotes from executing a trade unless they provide a minimum amount of
price improvement to the NBBO.\697\ This shift in order flow from ATSs
to exchanges could increase transparency and may further lower spreads,
increase liquidity, and improve price efficiency relative to the
Proposal.
---------------------------------------------------------------------------
\694\ This may help reverse a decline in pre-trade transparency.
Market participants have stated that liquidity displayed at or near
the NBBO on exchanges has declined over time. An analysis by an
exchange separately finds off-exchange trading has also increased
over a similar time period. See supra notes 375 and 376 and
accompanying text.
\695\ If the minimum pricing increment were larger, then OTC
market makers may submit more liquidity to a LOB.
\696\ Because individual investor orders exhibit lower adverse
selection risk, the average adverse selection risk faced by
liquidity suppliers on exchanges could decrease, which may cause
them to quote at more aggressive prices, resulting in a reduction in
quoted and effective spreads. See Glosten and Milgrom (1985) for a
discussion of how adverse selection risk affects quoted spreads.
However it is also possible that this effect may be limited if
tighter quoted spreads also cause market participants that pose
greater adverse selection risk to increase their liquidity demanding
orders, which could potentially increase the adverse selection risk
faced by liquidity suppliers on exchange LOBs.
\697\ The shift in volume from ATSs to exchanges would be
greater if the Commission set a larger threshold for the minimum
amount of price improvement needed to execute the order.
---------------------------------------------------------------------------
Under this alternative, wholesalers would likely internalize more
individual investor marketable orders compared to the Proposal.
However, the threshold the Commission selects for the minimum amount of
price improvement would affect to what degree wholesalers internalize
the marketable orders of individual investors.\698\ If the Commission
selected a smaller threshold, e.g., a threshold of 0.1 cents or 0.2
cents, then this would result in more marketable orders of individual
investors being internalized by wholesalers.\699\ Because these orders
would not be exposed to order-by-order competition when they are
internalized by wholesalers, the average price improvement individual
investors receive on their marketable orders would likely be reduced,
and the transaction costs of these orders would be higher, relative to
the Proposal.
---------------------------------------------------------------------------
\698\ This effect would also vary based on the quoted spread of
the stock. For stocks with quoted spreads above two cents, even if
the minimum threshold price improvement threshold was set at a full
tick, wholesalers would likely internalize more order flow compared
to the Proposal because they would have had to offer more than 1
cent of price improvement in order to internalize individual
investor orders at the midpoint without having to expose them in
qualified auctions. If the Commission selected a minimum price
improvement threshold of a full tick, then stocks with quoted
spreads less than two cents may have wholesalers internalize less
individual investor orders under this alternative compared to the
Proposal. These effects would vary if the minimum tick size for a
stock was different. The Commission also is proposing to amend Rule
612 regarding the minimum tick size. See Minimum Pricing Increments
Proposal, supra note 98. The Commission encourages commenters to
review that proposal to determine whether it might affect their
comments on this proposing release.
\699\ The proportion of individual investor order flow
internalized by wholesalers would decline as the threshold for the
minimum amount of price improvement increases, because wholesalers
would have to offer more price improvement to internalize these
orders.
---------------------------------------------------------------------------
Under this alternative, broker-dealers and trading centers would
not have the costs associated with identifying and handling segmented
orders, but they would have additional costs associated with developing
policies and procedures and adjusting their systems to implement the
trade-at requirements.
b. Permit Exchanges To Offer Auctions in Smaller Pricing Increments
As an alternative to mandating segmented orders be routed to
qualified auctions, the Commission could allow exchanges to run
auctions with 0.1 cent pricing increments that the orders of all market
participants would be eligible to trade in.\700\ Exchanges would be
able to run separate auctions for their RLPs and for orders that were
not eligible to be submitted to their RLPs, which would allow exchanges
to maintain some degree of segmentation (alternatively, the Commission
could permit a greater degree of segmentation as in the alternative
below). This less prescriptive alternative would allow exchanges to
offer sub-penny price improvement to a wider set of market participants
outside of their RLP programs. As in the trade-at alternative
considered above, it would maintain the current separation between how
market entities are allowed to segment orders, and the relative
anonymity of orders on exchange. By not contributing to further
segmentation of orders, relative to the Proposal, this alternative
might lower the cost for trading for investors currently identified as
having order flow with greater price impact. Because broker-dealers and
trading centers would not have to establish policies and procedures for
identifying and handling segmented orders, this alternative would have
significantly lower costs than the Proposal. However, it offers no
clear mechanism for creating significantly greater competition for
segmented orders, nor in improving execution quality for segmented
orders as defined in the Proposal.
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\700\ Currently, exchanges are able to offer smaller pricing
increments in their RLPs, but Rule 612 still applies to other
auctions that they run (e.g., open and closing auctions and auctions
following a trading halt). This alternative would allow exchanges to
offer smaller pricing increments for these other auctions.
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c. Trade-at Requirement for Segmented Orders Only
As a variation on the Trade-at Requirement alternative discussed
above, the Commission could only establish a trade-at requirement for
segmented orders, as defined by the Proposal or in combination with an
alternative definition of segmented
[[Page 229]]
orders as discussed below. This alternative would limit both the
potential positive and negative effects of the Trade-at alternative
because it would apply to a smaller set of orders. Relative to the two
alternatives above, it would maintain the definition of segmented
orders, thereby still contributing to the complexity that these two
alternatives seek to avoid. However, like the Proposal, it would
potentially expose segmented orders to order-by-order competition. The
degree of this competition would depend on the minimum price
improvement threshold selected because a higher threshold would result
in less internalization and more routing of orders to exchanges, where
they would be exposed to order-by-order competition. It would also
depend on whether these orders were revealed to be segmented orders--
given a flag, or sent to an existing RLP program--and whether they also
identify the originating broker. The less information, the lower the
degree of segmentation, which may help liquidity in general and
segmented orders presenting more adverse selection risk, but might
limit the ability for segmented orders presenting less adverse
selection risk to gain price improvement. Unlike the Trade-at
Requirement alternative discussed above, this alternative is explicitly
compatible with the provision in the Proposal to prevent a routing
broker to post a quote in a way that has priority, thereby potentially
lessening the information asymmetry and increasing competition if it
works as intended.
d. Create a Segmented Order Definition but Not Require Segmented Orders
To Be Exposed in Qualified Auctions
As an alternative, the Commission could introduce the proposed
definition of a segmented order and permit exchanges to offer separate
auction mechanisms for segmented orders with finer trading increments,
but not introduce a requirement for segmented orders to be exposed in
these auctions. There would be no minimum trading volume requirement in
order for exchanges to be able to run these segmented auctions and
exchanges would have greater flexibility in designing these auctions,
similar to the alternative discussed in section VII.D.3.a below.
Similar to the Proposal, this alternative would introduce the
definition of segmented orders and with it the additional complexity.
Relative to the Proposal, it contains no prescriptive requirements for
auctions, and thus may have lower costs for implementing them, similar
to the alternative in section VII.D.1.b. Because more exchanges would
be able to offer segmented auctions, there may be greater competition
among market centers that are able to offer segmented auctions compared
to the Proposal.
e. Continue To Permit National Securities Exchanges To Offer Separate
Trading Mechanisms for Segmented Orders in Addition to Qualified
Auctions
As an alternative, the Commission could allow national securities
exchanges to offer separate trading mechanisms for segmented orders in
addition to qualified auctions, such as allowing exchanges to continue
to operate RLPs. In addition to being able to submit a segmented order
to an exchange LOB or a qualified auction, broker-dealers could also
submit a segmented order to execute in other exchange trading
mechanisms designed for segmented orders.\701\ Separate trading
mechanisms for segmented orders could also be priced in 0.1 cents
increments, but, similar to current market practices, quotes in
exchange RLP programs would not be displayed in exchange proprietary
feeds or consolidated market data.\702\
---------------------------------------------------------------------------
\701\ Exchanges could either adjust the definitions of orders
they accepted to their RLPs to conform with the definition of
segmented orders or they could allow a broader set of individual
investor orders of which segmented orders would be a subset.
\702\ A flag would still be disseminated next to an exchange
quote in consolidated market data indicating that there was
liquidity present in an exchange's RLP program at a price better
than the NBBO.
---------------------------------------------------------------------------
Compared to the Proposal, this alternative might improve
competition among exchanges, and improve the competitive position of
lower-volume exchanges, because they would be allowed to offer trading
mechanisms for segmented orders even if they fell below the 1% average
daily volume requirement necessary to run a qualified auction. This
might result in less trading volume in segmented orders concentrating
on larger exchanges, which could reduce the risk that one or more small
exchanges might exit the market. It would also improve the ability of
market participants that might not possess the speed necessary to
respond to qualified auction messages, e.g., individual investors or
professional traders that do not utilize algorithmic trading
technology, to compete to supply liquidity to segmented orders. There
may be more methods available for them to supply liquidity to segmented
orders that do not require the speed necessary to respond to qualified
auction messages, such as posting quotes in exchange RLP programs.\703\
---------------------------------------------------------------------------
\703\ If an exchange operated both a qualified auction and an
RLP program, liquidity supplying orders submitted to the exchange's
RLP program could be incorporated into qualified auctions. Because
they could submit resting orders to RLP programs, liquidity
suppliers that were not fast enough to submit bids in qualified
auctions would still be able to submit an order in 0.1 cent pricing
increments that would only supply liquidity to a segmented order.
However, they may not be able to factor in information on the
originating broker submitting the segmented order into the liquidity
supplying orders they submit to qualified auctions.
---------------------------------------------------------------------------
However, compared to the Proposal, this alternative may increase
the ability of wholesalers or other broker-dealers handling segmented
orders to indirectly internalize an order by executing it against a
quote they are posting in another trading mechanism for segmented
orders, such as an RLP program. In these other trading mechanisms, the
broker-dealer may maintain a larger information advantage than it would
have with qualified auctions, because these other trading mechanisms
may not require identity disclosure of the originating retail-broker.
However, since qualified auctions would still be available and there
may be additional competition from liquidity on smaller exchanges, the
average price improvement and trading costs for marketable orders of
individual investors may not be significantly different under this
alternative compared to the Proposal.
This alternative could also allow quotes in RLPs to be displayed in
proprietary feeds and in consolidated market data. This would
potentially increase the transparency of liquidity available to
segmented orders and may further improve their order routing and
execution quality compared to not displaying RLP quotes under this
alternative. Displaying quotes in RLP programs may also further enhance
the competitive position of smaller exchanges and new exchanges that
enter the market that do not meet the criteria for an open competition
trading center but may operate an RLP. Displaying exchange RLP quotes
would provide more transparency into the liquidity available to the
orders of individual investors on these exchanges, which might result
in more individual investor orders being routed to these exchanges when
the prices of displayed quotes are equal to or better than the expected
execution prices individual investor orders may expect to receive in
qualified auctions (e.g., if the RLP is posting a quote at the NBBO
midpoint).
[[Page 230]]
2. Alternate Definitions of Segmented Orders
a. Current Market Practice as a Definition of Segmented Order
The Commission understands that current market practices concerning
definitions of retail orders often relies on brokers representing
retail flow as coming from natural persons.\704\ In addition, a number
of SRO rules prohibit the use of trading algorithms or computerized
technology for the eligibility of retail orders for their RLP
programs.\705\ As an alternative to the proposed definition of
segmented order, the Commission could adopt a definition of segmented
order that consisted of these two elements, i.e., the order must be
submitted by a natural person and does not originate from a trading
algorithm or any other computerized methodology,\706\ but without any
thresholds based on the number of trades executed or orders submitted
by the account.
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\704\ See supra notes 188, 189, and 190 and related discussions
(discussing natural person in context of definitions of retail
orders).
\705\ See supra note 193 (discussing restrictions on retail
orders originating from a trading algorithm).
\706\ Similar to the proposed definition 600(b)(91)(i), the
order could originate from a natural person or an account held in
legal form on behalf of a natural person or group of related family
members.
---------------------------------------------------------------------------
Compared to the Proposal, this could result in fewer orders meeting
the definition of a segmented order. Although a small number of
additional individual investor accounts would now meet the definition
of segmented order because there would be no minimum trade
threshold,\707\ a number of orders that previously would have been
included under the Proposal could be excluded because they originate
from a trading algorithm or any other computerized methodology.\708\
The Commission does not have data on how many retail orders originate
from trading algorithms or any other computerized methodology, but the
Commission understands that a number of retail brokers allow individual
investors to trade through APIs and that a number of retail brokers may
use trading algorithms to generate orders for individual accounts.\709\
To the extent that orders originating from a trading algorithm or
computerized methodology have larger adverse selection risk than other
orders originating from individual investors that met the definition of
a segmented order, then the adverse selection risk of segmented orders
in qualified auctions may decrease and liquidity suppliers might offer
slightly greater price improvement to segmented orders in qualified
auctions under this alternative compared to the Proposal. The costs to
originating brokers for identifying segmented orders under this
alternative may be similar to the Proposal.\710\
---------------------------------------------------------------------------
\707\ See analysis and discussion of the distribution of
individual investors' average daily number of orders resulting in a
trade in infra Table 22.
\708\ It is also possible that the orders from individual
investor accounts that average 40 or more trades a day could also be
excluded under this alternative if the orders originate from a
trading algorithm or any other computerized methodology.
\709\ For example, if a retail broker has automated methods for
rebalancing an individual investor's account, it may generate orders
using a trading algorithm.
\710\ Although originating brokers may not need to keep track of
the average number of trades each individual investor account
executes under this alternative, they would need to have systems to
track if an order submitted by an account originated from a trading
algorithm or computerized methodology.
---------------------------------------------------------------------------
b. Use a Quantitative Threshold Other Than Trades To Identify Segmented
Orders
Rather than using average number of trades, the Commission could
rely on an alternative metric, such as average number of orders
submitted by an individual investor's account to identify the threshold
for the definition of segmented orders. The Commission understands that
some exchanges in the options market have designed definitions of
retail orders that rely on a criteria based on the average number of
orders an account originates per day, as opposed to the average number
of trades.\711\
---------------------------------------------------------------------------
\711\ See supra note 197 for a discussion of how the average
number of orders submitted per day from a customer's account is
included in the definition of a ``Professional'' order.
---------------------------------------------------------------------------
The economic effects of using an average order threshold would
largely depend on the threshold selected. If the Commission selected an
average order threshold that corresponded to a similar percentage of
accounts being excluded as the proposed trade threshold, i.e., if the
Commission selected an average orders per day cutoff so that 99.9% of
individual investor accounts were below the threshold, then the
economic effects of this alternative would likely be similar to those
described in the Proposal. If the Commission varied the threshold, then
the economic effects would likely be similar to the effects of varying
the average trade threshold discussed below in section VII.D.2.c.
Similar to the Proposal, originating brokers would have to develop
systems to identify individual investor accounts that meet definition
of a segmented order. However, these costs may be higher if it is more
difficult for an originating broker to develop systems that track the
average number of orders that originate from a customer's account
compared to the number of trades.
c. Vary the Daily Trade Threshold of Individual Investors Covered by
the Proposal
The Commission could adopt alternative definitions of a segmented
order by varying the threshold for the average daily number of trades
in NMS stocks that a natural person or group of related family members
would need to be under in order for their orders to qualify as
segmented orders, including not having a maximum number of trades per
day threshold.\712\
---------------------------------------------------------------------------
\712\ If there were no trade threshold, then the segmented order
definition would be similar to the criteria that some exchanges use
to determine which investor orders are eligible to execute in their
RLP programs. Although some exchanges also have criteria using the
average number of orders submitted by the natural person as a
threshold for determining which orders are eligible to be submitted
to their RLP programs. See supra note 188 and accompanying text for
discussions of the orders that are eligible to be submitted to RLPs.
---------------------------------------------------------------------------
Table 22 estimates the distribution of the average daily number of
orders that an individual investor's account originates and results in
a trade (conditional on the individual investor submitting an order
during the observation period). The analysis shows that 99.9% of
individual investor accounts average 14.3 or fewer orders that result
in a trade each day and that 99% of individual investor accounts
average 1.86 or fewer orders that result in a trade each day.
[[Page 231]]
Table 22--Distribution of Individual Investors' Average Daily Number of Orders Resulting in a Trade
--------------------------------------------------------------------------------------------------------------------------------------------------------
Mean Std Min 25% 50% 75% 99% 99.9% 99.99% 99.999% Max
--------------------------------------------------------------------------------------------------------------------------------------------------------
0.20......................................... 118.74 0.00 0.01 0.02 0.06 1.86 14.30 83.92 318.83 667,289.34
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table uses CAT data to estimate the distribution of the average daily number of orders that an individual investor's account originates and are
associated with a trade. This is estimated from CAT identified Individual Customer accounts that originated an order during the six month period from
Jan. 1, 2022, through June 30, 2022. Because this analysis only includes Individual Customer Accounts that originated an order during this time
period, it may overestimate the value at a given percentile because accounts originating zero orders are not included in the distribution. See supra
note 194 for additional details on the analysis.
If the average trade threshold were lowered, fewer individual
investors would meet the definition of a segmented order and be
eligible to have their orders be routed to qualified auctions.
Individual investors that no longer met the definition of segmented
orders would experience lower execution quality than under the Proposal
because their orders would not be eligible to be segmented and
participate in qualified auctions. Instead, these orders would likely
either be internalized by wholesalers without being subject to order by
order competition if they have lower adverse selection risk or routed
and executed on an exchange LOB or ATS if wholesalers don't want to
internalize them. If these orders have larger adverse selection risk
than the average orders of individual investors that fall below the
average trade threshold, then the average adverse selection risk of
segmented orders in qualified auctions may decrease and liquidity
suppliers might offer slightly greater price improvement to segmented
orders in qualified auctions under this alternative compared to the
Proposal. However, as long as the average trade threshold remained
above 15 trades per day, then the effects of this alternative may not
be that significant, because it would affect less than 0.1% of
individual investors.
If the average trade threshold were increased or eliminated, then
orders of more individual investors would be included in qualified
auctions. However, the proportion of individual investors that meet the
definition of segmented orders under this alternative, but do not under
the Proposal would be small because more than 99.9% of individual
customer accounts average less than 40 trades per day. The marketable
orders of individual investors that average more than 40 trades per day
and meet the definition of segmented order under this alternative may
receive more price improvement and lower transaction costs compared to
the Proposal because their orders would now be eligible to be included
in qualified auctions. However, the orders of these individual
investors that trade more frequently may have greater adverse selection
risk compared to orders from individual investors that trade less
frequently. Compared to the Proposal, this may result in the average
adverse selection risk increasing in qualified auctions and liquidity
suppliers bidding in auctions may offer less price improvement on
average. This would result in the orders of individual investors that
average less than 40 trades per day receiving less price improvement on
their marketable orders and paying higher transactions costs than they
would under the Proposal. This would effectively result in a transfer
from individual investors that average less than 40 trades per day to
the ones that average more than 40 trades per day. Institutional
investors may also see increased transactions costs compared to the
Proposal because they may be more likely to supply liquidity to
individual investors with higher adverse selection risk. However, if
individual investors with more than 40 trades per day are limited to a
few broker-dealers, then the potential disclosure of the originating
broker in qualified auctions may limit the effect to these broker-
dealers.
3. Variation in Auction Design
a. Allow Open Competition Trading Centers More Flexibility in Designing
Qualified Auctions
As one alternative, the Commission could allow open competition
trading centers more flexibility in designing qualified auctions. This
would include allowing open competition trading centers more
flexibility in setting matching protocols, priority structure, auction
duration, disclosure of the identity of the originating broker, and
auction fees and rebates. However, the Commission could still specify a
minimum auction duration (open competition centers could choose greater
times). The Commission could also still specify that execution priority
shall not be based on time of receipt of the auction response
(otherwise, it is not clear how an auction might differ significantly
from the limit order book).
Compared to the Proposal, this alternative could lead to greater
innovation in the design of qualified auctions and foster greater
competition among open competition trading centers that run qualified
auctions. However, it could also lead to the design of qualified
auctions with mechanisms that could provide a greater advantage to
certain liquidity suppliers, which could result in less competition
among liquidity suppliers, and reduced benefits that come from it,
including less improvement in individual investor and institutional
investor execution quality compared to the Proposal.
Allowing more flexibility in the design of qualified auctions could
enhance innovation compared to the Proposal by allowing open
competition trading centers to incorporate auction features that better
fit the needs of different market participants, which in turn could
improve order execution quality for some market participants compared
to the Proposal. More flexibility in the design of qualified auctions
could also promote further competition among open competition trading
centers and lead to greater differentiation among qualified auction
mechanisms in order to attract segmented orders and liquidity
suppliers. It could also lead to more open market trading centers
operating qualified auctions, since an exchange group might be more
likely to operate multiple qualified auctions if it has the flexibility
to implement different designs at different exchanges. This, however,
could result in greater fragmentation of individual investor order flow
and liquidity supply across qualified auctions compared to the Proposal
and result in decreased competition among liquidity suppliers to
individual qualified auctions and less price improvement for individual
investors relative to the Proposal.
Compared to the Proposal, allowing greater flexibility in qualified
auction designs could result in some open competition trading centers
designing auction mechanisms that provide a greater competitive
advantage to some types of bidders over others. For example, an open
competition trading center could design an auction that includes an
auto-match pricing feature (where the order automatically adjusts
[[Page 232]]
to match the price of the best auction bid), and an allocation
guarantee to the participant that initially brought the order to the
auction if it provided the best bid. This would provide a competitive
advantage to whichever market participant brought the order to the
auction and increase the likelihood that it would trade with the
individual investor order. This could result in market participants
directing individual orders to qualified auctions that offered them a
greater competitive advantage, which would result in less competition
among market participants to supply liquidity to individual investor
orders and worse execution quality for individual investor orders
compared to the Proposal.
Additionally, because this alternative would not require qualified
auctions to ensure customer priority if multiple bids are at the same
price, it could reduce the likelihood of other investors trading
directly with individual investor orders compared to the Proposal
(e.g., it could increase the chance of broker-dealers bidding in
qualified auctions getting priority over institutional orders at the
same price compared to the Proposal). This could result in less
improvement in the execution quality for the orders of institutional
investors compared to the Proposal.\713\
---------------------------------------------------------------------------
\713\ See supra section VII.C.1.c discussing improvements in
execution quality for institutional investors.
---------------------------------------------------------------------------
b. Variation in the Duration of Qualified Auctions
As an alternative, the Commission could vary the minimum and
maximum durations for the qualified auction, making both larger or
smaller. Variations in the duration of qualified auctions results in a
trade-off between NBBO slippage and the exposure of the auctioned order
flow to potential bidders. Because the NBBO may vary over short time
horizons, auctioned orders may become stale or priced outside the NBBO
as best quotes move. This effect calls for shorter auction durations.
However, longer auction durations provide a longer opportunity, after
observing the auction message through the SIP, for other participants
to interact with the auctioned order flow, potentially raising the
number of bidders in qualified auctions.
The Commission performed analysis to estimate the risk of quote
slippage for different auction lengths by observing the likelihood that
that the NBBO spread moves (i.e., the ``fading probability'') as the
time lag increases (in milliseconds) after internalization of an
individual investor order.\714\ Research indicates there is a few-
millisecond gap between an off-exchange trade and the reporting of that
trade to the SIP.\715\ Assuming this lag applies to internalized
individual investor orders as well, NBBO movements were measured during
the initial moments following internalization of an individual investor
order. This analysis is performed on 600 randomly selected stocks that
are divided into three groups: high, medium, and low activity
stocks.\716\ The probability of fading is calculated at the stock level
as the overall likelihood that the NBO (NBB) will be higher (lower)
than the current NBO (NBB) for increasing durations of time after
internalization. These probabilities are then averaged across stocks in
each of the three groups of stocks. Figure 1 below indicates slippage
probabilities for different periods of delay after internalization:
\717\
---------------------------------------------------------------------------
\714\ From Daily TAQ's NBBO and Quote files, NBBO updates are
constructed based on nanoseconds time-stamps. Each quote update is
matched up with the NBBO that is in effect for different durations
of time (in milliseconds) after internalization. These durations
include 25, 50, 75, 100, 200, 300, and 500 milliseconds.
\715\ See Thomas Ernst & Chester S. Spratt, Payment for Order
Flow and Asset Choice (last revised May 16, 2022) (unpublished
manuscript), available at https://ssrn.com/abstract=4056512
(retrieved from Elsevier database).
\716\ Six hundred stocks were randomly selected from the
population of all NMS common shares and ETFs in Mar. 2022. Three
buckets were formed from the population of stocks based on trading
volume: top-500 (high activity), 501-1,000 (medium activity), and
1,001-3,000 (low activity). Then 200 stocks were randomly selected
from each bucket in a stratified manner, such that the final sample
included stocks from all levels of quoted spread.
\717\ Filters were used to identify off-exchange transactions
(sub-penny trades) that are attributable to individual investors. An
algorithm from Boehmer et al., supra note 572, was then used to
identify buyer vs. seller initiated such trades. See supra note 572
for further discussions of this algorithm.
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[[Page 233]]
[GRAPHIC] [TIFF OMITTED] TP03JA23.000
Results indicate that the fade probability goes from a cross-stock
average of 12% at 25 milliseconds after a quote update, to 14% at 100
milliseconds--an increase of only 2 percentage points. Focusing on
individual investor orders, the fade probability goes from an average
of 1.7% at 25 milliseconds after an internalized individual investor
order, to 2.9% at 100 milliseconds--an increase of only 1.2 percentage
points.
These findings suggest that changing qualified auction lengths
relative to the proposed 100 milliseconds length would not
significantly change the chance of ``adverse'' price movements when an
auction message is disseminated. The Commission believes, based on this
analysis, that the chance of the quotes moving against the individual
investor order does not significantly increase over horizons from 20
milliseconds to 500 milliseconds long. However, the Commission observes
that the likelihood of slippage may be greater in volatile markets.
In addition to the low risk of slippage within the Proposal's
auction durations, the Commission does not believe that changing the
qualified auction length would materially substantially impact the
number of potential bidders. Trading algorithms used by most market
participants may be fast enough to respond to an auction message in the
SIP in 10 milliseconds, so reducing or increasing the auction length
from the proposed 100 to 300 millisecond range may not have a
significant effect on the number of bidders. The Commission
[[Page 234]]
also observes that, even at 1 second most traders using screens would
not be fast enough to participate, limiting the additional market
participants that could potentially join the auctions as bidders.
However, auctions below 10 milliseconds may prevent some participants
that utilize algorithms from responding timely to SIP auction messages.
These limitations likely reflect geographical delay in the SIP, which
is estimated to be up to one millisecond between trading centers in New
York and New Jersey and up four milliseconds from Chicago to New York/
New Jersey.\718\
---------------------------------------------------------------------------
\718\ See MDI Adopting Release, supra note 81, note 1692 and
accompanying text.
---------------------------------------------------------------------------
c. Vary the Minimum Pricing Increment in Qualified Auctions
The Proposal sets the minimum pricing increment at 0.10 cents in a
qualified auction. As an alternative, the Commission could lower the
minimum pricing increment requirement to 0.01 cents in the qualified
auctions. Concern about a minimum pricing increment tends to occur
around pennying on a limit order book, which economically acts as an
erosion of time priority. However, auctions as required do not have
time priority, and so this is less of a concern. Lowering the minimum
pricing increments would allow bidding at more competitive prices. It
could, however, increase the possibility of de minimis price
improvement relative to the limit order book. This would drain
liquidity from the limit order book with little benefit to investors.
Varying the minimum pricing increment could affect the competitiveness
among liquidity suppliers in qualified auctions and also the potential
price improvement that segmented orders may receive.
d. Qualified Auctions With Liquidity Provider Backstop
As another alternative, the Commission could require qualified
auction operators to have a designated liquidity provider (DLP) for
each security to serve as a backstop and guarantee execution of a
portion of the segmented order at the NBBO if an auction does not
produce any bids. For each symbol, the number of shares a DLP would be
obligated to guarantee execution for in an order could be set at the
minimum of some percentage of the average quoted size at the NBBO or
some percentage of the average daily executed share volume, whichever
is smaller.\719\ In return for the DLP backstopping the qualified
auction, if the DLP were tied with other bidders at the best price, the
DLP would be given an allocation guarantee of some percentage of the
size of the segmented order or the size of their bid, whichever is
smaller.\720\ If there were multiple bidders besides the DLP at the
best price, each liquidity supplying order at the same price level
would be assigned a random priority and, after the DLP received its
allocation guarantee, any remaining shares would be filled based on the
random priority ranking. However, qualified auction features that gave
the DLP additional advantages, such as allowing it to automatically
match the best price, would not be allowed.
---------------------------------------------------------------------------
\719\ For example, the Commission could require the DLP to
guarantee execution of a number of shares that would be equal to 25%
of the average quoted size at the NBBO in a security or 0.1% of the
average daily executed share volume in a security, whichever is
smaller.
\720\ For example, the Commission could guarantee that a DLP
would have priority to execute 25% of the shares in the segmented
order if it were tied with other bidders at the same price.
---------------------------------------------------------------------------
Compared to the Proposal, this alternative would provide more
certainty regarding individual investor orders executing in qualified
auctions, particularly in less liquid securities where there may be a
higher chance that no liquidity suppliers bid in the auctions. This
execution certainty would be greater if the DLP's percentage execution
guarantee were higher. However, the DLP would also be taking on greater
risk, because they might have a larger inventory position, which would
put them at greater risk if prices moved against them.
Giving allocation guarantees to DLPs may reduce the incentive for
other market participants to compete to supply liquidity to segmented
orders compared to the Proposal, because they would be less likely to
execute against the segmented order if they submitted an order at the
same price as the DLP.\721\ The incentives of other market participants
to compete to supply liquidity may be reduced more if the percentage of
the segmented order the DLP is guaranteed priority to execute (i.e.,
the DLPs allocation guarantee) is greater.
---------------------------------------------------------------------------
\721\ The reduction in incentives to compete to supply liquidity
to segmented orders compared to the Proposal may be larger for
customer orders, including the orders of institutional investors,
because, in addition to the DLP allocation guarantee, the random
priority structure would further reduce their chance of executing
against an order when their order is tied with others at the same
price compared to the Proposal (in which customer orders had
priority in the event of a tie).
---------------------------------------------------------------------------
e. Two-Sided Auctions
Under this alternative, qualified auction messages would not
include information on the direction of the segmented order (i.e.,
whether it was a buy or sell order). Bidders would be able to submit a
one sided bid (i.e., a directional bid to either buy or sell) or a two
sided bid (i.e., a bid indicating the bidder was willing to both buy
and sell).\722\
---------------------------------------------------------------------------
\722\ A two sided bid could be submitted as providing some sort
of price improvement over the NBBO. For example, a market
participant supplying liquidity in the qualified auction could
submit a two-sided response specifying that they were willing to
execute the segmented order (i.e., they were willing to both buy and
sell to the individual investor) at 0.2 cents better than the NBBO.
---------------------------------------------------------------------------
On the one hand, not disclosing the direction of the segmented
order may reduce bidding from some market participants,\723\
potentially resulting in less competition to supply liquidity to the
segmented order, which may result in segmented orders receiving less
price improvement compared to the Proposal. On the other hand, not
disclosing the direction of the segmented order may also reduce the
risk of information leakage if an institutional investor was bidding in
the auction compared to the Proposal, because it would be more
difficult to discern the direction of the trade.\724\ This could
incentivize more bids from institutional investors, which could
increase the competition to supply liquidity to segmented orders and
potentially provide more improvement in institutional investor
execution quality compared to the Proposal.
---------------------------------------------------------------------------
\723\ For example, not knowing the direction of the segmented
order may reduce the willingness of some market participants to
cancel a resting order with queue position on another venue and
submit it as a bid in the qualified auction because it is more
difficult to know if their order was going to execute.
\724\ See supra section VII.C.2.f for a discussion on the risk
of information leakage from institutional investors supplying
liquidity in qualified auctions.
---------------------------------------------------------------------------
Not disclosing the direction of the segmented order may also reduce
the risk of the NBBO slippage during the qualified auction, i.e., the
risk of the NBBO quotes moving against the individual investor order
(e.g., the probability of an increase in the NBO for a segmented buy
order or a decrease in the NBB for a segmented sell order).\725\
Because market participants setting the NBBO quotes would not know the
direction of the segmented order, to the extent they would have
adjusted their quotes in response to an auction announcement under the
Proposal, they may be less likely to adjust their quotes under this
alternative.
---------------------------------------------------------------------------
\725\ See supra section VII.C.2.b for a further discussion on
individual investor slippage costs in qualified auctions.
---------------------------------------------------------------------------
[[Page 235]]
f. Alternative Maximum Fee for Auctions
The Proposal imposes a 5 mil access fee cap on executed auction
responses and does not allow a fee to be charged for submitting auction
responses or the submission or execution of segmented orders. The
alternative discussed in section VII.D.3.a allows more flexibility in
designing auctions, which could include more flexibility for exchanges
to charge greater fees (and offer greater rebates), both from those
routing orders to an exchange and from those bidding in an exchange. As
exchanges compete to offer auctions, it is possible that access fees
would be competed down to levels that make a cap unnecessary. However,
because the auctions are required for certain segmented orders prior to
internalization, there remains the possibility that this requirement
could lead to access fees being set above those that would occur in the
absence of such a requirement. Due to this market failure, setting a
maximum fee may be necessary. Alternatively the Commission could raise
the 5 mil qualified auction access fee cap to, for example, 10 mils,
and could allow a capped fee on auction respondents and on those
routing segmented orders to qualified auctions. This could raise the
access fees charged to auction responses and lower the price
improvement received by segmented orders, but it would raise the
incentives for exchanges to offer auctions.
g. No Requirement for Customer Priority in Case of Auction Responses at
Same Price
The Proposal currently requires qualified auctions to give priority
to auction responses for the account of a customer over auction
responses for the account of a broker or dealer at the same price.
Under this alternative, the Commission could not specify priority rules
requiring giving priority to customer auction responses. The Commission
could still maintain priority restrictions prohibiting time priority
and prohibiting priority rules favoring the broker-dealer that routed
the segmented order to the auction, the originating broker for the
segmented order, the open competition trading center operating the
auction, or any affiliate of the foregoing persons.\726\ Additionally,
the Commission could also still maintain the proposed priority rules
regarding how qualified auctions would interact with the continuous
limit order book.\727\
---------------------------------------------------------------------------
\726\ See supra section IV.C.5 for further discussions on these
priority restrictions.
\727\ See id. (discussing proposed Rule 615(c)(5)(v)).
---------------------------------------------------------------------------
While one of the goals of the Proposal is to promote the NMS
objective set forth in section 11A(a)(1)(C)(v) of the Exchange Act and
maximize the potential for customer orders to interact with other
customer orders,\728\ giving priority to customer orders may discourage
liquidity provision by broker-dealers in qualified auctions. Compared
to the Proposal, this alternative could encourage greater participation
by traditional liquidity providers, such as exchange market makers and
other OTC dealers, in qualified auctions. However, it might discourage
other customers, including institutional investors, from participating
in qualified auctions, which may be contrary to one of the goals of the
proposal.
---------------------------------------------------------------------------
\728\ See id. (discussing proposed Rule 615(c)(5)(ii)).
---------------------------------------------------------------------------
h. Do Not Reveal Identity of Originating Broker in Qualified Auction
Message
As an alternative, the Commission could not permit the identity of
the originating broker to be disclosed in qualified auction messages.
If the identity of the originating broker were not revealed to bidders
in qualified auctions, then they would need to price their auction
responses based on the average adverse selection risk of the segmented
orders in the qualified auctions. Relative to the proposal, this has
the potential to improve pricing and liquidity for the individual
investor orders from retail brokers presenting greater adverse
selection risk, thereby increasing incentives for information
production and potentially improving price efficiency. However, it may
also potentially reduce the price improvement and increase transaction
costs for individual investor orders of retail brokers presenting lower
adverse selection risk, since their orders could not be distinguished
from the orders of customers of retail brokers that imposed greater
adverse selection risk. Additionally, if wholesalers continue to route
segmented orders and bid in qualified auctions, then they would have a
larger information advantage relative to other participants in
qualified auctions because they would be aware of the identity of the
originating broker of a segmented order they submit to the qualified
auction. This could reduce the incentives of other market participants
to supply liquidity in qualified auctions, because they may be more
likely to suffer from winner's curse, i.e., they would be more likely
to only win qualified auction in which the wholesaler submitting the
segmented order to the auction didn't want to bid aggressively because
the individual investor order posed greater adverse selection risk.
This could reduce competition among liquidity suppliers in qualified
auctions and result in less price improvement and higher transactions
costs for segmented orders compared to the Proposal.
4. Variation in Exceptions to the Order Competition Requirement
a. Vary the Market Value of the Segmented Order Exception for Executing
a Segmented Order at a Restricted Competition Trading Center
As an alternative, the Commission could consider varying the
proposed $200,000 threshold of the order dollar value exception for
having to expose a segmented order in a qualified auction by either
increasing or decreasing the threshold. Table 23 estimates the
distribution of the dollar value of executed orders submitted by
individual investors. Approximately 98.9% of individual investor orders
have a dollar value less than $200,000 and more than 95% of individual
investor orders have a dollar value less than $55,000. Therefore,
unless the proposed order dollar value exception threshold is reduced
significantly, the vast majority of individual investor orders would
remain below the threshold level. Similarly, increasing the threshold
level would not significantly increase the percentage of orders that
would be required to be exposed in qualified auctions.
[[Page 236]]
Table 23--Distribution of Dollar Value of Orders Submitted by Individual Investor
--------------------------------------------------------------------------------------------------------------------------------------------------------
10 Pct 25 Pct 50 Pct 75 Pct 90 Pct 95 Pct 99 Pct
--------------------------------------------------------------------------------------------------------------------------------------------------------
$21.21 $136.13 $1,019.01 $6,232.51 $25,243.63 $54,728.69 $209,281.75
--------------------------------------------------------------------------------------------------------------------------------------------------------
This table presents analysis of CAT data showing the distribution of the original dollar value of orders that resulted in trades and originated from
CAT Individual Customer accounts at one of the 58 MPIDs in the CAT retail analysis identified in Table 7 during March 2022. The distribution is
calculated from all market and limit orders that originated from CAT Individual Customer accounts and resulted in a trade. Dollar values for limit
orders were calculated based on the limit price of the order (limit price times shares in the order). Dollar values of market orders were calculated
based on the far side NBBO quote at the time of order entry and then multiplying that by the number of shares in the order. The execution price was
used in the rare instances when the NBBO wasn't available. See supra Table 7 for details on how the broker-dealers were identified.
A smaller threshold value would result in more segmented orders
potentially being excepted from qualified auctions. Orders above this
value and below $200,000 would be more likely to not be exposed in a
qualified auction and would instead be more likely to be internalized
by a wholesaler without the wholesaler being subject to competition at
the individual order level. This may decrease price improvement offered
to these orders compared to the Proposal. It would also reduce the
chance that other market participants could interact with these
individual investor orders, potentially increasing their transaction
costs compared to the Proposal. However, it may also result in less of
a reduction in wholesaler revenue compared to the Proposal, which may
result in wholesalers not reducing PFOF as much. It may also increase
the likelihood of wholesalers continuing to not charge retail brokers
for their routing services. Both of these changes may also reduce the
chance retail brokers would resume charging commissions compared to the
Proposal.
A larger threshold value would result in more individual investor
orders potentially being included in qualified auctions. This could
result in more individual investors orders over $200,000 receiving
greater price improvement compared to the Proposal, because they would
be more likely to be exposed in qualified auctions. However, this
benefit may be limited, because the auctions may be less likely to
attract sufficient liquidity to fill the entire order.
b. Exception of Beyond-the-Midpoint Non-Marketable Limit Orders
As another alternative, the Commission could create an additional
exception to Proposed Rule 615 that would apply to all segmented orders
that were classified as non-marketable limit orders at the time of
order receipt. Proposed Rule 615 includes beyond-the-midpoint non-
marketable limit orders but exempts non-marketable limit orders with
limit prices at and below the midpoint. Under this alternative, beyond-
the-midpoint non-marketable limit orders that met the other criteria to
be considered a segmented order would also be exempted from Proposed
Rule 615.
Table 24 below provides a break-down of the share of different
order types for individual investors during Q1 2022. The data indicates
that beyond-the-midpoint non-marketable orders only accounted for 1.9%
of the executed dollar volume of orders individual investors routed to
wholesalers.\729\ Furthermore, only 17.7% of the dollar volume in these
orders were executed in a principle capacity, equaling 0.3% of total
executed dollar volume.\730\ Thus, the share of non-marketable limit
orders that is currently isolated at the order-by-order level is an
extremely small share of overall individual investor order flow.
---------------------------------------------------------------------------
\729\ Over 95% of the executed dollar volume individual
investors routed to wholesalers came from marketable orders.
\730\ The majority of the executed dollar volume in beyond-the-
midpoint non-marketable orders was executed in a riskless principal
capacity or was rerouted and executed on an agency basis.
Table 24--Distribution of Individual Investor Order Types, Q1 2022
------------------------------------------------------------------------
Share of
Order type dollar trading
volume (%)
------------------------------------------------------------------------
Marketable Order (% of total)........................... 80.6
Marketable Orders--Principle Execution (% of total)..... 73.5
Principle Share % of Marketable Orders.................. 91.1
Marketable Limit Orders (% of total).................... 14.7
Marketable Limit Orders--Principle Execution (% of 12.7
total).................................................
Principle Share % of Marketable Limit Orders............ 86.4
Beyond-the-Midpoint Non-Marketable Limit Orders (% of 1.9
total).................................................
Beyond-the-Midpoint Non-Marketable Limit Orders-- 0.3
Principle Execution (% of total).......................
Principle Share % of Beyond-the-Midpoint Non-Marketable 17.7
Limit Orders...........................................
Midpoint or below Non-Marketable Limit Orders (mp and 2.8
farside) (% of total)..................................
Midpoint or below Non-Marketable Limit Orders (mp and 0.3
farside)--Principle Execution (% of total).............
Principle Share of Midpoint or below Non-Marketable 10.5
Orders (mp and farside)................................
------------------------------------------------------------------------
This table looks at the percentage of dollar trading volume in NMS
stocks and ETFs of different market and limit (as measured by
marketability) order types that were routed to wholesalers from the 58
broker-dealer MPIDs in the CAT retail analysis in Q1 2022. See supra
Table 7 for additional information on the sample.
The analysis shows the order type's percentage of dollar trading
volume, i.e. the dollar trading volume belonging to a particular order
type (out of the total dollar trading volume across all order types).
The Principle Execution for an order type is the percentage of dollar
trading volume executed in a principal capacity by a wholesaler
belonging to a particular order type (out of the total dollar trading
volume executed in a principal capacity by a wholesaler across all
order types). The Principle Share % for a particular order type is the
percentage of dollar trading volume that was executed by a wholesaler
in a principal capacity (out of the total dollar trading volume in
that order type).
[[Page 237]]
Marketability of a limit order was determined using the NBBO from the
consolidated market data feed at the time the wholesaler received the
order. Marketable limit orders are limit orders where the limit price
is greater than or equal to the opposite side quote (NBB for sell
orders and NBO for buy orders). Beyond-the-midpoint Non-marketable
limit orders are limit orders with limit prices between the midpoint
and the opposite side quote (NBB for sell orders and NBO for buy
orders). Midpoint or below non-marketable limit orders are limit
orders with limit prices between the midpoint and the same side quote.
Given the small volume of beyond-the-midpoint non-marketable limit
orders, the costs and benefits of this alternative could be similar to
the Proposal. However, fewer beyond-the-midpoint non-marketable limit
orders would be submitted to qualified auctions. Instead, more of them
may be internalized or executed on a riskless principal basis, which
may reduce the price improvement they receive relative to the
Proposal.\731\
---------------------------------------------------------------------------
\731\ Both the Proposal and this alternative would allow beyond-
the-midpoint non-marketable limit orders to be routed to an exchange
LOB instead of being submitted to qualified auctions. Therefore,
this alternative may result in a similar portion of individual
investor beyond-the-midpoint non-marketable limit orders being
routed to exchange LOBs as under the Proposal.
---------------------------------------------------------------------------
5. Variation in the Definition of Open Competition Trading Centers
a. Vary Threshold To Become an Open Competition Trading Center
In addition to other requirements, the Proposal requires a trading
center to have an average daily share volume of 1.0 percent or more of
the aggregate average daily share volume for NMS stocks during at least
four of the preceding 6 calendar months in order to qualify as an open
competition trading center. As an alternative, the Commission could
choose to require a higher or a lower percentage, including zero
percent, of the average daily share volume in NMS stocks as the
threshold to qualify as an open competition trading center.
If the threshold were higher, then fewer exchanges and ATSs would
meet the definition of an open competition and be eligible to run
qualified auctions. It could result in reduced competition between
venues running qualified auctions. This may reduce innovation and, to
the extent it occurs within the 5 mil fee and rebate caps, result in
reduced competition between qualified auctions on the basis of access
fees and rebates, which could increase the net capture rate open
competition centers earn from their qualified auctions. However, the
reduced number of qualified auctions could result in more liquidity
suppliers competing in individual qualified auctions (i.e., there would
be less fragmentation of liquidity suppliers across qualified
auctions), which may provide more price improvement to segmented orders
submitted to these auctions.
If the threshold were lower, more exchanges and ATSs would be able
to meet the definition of an open market trading center and be able to
operate qualified auctions. More exchanges and ATSs might operate
qualified auctions, which could enhance competition between venues
running qualified auctions. This could encourage more innovation in
qualified auctions. For example, exchange groups may be more likely to
run multiple qualified auctions on different exchanges with different
structures, priority rules, or fees. It would also reduce the
competitive disadvantage of exchanges and ATSs that would be too small
to run qualified auctions under the Proposal but would be under this
alternative. However, it may result in greater fragmentation of
liquidity suppliers across different qualified auctions, which may
reduce competition between liquidity suppliers in individual qualified
auctions and reduce price improvement to segmented orders submitted to
these auctions. Additionally, greater fragmentation in qualified
auctions could increase the risk that a broker-dealer could route a
segmented order to a qualified auction with less competition from other
liquidity suppliers so that the routing broker-dealer may have a
greater chance to trade with the segmented order.
b. Only National Securities Exchanges as Open Competition Trading
Centers
As an alternative, the Commission could limit the definition of an
open competition trading center to only include national securities
exchanges. This alternative could be in combination with the 1% average
daily share volume in NMS stocks that the Proposal specifies, or some
other threshold (including no threshold) as discussed in section
VII.D.5.a. This would mean that NMS Stock ATSs would not be able to
operate qualified auctions.
Compared to the Proposal, this alternative would put NMS Stock ATSs
at a competitive disadvantage to exchanges. NMS Stock ATSs that would
have met the criteria to be considered open competition trading centers
under the Proposal would be considered restricted trading centers under
this alternative and would not be able to execute segmented orders,
unless it is via one of the exceptions.\732\ More segmented orders
would be routed to qualified auctions on exchanges, which could lead to
these exchanges attracting additional order flow and result in a
greater share of orders being executed on exchanges. This could raise
the barriers to entry for new NMS Stock ATSs and increase the chance
that a smaller NMS Stock ATS exits the market.
---------------------------------------------------------------------------
\732\ Under the Proposal, NMS stock ATSs operating qualified
auctions may have had a competitive advantage over exchanges in the
sense that they would have more flexibility in making changes to
their qualified auctions, because their changes would not be subject
to notice, comment, and Commission approval, like exchanges would.
---------------------------------------------------------------------------
However, relative to the Proposal, this alternative could result in
increased investor protection. Because qualified auctions would be
limited to being operated by national securities exchanges, proposed
rule changes to all qualified auctions would be subject to notice,
comment and Commission approval. This would give the Commission greater
ability to review and disapprove qualified auctions designs to ensure
they met standards of the Proposal, which may increase investor
protection.
c. Eliminate the Requirements for NMS Stock ATSs To Be Open Competition
Trading Centers
As an alternative, the Commission could choose to allow NMS Stock
ATSs to qualify as open competition trading centers and be eligible to
run qualified auctions without imposing the requirements of proposed
Rule 600(b)(64)(ii). However, any average daily NMS stock volume
threshold that would apply to exchanges for being able to run qualified
auctions would also apply to NMS Stock ATSs.\733\ This would mean that
the NMS Stock ATS would not be required to display quotes that are
disseminated in consolidated market data, although it would still need
to subscribe to the ADF so that its qualified auction messages are
included in consolidated data. Additionally, if the NMS Stock ATS was
not subject to the fair access requirements of Rule 301(b)(5), then it
would be allowed to limit subscriber access to its ATS and to its
qualified auction mechanisms. However, the NMS Stock ATS's
[[Page 238]]
qualified auction would still be limited by any of the qualified
auction requirements, either proposed Rule 615(c) or one of the
alternatives discussed in section VII.D.3.
---------------------------------------------------------------------------
\733\ Either the proposed 1% average daily volume threshold or a
higher or lower threshold (including zero percent) as discussed in
supra section VII.D.5.a.
---------------------------------------------------------------------------
This alternative would make it easier for an NMS Stock ATS to
operate a qualified auction and result in more NMS Stock ATSs operating
qualified auctions compared to the Proposal. On the one hand, this
could enhance competition between venues running qualified auctions and
encourage more innovation in qualified auctions. However, NMS Stock
ATSs operating qualified auctions would have a greater competitive
advantage over exchanges. Compared to exchanges, they could limit
access to their platform and the market participants that would be
eligible to participate in qualified auctions.\734\ Although they would
have to charge the same fees and rebates to all bidders in the
qualified auctions, they would have more flexibility in bundling other
aspects of their ATS or services to give an advantage to some
subscribers over others, which may allow these subscribers an indirect
advantage in bidding in qualified auctions. This may limit competition
among liquidity suppliers in these qualified auctions. NMS Stock ATSs
that operate qualified auctions may also be a more attractive
destination for some broker-dealers to route segmented orders because
they may give the broker-dealer routing the order an increased chance
of being able to trade with the segmented order compared to qualified
auctions operated by exchanges. These competitive advantages of NMS
Stock ATSs operating qualified auctions may limit the incentives for
exchanges to operate qualified auctions, which could reduce competition
between venues running qualified auctions.
---------------------------------------------------------------------------
\734\ Additionally, NMS stock ATSs would have more flexibility
in making changes to their qualified auctions, because their changes
would not be subject to notice, comment, and Commission approval,
like exchanges would.
---------------------------------------------------------------------------
6. Wholesaler Information Barriers
As an alternative, the Commission could establish a new information
barrier rule specifying new policies and procedures for wholesalers
that must be part of the policies and procedures for protecting
material, non-public information that Exchange Act Section 15(g)
requires of all broker-dealers. The new rule would require wholesalers
to not share information on customer order flow, either on individual
orders or in aggregate, outside of the wholesaler business functions
that were responsible for the handling and execution of the customer
orders. This would prevent wholesalers from sharing this information
with other business units and affiliates that may engage in proprietary
trading or other business functions not related to the handling or
execution of the customer order. The rule particularly would focus on
assuring that customer order information is not used in a way that
would detract from the interests of customers in obtaining best
execution of their orders.
A wholesaler information barrier rule would result in greater
protection of customer order information at wholesalers, which would
improve investor protection. It may also improve customer order
execution quality by reducing the chance that another trader will be
able to use customer order information to trade ahead of or adjust
liquidity to disadvantage the customer order. This rule may reduce the
profits of other wholesaler lines of business or affiliates that may
have benefited from customer order information. This may reduce the
incentives for wholesalers to handle individual investor orders, which
may reduce the amount of price improvement they offer to individual
investor orders or the PFOF they pay to retail brokers. To the extent
that the use of this information by other wholesaler business lines
increases information asymmetries and adverse selection risk for other
market participants, the rule may reduce adverse selection risk faced
by other liquidity providers, which could improve market quality.
7. Display Quotes in Retail Liquidity Programs
As an alternative the Commission could allow national securities
exchanges to display the price and size of quotes in their RLP programs
on their proprietary feeds and in the consolidated market data feed.
Under this alternative, exchanges would not execute as large a share of
marketable individual investor orders as under the Proposal. Instead,
the majority of marketable individual investor orders would still be
internalized by wholesalers. This would occur because liquidity
providers quoting in exchange RLP programs would not know the identity
of the retail broker of the marketable individual investor orders they
are trading against. Therefore, they would usually need to set their
quotes in the RLP programs wider to account for the risk of trading
with individual investor order flow that imposed greater adverse
selection risk. However, wholesalers would know the identity of the
retail broker of the order they were handling. This means wholesalers
could avoid internalizing individual investor order flow that posed
greater adverse selection risk and give greater price improvement to
individual investor orders with less adverse selection risk.
On average, marketable individual investor orders would receive
less price improvement under this alternative than the Proposal because
wholesalers would not need to compete on an order by order basis when
they internalize an individual investor order. Institutional investor
transaction costs would also be higher than under the Proposal because
they would not be able to trade with marketable individual investor
orders as frequently. A lack of order-by-order competition would also
allow wholesalers to pay more PFOF to retail brokers than under the
proposal, since wholesalers would be able to internalize order flow at
more profitable spreads relative to those that would emerge under
qualified auctions. From this increased profitability, wholesalers
would be able to pay more PFOF. Increased PFOF revenue would reduce the
incentive for broker-dealers to generate new revenue lines or expand
existing revenue lines. Therefore, under this alternative there would
not be as significant a change in retail broker business models.
Compared to the baseline, there would be greater transparency in
the liquidity available to the marketable orders of individual
investors. This could increase competition between exchange RLPs and
wholesalers for the execution of individual investor marketable orders
and result in more individual investor orders being executed in
exchange RLPs (although the majority of individual investor orders
would still likely be internalized by wholesalers). Because broker-
dealers would be able to see the displayed quotes in RLPs, when
marketable orders of individual investors are routed to execute in
RLPs, it may be because the quoted prices in the RLP were better than
the prices the wholesaler would have been willing to internalize the
individual investor order at. Additionally, the increase in competition
may result in wholesalers offering more price improvement to the
marketable orders of individual investors to attract order flow from
retail brokers. Both of these effects may result in lower trading costs
for marketable orders of individual investors compared to the baseline.
However, if wholesalers earn lower marginal profits from internalizing
the orders of individual investors, they may reduce the amount of PFOF
they pay to retail brokers that accept PFOF, which could indirectly get
passed through to the retail brokers'
[[Page 239]]
customers in the form of reduced services or an increased risk of the
retail broker charging commissions.
8. Creation of a Retail Best Bid and Offer
As an alternative, in addition to displaying quotes in RLPs, the
Commission could introduce a new, smaller-sized benchmark from the NBBO
for segmented orders. The new benchmark would be called the Retail Best
Bid and Offer (``RBBO''). It would be constructed similar to the NBBO,
but the threshold for determining when an exchange's quotes qualified
for the RBBO would be based on a $500 notional value. It would also
incorporate information from smaller odd lot quotations and quotes from
exchange RLPs, which would be aggregated up across multiple price
levels by individual exchanges until they exceeded a value of $500 or
greater. The least aggressive price level from this aggregation would
be sent to the SIP for the purposes of determining the RBBO. The RBBO
would be a protected quote for the purposes of executing segmented
orders and would also be added as a benchmark in Rule 605 reports for
calculating price improvements statistics for segmented orders.
Compared to the Proposal, this alternative would result in
wholesalers internalizing a larger share of marketable orders of
individual investors and fewer such orders being executed on exchanges.
Although quotes in RLPs and smaller odd-lot quotes would be protected
with respect to segmented orders, liquidity providers quoting in
exchange RLPs would usually need to set their quotes in the RLPs wider
than the prices at which wholesalers might internalize individual
investor orders to account for the risk of trading with individual
investor order flow that imposed greater adverse selection risk.\735\
---------------------------------------------------------------------------
\735\ Wholesalers would still know the identity of the retail
broker whose orders they internalize. Compared to liquidity
suppliers in exchange RLP programs, they would likely be able to
further sub-segment individual investor order flow when considering
how much price improvement to offer.
---------------------------------------------------------------------------
On average, marketable orders of individual investors would receive
less price improvement under this alternative than the Proposal because
wholesalers would not need to compete on an order by order basis when
they internalize an individual investor order. Institutional investor
trading costs would also be higher than under the Proposal because they
would not be able to trade with marketable orders of individual
investors as frequently. A lack of order by order competition would
also allow wholesalers to pay more PFOF to retail brokers than under
the Proposal. Therefore, there would not be as significant improvements
in retail broker business models.
However, compared to the baseline, there would be more price
improvement and lower trading costs for marketable orders of individual
investors. This would occur because wholesalers would need to offer
price improvement against a tighter benchmark in order to internalize a
segmented order. The disclosure of price improvement against the NBBO
in Rule 605 reports might also enhance competition among wholesalers to
offer greater price improvement in order to attract more order flow
from retail brokers.
9. Disclosure of Execution Quality of Individual Investor Orders
Instead of requiring that segmented orders be routed to qualified
auctions, the Commission could require that execution quality
information concerning an individual investor's order be disclosed on
their transaction confirmations. Specifically, under this alternative
retail brokers would be required to disclose information on the number
of shares executed, the price improvement relative to the NBBO, the
effective-to-quoted spread ratio, and time to execution. This
information would be provided along with the confirmation of each trade
to the customer who had placed the order, enhancing transparency on
each individual investor's own execution quality.
The Commission believes that this disclosure would not
significantly increase transparency regarding how execution quality
varies across retail brokers for two reasons. First, reflecting their
small scale of trading activity, most individual investors rely on a
single retail broker that executes orders on their behalf. As such,
most customers would never have a chance to compare the execution
quality of their trades via a given retail broker to similar executions
at another retail broker. Second, even if a customer used services of
more than one retail broker contemporaneously, the small sample of that
individual investor's execution quality metrics as well as differences
between the orders of the customer that were handled by different
retail brokers may lead to misleading inferences about execution
quality differences across brokers.
The Commission also believes that the benefits of this alternative
are limited relative to the Proposal because marketable individual
investor orders would remain mostly isolated, i.e., mostly executed by
the wholesaler handling these orders. A lack of interaction with
trading interest from other market participants would prevent the
execution quality improvements that would otherwise obtain under the
Proposal. As such, there would be less of an increase in price
improvement (and reduction in transaction costs) for individual
investors compared to the Proposal. Additionally, compared to the
Proposal, this alternative would not provide other market participants,
including institutional investors, as great a chance to directly
interact with order flow from individual investors, which may result in
institutional investors receiving worse order execution quality
compared to the Proposal.
E. Request for Comments
The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (1) identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (2) given due consideration to each
benefit and cost, including each effect on efficiency, competition, and
capital formation; and (3) identified and considered reasonable
alternatives to the proposed new rules and rule amendments. The
Commission requests and encourages any interested person to submit
comments regarding the proposed rules, the Commission's analysis of the
potential effects of the proposed rules and proposed amendments, and
other matters that may have an effect on the proposed rules. The
Commission requests that commenters identify sources of data and
information as well as provide data and information to assist us in
analyzing the economic consequences of the proposed rules and proposed
amendments. The Commission also is interested in comments on the
qualitative benefits and costs identified and any benefits and costs
that may have been overlooked. In addition to our general request for
comments on the economic analysis associated with the proposed rules
and proposed amendments, the Commission requests specific comment on
certain aspects of the proposal:
38. Do commenters believe the Commission has adequately described
the market failures due to the existing structure of U.S. stock
markets? Why or why not?
39. Do commenters agree with the Commission's qualitative and
quantitative baseline descriptions of the structure of trading for NMS
stocks, including trading service, broker services, and access to
market centers? Why or why not?
[[Page 240]]
40. Do commenters agree with the Commission's qualitative and
quantitative baseline descriptions of order routing behavior of retail
brokers? Why, or why not?
41. Do commenters agree with the Commission's assessment of
execution quality and fill rates of individual investor orders in NMS
stocks? Why, or why not?
42. Do commenters agree with the Commission's assessment of
brokers' handling of fractional individual investor orders? Why or why
not?
43. Do commenters agree with the Commission's characterization of
individual investor order flow segmentation by wholesalers? Why, or why
not?
44. Do commenters agree with the Commission's characterization of
the interaction between wholesalers and institutional investors? Please
explain why, or why not?
45. Do commenters agree with the Commission's description of market
making expenses of wholesalers? What other types of such market making
costs should be considered? Please provide conceptual and quantitative
context.
46. Do commenters agree with the Commission's description of the
trade-off between PFOF and execution quality of individual investor
orders faced by PFOF receiving retail brokers, driven by the business
models of these brokers and the wholesalers who offer PFOF? Why, or why
not?
47. Do commenters agree with the Commission's descriptions of
different aspects of retail brokers' business models? Why, or why not?
48. Do commenters agree the Commission's assessment of conflict of
interests on the parts of wholesalers and PFOF receiving brokers?
Please explain your reasoning.
49. Do commenters agree with the Commission's assessment of the
impacts of such conflicts of interest on the execution quality of
individual investor orders? Why or why not?
50. Do commenters agree with the Commission that a lack of order-
by-order competition is a key missing component in the individual
investor order execution process? Please explain why or why not.
51. Do commenters agree with Commission's assessment that retail
brokers' use of past execution quality metrics to determine the
allocation of current individual investor order flow across wholesalers
may lead to poor execution quality for some individual investor orders?
Why or why not?
52. Do commenters agree with the Commission that the existing
execution practices for individual investor orders makes the portion of
individual investor order flow with the least adverse selection risk
inaccessible to other market participants, including institutional
investors? Please explain why or why not.
53. Do commenters agree with the Commission's assessment that the
ability of wholesalers to choose which orders to internalize and which
ones to allow to interact with trading interest with other market
participants places wholesalers at a competitive advantage? Why or why
not?
54. Do commenters agree that the proposed Rule would improve
competition, including in the market for trading service and the market
for broker-dealer services? Why or why not?
55. Do you agree with the Commission that the proposed Rule would
lower trading costs to individual and institutional investors, enhance
individual investor order execution quality and price discovery, and
improve efficiency in the operations of retail brokers? Please explain
why or why not?
56. Does the Economic Analysis in this release account for all
compliance costs? If not, what other compliance cost would market
participants or exchanges incur? Please provide estimates of the
additional compliance costs that you believe should be considered.
57. Does the Economic Analysis in this release account for all
relevant costs? If not, which other costs should the economic analysis
consider? Please provide estimates of additional costs, other than
compliance costs, that you believe should be considered.
58. Do commenters agree with the Commission's assessment of how the
Proposed Rule would impact efficiency and capital formation? Why, or
why not? Please explain.
59. Do commenters agree with the Commission's analysis of the
benefits and costs of the reasonable alternatives to the Proposed Rule?
Why, or why not? Please explain.
60. Are there any additional reasonable alternatives the Commission
should consider? If so, please describe that alternative and provide
the benefits and costs of that alternative relative to the baseline and
to the proposed Rule.
61. Should the Commission specify a minimum set of auction
standards as part of the reasonable alternative to allow open
competition trading centers more flexibility in designing qualified
auctions? If so, what minimum set of auction standards should the
Commission specify and why? Please explain. What would be the costs and
benefits or other economic effects of specifying this minimum set of
auctions standards? Should the Commission specify a minimum auction
duration as part of this alternative? Why or why not? If so, what
minimum auction duration should the Commission specify? Please explain
and provide as much analysis and discussion as possible. Should the
Commission specify that execution priority shall not be based on time
of receipt of the auction response as part of this alternative? Why or
why not? Please explain.
62. Instead of requiring the consolidated tapes to amend their
plans to include qualified auction messages, should the Commission
accelerate the inclusion of all auction information in NMS data from
the MDI Rules? What would be the costs and benefits or other economic
effects of accelerating the inclusion of all auction information in NMS
data? How would such an acceleration impact eventual competition among
competing consolidators or the realization of the anticipated costs and
benefits of the MDI Rules? Please explain.
VIII. Regulatory Flexibility Act Certification
The Regulatory Flexibility Act (``RFA'') \736\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) of the Administrative Procedure
Act,\737\ as amended by the RFA, generally requires the Commission to
undertake an initial regulatory flexibility analysis of the impact of
the proposed rule amendments on ``small entities.'' \738\ Section
605(b) of the RFA states that this requirement shall not apply to any
proposed rule or proposed rule amendment which, if adopted, would not
have a significant impact on a substantial number of small
entities.\739\
---------------------------------------------------------------------------
\736\ 5 U.S.C. 601 et seq.
\737\ 5 U.S.C. 603(a).
\738\ Although section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
``small entity'' for the purposes of Commission rulemaking in
accordance with the RFA. Those definitions, as relevant to this
proposed rulemaking, are set forth in Rule 0-10 under the Exchange
Act, 17 CFR 240.0-10.
\739\ 5 U.S.C. 605(b).
---------------------------------------------------------------------------
Certification for Proposed Rule 615 and the Related Amendments
Proposed Rule 615 and the proposed related amendments are discussed
in detail in section IV (Description of Proposed Rule 615) above. The
economic impact, including the estimated compliance costs and burdens,
of Proposed Rule 615 are
[[Page 241]]
discussed in section VI (Paperwork Reduction Act Analysis) and section
VII (Economic Analysis). As discussed above in those sections, Proposed
Rule 615 and the proposed related amendments would have an impact on
certain broker-dealers, NMS Stock ATSs, national securities exchanges,
and national securities associations.
Impact on Broker-Dealers
Although section 601(b) of the RFA defines the term ``small
business,'' as stated above, the statute permits agencies to formulate
their own definitions, and for purposes of Commission rulemaking in
connection with the RFA, a small business includes a broker or dealer
that: (1) had total capital (net worth plus subordinated liabilities)
of less than $500,000 on the date in the prior fiscal year as of which
its audited financial statements were prepared pursuant to Rule 17a-
5(d) under the Exchange Act,\740\ or, if not required to file such
statements, a broker-dealer with total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last day of the
preceding fiscal year (or in the time that it has been in business, if
shorter); and (2) is not affiliated with any person (other than a
natural person) that is not a small business or small
organization.\741\ Applying this test and based on a review of data
relating to broker-dealers,\742\ the Commission estimates, as discussed
below, that of the 3,498 broker-dealers, there are only 4 that would be
``small entities'' and also in the scope of Proposed Rule 615.
---------------------------------------------------------------------------
\740\ 17 CFR 240.17a-5(d).
\741\ See 17 CFR 240.0-10(c); see also 17 CFR 240.0-10(i)
(providing that a broker or dealer is affiliated with another person
if: such broker or dealer controls, is controlled by, or is under
common control with such other person; a person shall be deemed to
control another person if that person has the right to vote 25% or
more of the voting securities of such other person or is entitled to
receive 25% or more of the net profits of such other person or is
otherwise able to direct or cause the direction of the management or
policies of such other person; or such broker or dealer introduces
transactions in securities, other than registered investment company
securities or interests or participations in insurance company
separate accounts, to such other person, or introduces accounts of
customers or other brokers or dealers, other than accounts that hold
only registered investment company securities or interests or
participations in insurance company separate accounts, to such other
person that carries accounts on a fully disclosed basis).
\742\ The Commission considered FOCUS data and information about
broker-dealers made publicly available by FINRA through reports
available at https://brokercheck.finra.org/.
---------------------------------------------------------------------------
Proposed Rule 615(a) would apply to any restricted competition
center that executes internally segmented orders in NMS stocks.
Restricted competition trading centers would include NMS Stock ATSs
that do not meet the definition of open competition trading center,
and, with the exception of national securities exchanges, any other
trading center that executes segmented orders, which would include
certain broker-dealers. The Commission has identified no broker-dealers
that likely execute internally orders for customer accounts that would
be ``small entities.''
Proposed Rule 615 and the related amendments would also apply to
any broker or dealer that could potentially handle segmented orders. As
discussed in section VI, this would include the 157 broker-dealers that
the Commission has identified that carry customer accounts, and would
be in the scope of Proposed Rule 615. Of these, the Commission has
identified 1 that may be a ``small entity.'' Also as discussed in
section VI, the Commission has identified 25 broker-dealers that may
fall within the scope of Proposed Rule 615 because, although they
report that do not carry customer accounts, they report that they do
effect public customer transactions in equity securities on a national
securities exchange or OTC and likely are acting as ``executing
brokers.'' Of these, the Commission has identified 3 that may
potentially be engaged in lines of business that would make them within
the scope of Proposed Rule 615 and that may also be ``small entities.''
Finally, as discussed in section VI, the Commission has identified
1,267 broker-dealers that would likely be ``originating brokers'' with
responsibility for monitoring customer accounts that could potentially
fall within the scope of Proposed Rule 615. Of these, however, the
Commission concludes that none of the approximately 20 broker-dealers
that the Commission estimates would fall within the scope of Proposed
Rule 615, because they may make the certification referred to in
paragraph (c)(1) of Proposed Rule 615,\743\ would be ``small
entities.''
---------------------------------------------------------------------------
\743\ Supra section VI.C.3 (discussing which broker-dealers
would likely certify that they established, maintained, and enforced
policies and procedures reasonably designed to assure that the
identity of the originating broker will not be disclosed, directly
or indirectly, to any person that potentially could participate in
the qualified auction or otherwise trade with the segmented order).
---------------------------------------------------------------------------
Impact on National Securities Exchanges, National Securities
Associations, and NMS Stock ATSs
Also as discussed above in sections IV, VI and VII, Proposed Rule
615 and the proposed related amendments would impose requirements on
national securities exchanges, national securities associations, and
NMS Stock ATSs. With respect to national securities exchanges, the
Commission's definition of a small entity is an exchange that has been
exempt from the reporting requirements of Rule 601 of Regulation NMS,
and is not affiliated with any person (other than a natural person)
that is not a small business or small organization.\744\ Applying this
test, no national securities exchange is a small entity. The only
national securities association, is also not a ``small entity.'' \745\
---------------------------------------------------------------------------
\744\ See 17 CFR 240.0-10(e) (providing that when used with
reference to an exchange, means any exchange that: (1) has been
exempted from the reporting requirements of Rule 601; and (2) is not
affiliated with any person (other than a natural person) that is not
a small business or small organization); see also 17 CFR 240.0-10(i)
(providing that a person is affiliated with another person if that
person controls, is controlled by, or is under common control with
such other person; and a person shall be deemed to control another
person if that person has the right to vote 25% or more of the
voting securities of such other person or is entitled to receive 25%
or more of the net profits of such other person or is otherwise able
to direct or cause the direction of the management or policies of
such other person).
\745\ See 13 CFR 121.201.
---------------------------------------------------------------------------
With respect to NMS Stock ATSs, all ATSs, including NMS Stock ATSs,
are required to register as broker-dealers.\746\ The Commission
examined recent FOCUS data for the broker-dealers that operate the 32
NMS Stock ATSs and applying the test for broker-dealers described above
\747\ believes that none of the NMS Stock ATSs currently trading were
operated by a broker-dealer that is a ``small entity.''
---------------------------------------------------------------------------
\746\ Rule 301(b)(1) of Regulation ATS. Also, while a national
securities exchanges can operate an ATS, subject to certain
conditions, such an ATS would have to be registered as a broker-
dealer. See Regulation ATS Adopting Release, supra note 27, at
70891. Currently, no national securities exchange operates an ATS
that trades NMS stocks.
\747\ Supra note 741 and accompanying text.
---------------------------------------------------------------------------
For the above reasons, the Commission certifies that Proposed Rule
615 and the proposed related amendments would not have a significant
economic impact on a substantial number of small entities for purposes
of the RFA.
The Commission requests written comments regarding this
certification. The Commission invites commenters to address whether the
proposed rules would have a significant impact on a substantial number
of small entities, and requests that commenters describe the nature of
any impact on small entities and provide empirical data to support the
extent of the impact.
IX. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of
[[Page 242]]
1996, or ``SBREFA,'' \748\ the Commission must advise OMB whether a
proposed regulation constitutes a ``major'' rule. Under SBREFA, a rule
is considered ``major'' where, if adopted, it results in or is likely
to result in (1) an annual effect on the economy of $100 million or
more; (2) a major increase in costs or prices for consumers or
individual industries; or (3) significant adverse effects on
competition, investment, or innovation. The Commission requests comment
on the potential effect of the proposed amendments on the U.S. economy
on an annual basis; any potential increase in costs or prices for
consumers or individual industries; and any potential effect on
competition, investment, or innovation. Commenters are requested to
provide empirical data and other factual support for their views to the
extent possible.
---------------------------------------------------------------------------
\748\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
Statutory Authority
Pursuant to the Exchange Act (15 U.S.C. 78a et seq.), and
particularly sections 3(b), 5, 6, 11A, 15, 15C, 17(a), 17(b), 19,
23(a), and 36 thereof (15 U.S.C. 78c(b), 78e, 78f, 78k-1, 78o, 78o-5,
78q(a), 78q(b), 78s, 78w(a), and 78mm), the Commission proposes to
amend parts 240 and 242 of chapter II of title 17 of the Code of
Federal Regulations as follows:
List of Subjects in 17 CFR Parts 240 and 242
Brokers, Reporting and recordkeeping requirements, Securities.
Text of the Proposed Rule and Amendments
For the reasons stated in the preamble, the Commission is proposing
to amend title 17, chapter II of the Code of Federal Regulations:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT of
1934
0
1. The general authority citation for part 240 continues to read as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et
seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C.
1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub. L. 112-
106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise noted.
* * * * *
Sec. 240.3a51-1 [Amended]
0
2. Amend Sec. 240.3a51-1 by, in paragraph (a), removing the text
``Sec. 242.600(b)(55)'' and adding in its place ``Sec.
242.600(b)(58)''.
Sec. 240.13h-1 [Amended]
0
3. Amend Sec. 240.13h-1 by, in paragraph (a)(5), removing the text
``Sec. 242.600(b)(54)'' and adding in its place ``Sec.
242.600(b)(57)''.
PART 242--REGULATIONS M, SHO, ATS, AC, NMS, AND SBSR AND CUSTOMER
MARGIN REQUIREMENTS FOR SECURITY FUTURES
0
4. The authority for part 242 continues to read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2),
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g),
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and
80a-37.
Sec. 242.105 [Amended]
0
5. Amend Sec. 242.105 by:
0
a. In paragraph (b)(1)(i)(C), removing the text ``Sec.
242.600(b)(30)'' and adding in its place ``Sec. 242.600(b)(33)''.
0
b. In paragraph (b)(1)(ii), removing the text ``Sec. 242.600(b)(77)''
and adding in its place ``Sec. 242.600(b)(84)''.
Sec. 242.201 [Amended]
0
6. Amend Sec. 242.201 by:
0
a. In paragraph (a)(1), removing the text ``Sec. 242.600(b)(55)'' and
adding in its place ``Sec. 242.600(b)(58)''.
0
b. In paragraph (a)(2), removing the text ``Sec. 242.600(b)(30)'' and
adding in its place ``Sec. 242.600(b)(33)''.
0
c. In paragraph (a)(3), removing the text ``Sec. 242.600(b)(68)'' and
adding in its place ``Sec. 242.600(b)(74)''.
0
d. In paragraph (a)(4), removing the text ``Sec. 242.600(b)(50)'' and
adding in its place ``Sec. 242.600(b)(53)''.
0
e. In paragraph (a)(5), removing the text ``Sec. 242.600(b)(58)'' and
adding in its place ``Sec. 242.600(b)(62)''.
0
f. In paragraph (a)(6), removing the text ``Sec. 242.600(b)(67)'' and
adding in its place ``Sec. 242.600(b)(73)''.
0
g. In paragraph (a)(7), removing the text ``Sec. 242.600(b)(77)'' and
adding in its place ``Sec. 242.600(b)(84)''.
0
h. In paragraph (a)(9), removing the text ``Sec. 242.600(b)(95)'' and
adding in its place ``Sec. 242.600(b)(105)''.
Sec. 242.204 [Amended]
0
7. Amend Sec. 242.204 by:
0
a. In paragraph (g)(2), removing the text ``Sec. 242.600(b)(77) (Rule
600(b)(77) of Regulation NMS)'' and adding in its place ``Sec.
242.600(b)(84) (Rule 600(b)(84) of Regulation NMS)''.
0
8. Amend Sec. 242.600 by:
0
a. In paragraph (b) introductory text, removing the text ``(Sec. Sec.
242.600 through 242.612)'' and adding in its place ``(Sec. Sec.
242.600 through 242.615)'';
0
b. Redesignating paragraphs (b)(3) through (100) as follows:
------------------------------------------------------------------------
Old paragraph New paragraph
------------------------------------------------------------------------
(b)(3).................................... (b)(4)
(b)(4).................................... (b)(5)
(b)(5).................................... (b)(6)
(b)(6).................................... (b)(7)
(b)(7).................................... (b)(8)
(b)(8).................................... (b)(9)
(b)(9).................................... (b)(10)
(b)(10)................................... (b)(11)
(b)(11)................................... (b)(12)
(b)(12)................................... (b)(13)
(b)(13)................................... (b)(14)
(b)(14)................................... (b)(15)
(b)(15)................................... (b)(16)
(b)(16)................................... (b)(17)
(b)(17)................................... (b)(18)
(b)(18)................................... (b)(19)
(b)(19)................................... (b)(20)
(b)(20)................................... (b)(21)
(b)(21)................................... (b)(24)
(b)(22)................................... (b)(25)
(b)(23)................................... (b)(26)
(b)(24)................................... (b)(27)
(b)(25)................................... (b)(28)
(b)(26)................................... (b)(29)
(b)(27)................................... (b)(30)
(b)(28)................................... (b)(31)
(b)(29)................................... (b)(32)
(b)(30)................................... (b)(33)
(b)(31)................................... (b)(34)
(b)(32)................................... (b)(35)
(b)(33)................................... (b)(36)
(b)(34)................................... (b)(37)
(b)(35)................................... (b)(38)
(b)(36)................................... (b)(39)
(b)(37)................................... (b)(40)
(b)(38)................................... (b)(41)
(b)(39)................................... (b)(42)
(b)(40)................................... (b)(43)
(b)(41)................................... (b)(44)
(b)(42)................................... (b)(45)
(b)(43)................................... (b)(46)
(b)(44)................................... (b)(47)
(b)(45)................................... (b)(48)
(b)(46)................................... (b)(49)
(b)(47)................................... (b)(50)
(b)(48)................................... (b)(51)
(b)(49)................................... (b)(52)
(b)(50)................................... (b)(53)
(b)(51)................................... (b)(54)
(b)(52)................................... (b)(55)
(b)(53)................................... (b)(56)
(b)(54)................................... (b)(57)
(b)(55)................................... (b)(58)
(b)(56)................................... (b)(60)
(b)(57)................................... (b)(61)
(b)(58)................................... (b)(62)
(b)(59)................................... (b)(63)
(b)(60)................................... (b)(65)
(b)(61)................................... (b)(66)
(b)(62)................................... (b)(67)
(b)(63)................................... (b)(68)
(b)(64)................................... (b)(70)
(b)(65)................................... (b)(71)
(b)(66)................................... (b)(72)
(b)(67)................................... (b)(73)
(b)(68)................................... (b)(74)
(b)(69)................................... (b)(75)
(b)(70)................................... (b)(76)
(b)(71)................................... (b)(77)
[[Page 243]]
(b)(72)................................... (b)(78)
(b)(73)................................... (b)(79)
(b)(74)................................... (b)(80)
(b)(75)................................... (b)(82)
(b)(76)................................... (b)(83)
(b)(77)................................... (b)(84)
(b)(78)................................... (b)(85)
(b)(79)................................... (b)(86)
(b)(80)................................... (b)(88)
(b)(81)................................... (b)(89)
(b)(82)................................... (b)(90)
(b)(83)................................... (b)(92)
(b)(84)................................... (b)(93)
(b)(85)................................... (b)(94)
(b)(86)................................... (b)(95)
(b)(87)................................... (b)(96)
(b)(88)................................... (b)(97)
(b)(89)................................... (b)(98)
(b)(90)................................... (b)(99)
(b)(91)................................... (b)(101)
(b)(92)................................... (b)(102)
(b)(93)................................... (b)(103)
(b)(94)................................... (b)(104)
(b)(95)................................... (b)(105)
(b)(96)................................... (b)(106)
(b)(97)................................... (b)(107)
(b)(98)................................... (b)(108)
(b)(99)................................... (b)(109)
(b)(100).................................. (b)(110)
------------------------------------------------------------------------
0
c. Adding new paragraphs (b)(3), (b)(22), (b)(23), (b)(59), (b)(64),
(b)(69), (b)(81), (b)(87), (b)(91), and (b)(100).
The additions read as follows:
Sec. 242.600 NMS security designation and definitions.
* * * * *
(b) * * *
(3) Affiliate means, with respect to a specified person, any person
that, directly or indirectly, controls, is under common control with,
or is controlled by, the specified person.
* * * * *
(22) Continuous order book means a system that allows orders for
NMS stocks to be accepted and executed on a continuous basis.
(23) Control means the power, directly or indirectly, to direct the
management or policies of a broker, dealer, or open competition trading
center, whether through ownership of securities, by contract, or
otherwise. A person is presumed to control a broker, dealer, or open
competition trading center if that person:
(i) Is a director, general partner, or officer exercising executive
responsibility (or having similar status or performing similar
functions);
(ii) Directly or indirectly has the right to vote 25 percent or
more of a class of voting securities or has the power to sell or direct
the sale of 25 percent or more of a class of voting securities of the
broker, dealer, or open competition trading center; or
(iii) In the case of a partnership, has contributed, or has the
right to receive upon dissolution, 25 percent or more of the capital of
the broker, dealer, or open competition trading center.
* * * * *
(59) NMS Stock ATS has the meaning provided in Sec. 242.300(k).
* * * * *
(64) Open competition trading center means either:
(i) A national securities exchange that:
(A) Operates an SRO trading facility that is an automated trading
center and displays automated quotations that are disseminated in
consolidated market data pursuant to Sec. 242.603(b);
(B) Provides transaction reports identifying the national
securities exchange as the venue of execution that are disseminated in
consolidated market data pursuant to Sec. 242.603(b);
(C) During at least four of the preceding 6 calendar months, had an
average daily share volume of 1.0 percent or more of the aggregate
average daily share volume for NMS stocks as reported by an effective
transaction reporting plan; and
(D) Operates pursuant to its own rules providing that the national
securities exchange will comply with the requirements of Sec.
242.615(c) for a qualified auction; or
(ii) An NMS Stock ATS that:
(A) Displays quotations through an SRO display-only facility in
compliance with Sec. 242.610(b);
(B) Operates as an automated trading center and displays automated
quotations that are disseminated in consolidated market data pursuant
to Sec. 242.603(b);
(C) Provides transaction reports identifying the NMS Stock ATS as
the venue of execution that are disseminated in consolidated market
data pursuant to Sec. 242.603(b);
(D) Permits any registered broker or dealer to become a subscriber
of the NMS Stock ATS; provided, however, the NMS Stock ATS:
(1) Shall not permit any registered broker or dealer subject to a
statutory disqualification to be or become a subscriber; and
(2) May, pursuant to written policies and procedures, prohibit any
registered broker or dealer from being or becoming a subscriber, or
impose conditions upon such a subscriber, that does not meet the
standards of financial responsibility or operational capability as are
prescribed by such written policies and procedures;
(E) Provides equal access among all subscribers of the NMS Stock
ATS and the registered broker-dealer of the NMS Stock ATS to all
services that are related to:
(1) A qualified auction operated by the NMS Stock ATS under Sec.
242.615(c); and
(2) Any continuous order book operated by the NMS Stock ATS;
(F) During at least four of the preceding six calendar months, had
an average daily share volume of 1.0 percent or more of the aggregate
average daily share volume for NMS stocks as reported by an effective
transaction reporting plan; and
(G) Operates pursuant to an effective Form ATS-N under Sec.
242.304, and such Form ATS-N evidences compliance by the NMS Stock ATS
with the requirements of Sec. 242.615(c) for a qualified auction and
with the provisions of paragraphs (b)(64)(ii)(A) through (b)(64)(ii)(F)
of this section.
* * * * *
(69) Originating broker means any broker with responsibility for
handling a customer account, including, but not limited to, opening and
monitoring the customer account and accepting and transmitting orders
for the customer account.
* * * * *
(81) Qualified auction means an auction that is operated by an open
competition trading center pursuant to Sec. 242.615(c).
* * * * *
(87) Restricted competition trading center means any trading center
that is not an open competition trading center and is not a national
securities exchange.
* * * * *
(91) Segmented order means an order for an NMS stock that is for an
account:
(i) Of a natural person or an account held in legal form on behalf
of a natural person or group of related family members; and
(ii) In which the average daily number of trades executed in NMS
stocks was less than 40 in each of the six preceding calendar months.
(iii) For purposes of this paragraph (b)(91), group of related
family members means a group of natural persons with any of the
following relationships: child, stepchild, grandchild, great
grandchild, parent, stepparent, grandparent, great grandparent,
domestic partner, spouse, sibling, stepbrother, stepsister, niece,
nephew, aunt, uncle, mother-in-law, father-in-law, son-in-law,
daughter-in-law, brother-in-law, or sister-in-law, including adoptive
and foster relationships; and any other natural person (other than a
tenant or employee)
[[Page 244]]
sharing a household with any of the foregoing natural persons.
* * * * *
(100) Subscriber has the meaning provided in Sec. 242.300(b).
* * * * *
Sec. 242.602 [Amended]
0
9. Amend Sec. 242.602 by, in paragraphs (a)(5)(i) and (ii), removing
the text ``Sec. 242.600(b)(90)'' and adding in its place ``Sec.
242.600(b)(99)''.
Sec. 242.611 [Amended]
0
10. Amend Sec. 242.611 by, in paragraph (c), removing the text ``Sec.
242.600(b)(38)'' and adding in its place ``Sec. 242.600(b)(41)''.
Sec. 242.614 [Amended]
0
11. Amend Sec. 242.614 by, in paragraphs (d)(1), (2), and (3),
removing the text ``Sec. 242.600(b)(20)'' and adding in its place
``Sec. 242.600(b)(21)''.
0
12. Add Sec. 242.615 to read as follows:
Sec. 242.615 Order competition rule.
(a) Order competition requirement. A restricted competition trading
center shall not execute internally a segmented order for an NMS stock
until after a broker or dealer has exposed such order to competition at
a specified limit price in a qualified auction that meets the
requirements of paragraph (c) of this section and is operated by an
open competition trading center. If the segmented order is not executed
in the qualified auction, a restricted competition trading center may,
as soon as reasonably possible, execute the segmented order internally
at a price that is equal to or more favorable for the segmented order
than the specified limit price in the qualified auction.
(b) Exceptions. The order competition requirement of paragraph (a)
of this section shall not apply if:
(1) The segmented order is received and executed by the restricted
competition trading center during a time period when no open
competition trading center is operating a qualified auction for the
segmented order;
(2) The market value of the segmented order is at least $200,000
calculated with reference to the midpoint of the national best bid and
national best offer when the segmented order is received by the
restricted competition trading center;
(3) The segmented order is executed by the restricted competition
trading center at a price that is equal to or more favorable for the
segmented order than the midpoint of the national best bid and national
best offer when the segmented order is received by the restricted
competition trading center;
(4) The segmented order is a limit order with a limit price
selected by the customer that is equal to or more favorable for the
segmented order than the midpoint of the national best bid and national
best offer when the segmented order is received by the restricted
competition trading center; or
(5) The segmented order is received and executed by the restricted
competition trading center during a time period when no open
competition trading center is operating a qualified auction for the
segmented order that accepts orders that are not entirely in whole
shares, and the customer selected a size for a segmented order that is
not entirely in whole shares of an NMS stock, in which case any portion
of such segmented order that is less than one whole share of the NMS
stock, and only such portion, shall not be subject to the order
competition requirement of paragraph (a) of this section.
(c) Qualified auction requirements. An open competition trading
center shall comply with the following requirements for operation of a
qualified auction for segmented orders.
(1) Auction message. (i) An auction message announcing the
initiation of a qualified auction for a segmented order shall be
provided for dissemination in consolidated market data pursuant to
Sec. 242.603(b). Each such auction message shall invite priced auction
responses to trade with a segmented order and shall include the
identity of the open competition trading center and the symbol, side,
size, limit price, and identity of the originating broker for the
segmented order.
(ii) If more than one broker is an originating broker for a
segmented order, the originating broker identified pursuant to
paragraph (c)(1)(i) of this section shall be the broker responsible for
approving the opening of accounts with customers.
(iii) Notwithstanding the provisions of paragraph (c)(1)(i) of this
section, the identity of the originating broker shall not be disclosed
in the auction message if such originating broker certifies that it has
established, maintained, and enforced written policies and procedures
reasonably designed to assure that the identity of the originating
broker will not be disclosed, directly or indirectly, to any person
that potentially could participate in the qualified auction or
otherwise trade with the segmented order, and the originating broker's
certification is communicated to the open competition trading center
conducting the qualified auction.
(2) Auction responses. An open competition trading center shall
accept auction responses for a period of at least 100 milliseconds
after an auction message is provided for dissemination in consolidated
market data and shall end the auction not more than 300 milliseconds
after an auction message is provided for dissemination in consolidated
market data. Auction responses shall remain undisplayed during the
auction period and not disseminated at any time thereafter.
(3) Pricing increments. Segmented orders and auction responses
shall be priced in an increment of no less than $0.001 for segmented
orders and auction responses with prices of $1.00 or more per share, in
an increment of no less than $0.0001 for segmented orders and auction
responses with prices of less than $1.00 per share, or at the midpoint
of the national best bid and national best offer.
(4) Fees and rebates. No fee shall be charged for submission or
execution of a segmented order. No fee shall be charged for submission
of an auction response. The fee for execution of an auction response
shall not exceed $0.0005 per share for auction responses priced at
$1.00 per share or more, shall not exceed 0.05% of the auction response
price per share for auction responses priced at less than $1.00 per
share, and otherwise shall be the same rate for executed auction
responses in all auctions. Any rebate for the submission or execution
of a segmented order or for the submission or execution of an auction
response shall not exceed $0.0005 per share for segmented orders or
auction responses priced at $1.00 per share or more, shall not exceed
0.05% of the segmented order or auction response price per share for
segmented orders or auction responses priced at less than $1.00 per
share, and otherwise shall be the same rate for segmented orders in all
auctions and shall be the same rate for auction responses in all
auctions.
(5) Execution priority of auction responses and resting orders. (i)
The highest priced auction responses to buy and the lowest priced
auction responses to sell shall have priority of execution.
(ii) Auction responses for the account of a customer shall have
priority over auction responses for the account of a broker or dealer
at the same price.
(iii) As long as an auction response is received within the
prescribed time period, execution priority shall not be based on time
of receipt of the auction response.
(iv) The terms of execution priority shall not favor the broker or
dealer that routed the segmented order to the auction, the originating
broker for the segmented order, the open competition
[[Page 245]]
trading center operating the auction, or any affiliate of the foregoing
persons.
(v) Orders resting on a continuous order book of the open
competition trading center operating the qualified auction at the
conclusion of an auction period shall have priority over auction
responses at a less favorable price for the segmented order. Displayed
orders resting on a continuous order book of the open competition
trading center operating the qualified auction shall have priority over
auction responses at the same price. Auction responses shall have
priority over undisplayed orders resting on a continuous order book of
the open competition trading center operating the qualified auction at
the same price.
(d) Open competition trading centers. (1) A national securities
exchange or NMS Stock ATS shall not operate a qualified auction for
segmented orders unless it complies with the provisions of this section
and meets the definition of open competition trading center in Sec.
242.600(b)(64).
(2) An open competition trading center shall not operate a system,
other than a qualified auction, that is limited, in whole or in part,
to the execution of segmented orders unless any segmented order
executed through such system:
(i) Is received and executed by the open competition trading center
during a time period when no open competition trading center is
operating a qualified auction for the segmented order;
(ii) Has a market value of at least $200,000 calculated with
reference to the midpoint of the national best bid and national best
offer when the segmented order is received by the open competition
trading center; or
(iii) Is executed by the open competition trading center at a price
that is equal to or more favorable for the segmented order than the
midpoint of the national best bid and national best offer when the
segmented order is received by the open competition trading center.
(iv) Is a limit order with a limit price selected by the customer
that is equal to or more favorable for the segmented order than the
midpoint of the national best bid and national best offer when the
segmented order is received by the open competition trading center; or
(v) Is received and executed by the open competition trading center
during a time period when no open competition trading center is
operating a qualified auction for the segmented order that accepts
orders that are not entirely in whole shares, and is a size, selected
by the customer, that is not entirely in whole shares of an NMS stock,
in which case any portion of such segmented order that is less than one
whole share of the NMS stock, and only such portion, may be executed
through such system.
(e) Originating brokers. (1) An originating broker shall establish,
maintain, and enforce written policies and procedures reasonably
designed to identify the orders of customers as segmented orders as
defined in Sec. 242.600(b)(91).
(2) An originating broker shall not route a customer order
identified as a segmented order without also identifying such order as
a segmented order to the routing destination.
(3) An originating broker that makes a certification referred to in
paragraph (c)(1)(iii) of this section shall establish, maintain, and
enforce written policies and procedures reasonably designed to assure
that the identity of the originating broker will not be disclosed,
directly or indirectly, to any person that potentially could
participate in the qualified auction or otherwise trade with the
segmented order.
(4) Where there are multiple originating brokers for a segmented
order, an originating broker shall not be deemed to be in violation of
the provisions of paragraphs (e)(1) through (3) of this section arising
solely from a failure to meet a responsibility that was specifically
allocated by prior written agreement to another originating broker.
(f) Brokers or dealers. (1) No broker or dealer that receives an
order identified as a segmented order shall route such order without
identifying such order as a segmented order to the routing destination.
(2) No broker or dealer with knowledge of where a segmented order
is to be routed for execution shall submit an order, or enable an order
to be submitted by any other person, to the continuous order book of an
open competition trading center or of a national securities exchange
that could have priority to trade with the segmented order at such open
competition trading center or national securities exchange.
(g) National securities exchanges. A national securities exchange
shall not operate a system, other than a qualified auction, that is
limited, in whole or in part, to the execution of segmented orders
unless any segmented order executed through such system:
(1) Is received and executed by the national securities exchange
during a time period when no open competition trading center is
operating a qualified auction for the segmented order;
(2) Has a market value of at least $200,000 calculated with
reference to the midpoint of the national best bid and national best
offer when the segmented order is received by the national securities
exchange;
(3) Is executed by the national securities exchange at a price that
is equal to or more favorable for the segmented order than the midpoint
of the national best bid and national best offer when the segmented
order is received by the national securities exchange.
(4) Is a limit order with a limit price selected by the customer
that is equal to or more favorable for the segmented order than the
midpoint of the national best bid and national best offer when the
segmented order is received by the national securities exchange; or
(5) Is received and executed by the national securities exchange
during a time period when no open competition trading center is
operating a qualified auction for the segmented order that accepts
orders that are not entirely in whole shares, and is a size, selected
by the customer, that is not entirely in whole shares of an NMS stock,
in which case any portion of such segmented order that is less than one
whole share of the NMS stock, and only such portion, may be executed
through such system.
Sec. 242.1000 [Amended]
0
13. Amend Sec. 242.1000, in the definition Plan processor, by removing
the text ``Sec. 242.600(b)(67)'' and adding in its place ``Sec.
242.600(b)(73)''.
By the Commission.
Dated: December 14, 2022.
J. Matthew DeLesDernier,
Deputy Secretary.
[FR Doc. 2022-27617 Filed 12-30-22; 8:45 am]
BILLING CODE 8011-01-P