On December 14, 2022, the U.S. Securities and Exchange Commission (the "SEC" or "Commission") voted to approve four proposals to modify the trading rules for equities and other securities, which, taken together, represent the most significant package of market structure reforms since Regulation NMS ("Reg NMS") was adopted in 2005. Each of the proposals addresses a different aspect of market structure: (1) disclosure of order execution information (the "Rule 605 Proposal");1 (2) tick sizes, exchange access fees and order transparency (the "Rule 610/612 Proposal" and together with the Rule 605 Proposal, the "NMS Updates");2 (3) market segmentation for retail orders due to the practice of retail order "internalization" (the "Order Competition Proposal");3 and (4) broker-dealer best execution obligations (the "Best Execution Proposal").4 The Order Competition Proposal and Best Execution Proposal would impose substantial new duties on broker-dealers by requiring pre-internalization auctions for certain types of retails orders and establishing a new best-execution rule and related procedural requirements.

While Chair Gensler and the SEC staff emphasized during a marathon hearing that each of these proposals address a separate set of problems identified by the Commission, it is clear that the effects of these proposals would be aggregative and interactive. It is also clear that at least one target of the package as a whole is the role and practices of the six wholesale broker-dealers that execute a large percentage of retail orders in equity securities, and, in particular, their practice of providing payment for order flow ("PFOF"). While the proposed rules will not ban PFOF, as discussed below, the regulatory costs to accept PFOF would be substantially higher, while the ability of wholesale broker-dealers to monetize order flow obtained through PFOF would potentially be reduced.

Though concern about the role of wholesale broker-dealers is central to the proposals, retail broker-dealers also would face significant new requirements. In particular, the Rule 605 Proposal would impose new obligations on large retail broker-dealers, while the Best Execution Proposal would impose new obligations on introducing brokers that have historically relied on their clearing brokers to provide reviews of execution quality.

Further, while the proposals primarily impact the market for NMS stocks, 5 the Best Execution Proposal would apply to all securities, including options, bonds and crypto securities. The comment period for each proposal will remain open until the later of March 31, 2023 or 60 days after publication in the Federal Register.

Below, we summarize the key elements of each proposal and provide a brief discussion of the commentary and our own thoughts.

The NMS Updates

The NMS Updates aim to amend existing rules under Reg NMS to respond to technological advancements in the marketplace and other evolutionary developments. While significant, these rules are largely technical updates to the standards applicable in the national market system and are likely to be less controversial in broad terms than the Order Competition Proposal and the Best Execution Proposal. That said, the expansion of the Rule 605 Proposal (as described below) would impose material new obligations on large retail broker-dealers. Each of these proposals was approved unanimously by the Commission, though Commissioners Peirce and Uyeda raised various concerns.

Rule 605 Proposal

Under current Rule 605, "market centers," meaning national securities exchanges, alternative trading systems ("ATSs"), exchange market makers and OTC market makers are required to make available standardized monthly reports concerning the rates, speeds and pricing at which orders in NMS stocks are executed. The purpose of the rule is to provide broker-dealers and the public with comparable data about execution quality for purposes of making informed routing decisions and fostering competition.

The Rule 605 Proposal would expand the scope of the rule and amend the information reporting standards to make the data more usable and informative. Specifically, the Commission's proposed amendments would:

  • expand the scope of entities that must prepare Rule 605 reports to include larger broker-dealers that have a customer-facing line of business, single-dealer platforms and market centers;
  • amend the definitions of "covered order" to include certain orders submitted outside of regular trading hours and orders submitted with stop prices;
  • amend the categorization of information required to be reported including adding new order size categories for odd lots, fractional shares and larger-sized orders;
  • group orders into separate categories for market orders, marketable limit orders, marketable immediate-or-cancel orders, beyond-the-midpoint limit orders, executable non-marketable limit orders and executable orders submitted with stop prices;
  • replace the current time-to-execution buckets for all order types with average time to execution, share-weighted median time to execution and 99th percentile time to execution;
  • require average realized spread calculations at intervals of 15 seconds and one minute after the execution; and
  • require all reporting entities to produce new summary execution quality statistics.

Under the proposal, all broker-dealers that introduce or carry 100,000 or more customer accounts,6 single-dealer platforms and entities that operate proposed qualified auctions (as defined in the Order Competition Proposal) would be subject to the rule. The Commission's rationale for the proposal is to allow the investing public to compare the execution quality provided by customer-facing broker-dealers. According to the Commission, current Rule 606 routing data produced by broker-dealers does not provide a clear view of execution quality when combined with Rule 605 market center data because the execution quality provided by market centers may vary across routing brokers.

Footnotes

1 Disclosure of Order Execution Information, available at https://www.sec.gov/rules/proposed/2022/34-96493.pdf.

2 Regulation NMS: Minimum Pricing Increments, Access Fees, and Transparency of Better Priced Orders, available at https://www.sec.gov/rules/proposed/2022/34-96494.pdf.

3 Order Competition Rule, available at https://www.sec.gov/rules/proposed/2022/34-96495.pdf.

4 Regulation Best Execution, available at https://www.sec.gov/rules/proposed/2022/34-96496.pdf.

5 National market system stocks are stocks listed or traded on a national securities exchange. Related Rule 606 requires routing broker-dealers to publish quarterly reports on their routing of non-direct "held" orders in NMS stocks as well as in listed options and also requires the broker-dealer to provide customers (upon request) with specified information about how their orders are routed.

6 The Commission estimates that this category would cover approximately 85 broker-dealers or 6.7% of customer-carrying broker-dealers. Rule 605 Proposal at p. 52.

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