Minimum Pricing Increment
Chair Gensler suggested that the market today lacks an even playing field between investors in lit markets and wholesalers, based on the disparity in minimum pricing increments available to each. While investors in lit markets see prices in one-penny increments, wholesalers are able to fill orders at sub-penny prices with virtually no competition, placing lit market investors at a competitive disadvantage. The Chair noted that to address this asymmetry, and to make lit exchanges more competitive, the SEC Staff (the “Staff”) is preparing recommendations to address (1) possibly harmonizing the tick size – or minimum increments at which securities are traded – across different market centers to enable all trading to occur in the minimum increment, and (2) potentially shrinking the minimum tick size to better align with off-exchange activity.
National Best Bid and Offer (NBBO)
The National Best Bid and Offer (NBBO) quote reflects an aggregation of information across exchanges. Chair Gensler noted that today, NBBO includes only quotes for “round lots,” or orders of 100 shares or more, failing to capture and provide to retail investors quotes for “odd lot” trades, which accounted for more than 55 percent of trades in March 2022. To address this information disparity, the Chair has asked the Staff to consider (1) accelerated implementation of a new “round lot” definition adopted as part of the 2020 Market Infrastructure Rule, which, depending on price, could include trades for a single share, (2) accelerate implementation of the portion of the Infrastructure Rule that enhances transparency of quotation information for remaining odd lots, and (3) whether there should be an odd-lot best bid and offer so that investors would know the best price available in the market regardless of share quantity.
Disclosure of Order Execution Quality
Chair Gensler noted that retail investors’ do not have the ability to compare execution quality metrics, such as price improvement, across brokers. To address this issue, the Chair has asked the Staff for “recommendations considering whether to require that all reporters provide summary statistics of execution quality, such as the price improvement as a percentage of the spread.”
Best Execution
Recognizing that FINRA and the MSRB have in place best execution rules requiring broker-dealers to exercise “reasonable diligence” in executing customer orders to ensure the most favorable prices under existing market conditions, Chair Gensler noted that he has asked the Staff to consider recommending that the SEC propose its own best execution rule. The Chair cited his belief that such a rule would benefit retail investors, also expressing that broker-dealers might benefit from enhanced detail surrounding the procedural standards they must abide in executing customer orders.
Order-by-Order Competition
Chair Gensler recognized the challenges posed by market segmentation – namely the fact that the vast majority of retail marketable orders are flowing to wholesalers (or “market centers”) that pay retail broker-dealers for this order flow. The Chair noted that segmentation effectively prevents larger, institutional investors from interacting with that order flow, potentially resulting in less competition, and smaller price improvements to retail investors by wholesalers. In order to address this issue and reduce “excess profits above market competition” earned by wholesalers, Chair Gensler has asked the Staff for recommendations to enhance order-by-order competition, including through open and transparent auctions akin to those currently operated by listed options exchanges.
Payment for Order Flow, Exchange Rebates, and Related Access Fees
Lastly, Chair Gensler addressed potential conflicts of interest relating to payment for order flow (PFOF) from market centers to retail broker-dealers. Citing the Commission’s 2020 settlement with Robinhood Financial, LLC, Chair Gensler commented that PFOF may distort routing decisions by broker-dealers due to the incentive of increased payments in exchange for lesser price improvement for customers. The chair also suggested that PFOF also may incentivize broker-dealers to encourage their customers to trade with higher frequency. Similarly, exchange rebates paid to traders benefit high volume traders and may also adversely impact the routing of customer limit orders. Accordingly, Chair Gensler has asked the Staff to make recommendations as to the mitigation of conflicts of interest with respect to PFOF and exchange rebates. We note that previously, in an interview conducted by Barron’s in August 2021, Chair Gensler commented that an outright ban on PFOF was “on the table."
An Ounce of Prevention
In light of Chair Gensler’s remarks and guidance issued by FINRA in 2021 “to remind firms of existing rules and guidance concerning best execution and payment for order flow,” firms would be prudent to anticipate regulatory interest in their best execution and payment for order flow practices. In particular, firms are encouraged to review their policies, procedures and supervisory controls to ensure that they are reasonably designed and implemented to effectively mitigate potential conflicts of interest arising out of their receipt of PFOF.
Client Alert 2022-154
