SEC Issues Four Proposals with Potentially Broad Ramifications on Equity Market Structure

The Securities and Exchange Commission ("SEC" or the "Commission") issued four sweeping proposals on December 14, 2022, covering a broad range of market structure and regulatory issues facing the equities markets. The four proposals cover:

1. Amendments to Rule 605 regarding the disclosure of order execution information;
2. Amendments to various NMS provisions covering minimum pricing increments, access fees, and acceleration of certain changes associated with the Market Data Infrastructure Rules ("MDI Rules");
3. New Rule 615 to require the submission of certain orders to qualified auctions prior to execution; and
4. New Regulation Best Execution to enhance requirements concerning the duty of best execution.

This client alert summarizes each of the proposals below. The comment periods for each proposal run until the later of March 31, 2023, or 60 days after the date of publication in the Federal Register.

I. RULE 605 AMENDMENTS

The SEC's first proposed rule change would amend Rule 605 regarding the disclosures of order execution information. In particular, the proposal would:

• Expand the scope of reporting entities subject to Rule 605 to cover broker-dealers with a large number of customers;
• Amend the definition of "covered order" to expand the type of orders falling within the definition; and
• Expand the information required under Rule 605, including how information is categorized by order size and order type.

A. Expand Scope of Reporting Entities

With respect to increasing the scope of reporting entities, Rule 605 currently applies to market centers where a market center is any exchange market maker, OTC market maker, ATS, national securities exchange, or national securities association. Proposed amended Rule 605 would include broker-dealers as required reporting entities where such broker-dealer introduces or carries 100,000 or more customer accounts through which NMS stocks are purchased or sold. In the event that a broker-dealer meeting the customer account threshold is also a market center, such broker-dealer would need to produce two separate reports, one with respect to its customer accounts and another with respect to its market center functionality.

Additionally, as explained in more depth below, the Commission has proposed rules that generally would require individual investor orders be exposed to order-by-order competition in fair and open auctions before such orders could be internalized by wholesalers or any other type of trading center that restricts order-by-order competition. In the event a market center operates qualified auctions, such market center would be required to prepare a separate report covering only those orders received for execution in the qualified auction.

Finally, ATSs and broker-dealers operating single dealer platforms would be required to produce Rule 605 reports that are specific to the ATS or SDP and separate from the broker-dealer's other trading activity.

B. Expand Definition of Covered Order

With respect to the definition of "covered order," the Commission is proposing to include non-marketable limit orders ("NMLOs") that are submitted pre-opening and post-closing if they become executable after the opening or reopening of trading during regular trading hours. Such NMLOs would be benchmarked based on the time that the orders become executable rather than based on time of order receipt. Additionally, the marketability of an order would be based on the National Best Bid and Offer (“NBBO”) that is first disseminated after the time of order receipt. Orders executed at the opening or reopening price would be excluded from the expanded definition as well as orders that were executed outside of regular trading hours.

The Commission is also proposing to expand the definition of "covered order" to include stop orders where such orders become executable, which as defined in the proposed rules would be when the NBB equals or falls below the stop price for buy orders or when the NBO equals or exceeds the stop price for sell orders. The benchmark for such orders would be based on when the stop prices are reached. The Commission would also include non-exempt short sale orders as long as a price test restriction is not in effect for the security.

C. Information Required Under Rule 605

The Commission is also proposing to modify the type of information to be disclosed under Rule 605 as well as the categorization of information. For example, the Commission is modifying the order size categories to: (i) less than 1 share; (ii) odd lot; (iii) 1 round lot to less than 5 round lots; (iv) 5 round lots to less than 20 round lots; (v) 20 round lots to less than 50 round lots; (vi) 50 round lots to less than 100 round lots; and (vii) 100 round lots or greater. In a separate proposal, the Commission is amending the definition of round lots, and the amended Rule 605 categories would incorporate that new definition. The amended definition also results in fractional shares and odd lot order categories being included in Rule 605 reports. The new categories also result in larger-sized orders, which are currently excluded due to exemptive relief where the order is 10,000 shares or greater.

The Commission is also modifying the order type categories to: (i) market orders, (ii) marketable limit orders (excluding immediate-or-cancel orders), (iii) marketable immediate-or-cancel orders, (iv) beyond-the-midpoint limit orders, (v) executable non-marketable limit orders (excluding beyond-the-midpoint limit orders and orders submitted with stop prices), and (vi) executable orders submitted with stop prices. The proposal would eliminate the three current categories for NMLOs (inside-the-quote limit orders, at-the-quote limit orders, and near-the-quote limit orders) and replace them with non-marketable limit orders that become executable and beyond-the-midpoint limit orders (which are orders priced more aggressively than the midpoint of the NBBO).

Finally, the Commission is requiring additions to the information to be disclosed by requiring realized spread at specified intervals of 15 seconds and one minute after the time of execution, average effective spread, percentage spreads (effective and realized), effective-over-quoted spread, and size improvement. The Commission also is proposing a variety of additional price improvement statistics related to the best available displayed price, which accounts for the fact that (due to a separate proposal) a better-priced odd lot quote may be available as compared to the NBBO.

D. Summary Reports

In an effort to make Rule 605 statistics more digestible, the Commission is proposing to require market centers and BDs subject to Rule 605 to prepare summary execution quality statistics.

II. REG. NMS – PRICING INCREMENTS, ACCESS FEES, AND TRANSPARENCY

As part of the Commission's second proposal, the Commission is proposing to amend Rule 612 to adopt variable minimum pricing increments for quoting and trading of NMS stocks, amend Rule 610 to reduce access fee caps, and accelerate certain changes associated with the MDI Rules.

A. Minimum Pricing Increments

Currently, Rule 612 requires quotations for NMS stocks priced at or greater than $1.00 to have minimum pricing increments of $0.01 and for stocks priced below $1.00 to have minimum pricing increments of $0.0001. The Commission's proposal would adopt variable minimum pricing increments based on the "Time Weighted Average Quoted Spread" that is assessed during an "Evaluation Period."

The Time Weighted Average Quoted Spread would be defined as the average dollar value difference between the NBB and NBO during regular trading hours where each instance of a unique NBB and NBO is weighted by the length of time that the quote prevailed as the NBB or NBO. The Evaluation Periods would occur during the months of March, June, September, and December of a particular calendar year, and the results of the analysis would dictate the minimum pricing increment for the three months following an Evaluation Period. The primary listing exchanges would be responsible for conducting the analysis, and the primary listing exchanges would be required to provide an indicator of the applicable minimum pricing increment to competing consolidators, self-aggregators, and the exclusive SIPs.

With respect to the actual minimum pricing increments proposed by the rules, the minimum pricing increment for quotations and orders in NMS stocks that are priced at $1.00 or more per share would be variable and no smaller than (1) $0.001, if the Time Weighted Average Quoted Spread for the NMS stock during the Evaluation Period was equal to, or less than, $0.008; (2) $0.002, if the Time Weighted Average Quoted Spread for the NMS stock during the Evaluation Period was greater than $0.008 but less than, or equal to, $0.016; (3) $0.005, if the Time Weighted Average Quoted Spread for the NMS stock during the Evaluation Period was greater than $0.016 but less than, or equal to, $0.04; and (4) $0.01, if the Time Weighted Average Quoted Spread for the NMS stock during the Evaluation Period was greater than $0.04.

Finally, Rule 612 currently only prohibits the display, rank, or acceptance of orders below the minimum pricing increment; however, Rule 612 does not prevent trades being executed at increments smaller than those set forth in Rule 612. Proposed Rule 612 would eliminate this distinction and require that trades also must be executed at prices that are consistent with the minimum pricing increments set forth in proposed Rule 612. Orders executed at the midpoint of the NBBO and VWAP/TWAP orders would be excepted from this particular requirement.

B. Access Fee Amendments

Rule 610 currently caps access fees to $0.003 per share where the price of a protected quotation is $1.00 or more and .3% of the quotation price per share where the protected quotation is less than $1.00. The Commission is proposing to amend Rule 610 to reduce the access fee caps for protected quotations in NMS stocks and, in certain circumstances, base the access fee cap on the minimum pricing increment set forth in proposed Rule 612 rather than the price of the quotation. In particular, access fee caps for protected quotations in NMS stocks priced $1.00 or more would be set at $0.0005 per share for NMS stocks that have a minimum pricing increment of $0.001 and $0.001 per share for NMS stocks that have a minimum pricing increment greater than $0.001 per share. Access fee caps for protected quotations in NMS stocks priced less than $1.00 per share would be set to 0.05% of the quotation price.

The Commission also is proposing to require exchange fees and rebates to be determinable at the time of order execution. Currently, exchange fee schedules may include volume-based tiers or other incentives calculated at month's end. Exchanges would be required to amend their fee schedules to set any volume-based tiers on a stated period prior to the assessment of the fee or rebate rather than after.

C. Acceleration of MDI Rule Changes

As part of the MDI Rules, the Commission amended the definition of round lot that assigned a round lot size based on the stock's share price. Specifically, for NMS stocks priced $250.00 or less per share, a round lot will be 100 shares; for NMS stocks priced $250.01 to $1,000.00 per share, a round lot will be 40 shares; for NMS stocks priced $1,000.01 to $10,000.00 per share, a round lot will be 10 shares; and for NMS stocks priced $10,000.01 or more per share, a round lot will be 1 share. The Commission also required certain information on odd lot orders priced better than the NBBO to be included in the information disseminated in the public data stream, specifically odd lots at a price greater than or equal to the national best bid and less than or equal to the national best offer, aggregated at each price level at each national securities exchange and national securities association. Finally, the Commission would require the identification and dissemination of the best available odd lot price on both the buy and sell side and where such liquidity is available.

With respect to round lot changes, quotation sizes disseminated by the exclusive processors would be represented in terms of the number of shares rather than the current convention of representing quotation sizes in terms of the number of round lots.

The Commission noted that the full implementation of the MDI Rules, including the implementation of round lot definition and inclusion of odd lots priced better than the NBBO, would be at least two years after the Commission's approval of plan amendments implementing the changes required under Rule 614(e). The Commission therefore accelerated the requirement of the new round lot definitions and inclusion of odd lots information in the consolidated market data stream to 90 days from Federal Register publication of any Commission adoption of the new round lot definitions and inclusion of odd lots.

III. ORDER COMPETITION RULE

The Commission's third proposal would create new Rule 615, which would prohibit certain trading centers from internally executing "segmented orders" of individual investors at a price unless the orders were first exposed to competition at that price in a qualified auction operated by an open competition trading center.

A. Open Competition Trading Center vs. Restricted Competition Trading Center

The proposal distinguishes between "open competition trading centers" and "restricted competition trading centers." An open competition trading center would be defined as either a national securities exchange or an NMS Stock ATS that meets certain specified criteria. For a national securities exchange, the exchange would need to (1) operate a trading facility that is automated and displayed automated quotations that are disseminated in consolidated market data, (2) provide transaction reports disseminated in consolidated market data, (3) during at least four of the preceding six calendar months, have an average daily share volume of 1% or more of the aggregate average daily share volume for NMS stocks, and (4) operate pursuant to its own rules that the exchange will comply with proposed Rule 615(c) for a qualified auction.

For an NMS Stock ATS to meet the "open competition trading center" definition, the NMS Stock ATS would need to (1) display quotations through an SRO display-only facility (i.e., the FINRA ADF), (2) operate a trading facility that is automated and displayed automated quotations that are disseminated in consolidated market data, (3) provide transaction reports disseminated in consolidated market data, (4) permit any registered BD to become a subscriber to the NMS Stock ATS (subject to certain exceptions), (5) provide equal access among all subscribers to all services that are related to a qualified action and any continuous order book operated by the NMS Stock ATS, (6) during at least four of the preceding six calendar months, have an average daily share volume of 1% or more of the aggregate average daily share volume for NMS stocks, and (7) operate pursuant to an effective Form ATS-N with the Form ATS-N describing how the NMS Stock ATS's qualified auction will comply with proposed Rule 615(c).

A restricted competition trading center would be any trading center that is not an open competition trading center and is not a national securities exchange.

The definition of "open competition trading center" is important in determining what entities are permitted to operate a qualified auction. The definition of a restricted competition trading center is important as it specifies what entities are subject to the order competition requirements of proposed Rule 615. As a result of the definitions, certain exchanges would not be permitted to operate a qualified auction; however, they would not be subject to the order competition requirements of proposed Rule 615. The special treatment of exchanges as excepted from the definition of restricted competition trading centers will certainly draw comments from entities operating NMS Stock ATSs. As the Commission notes, no NMS Stock ATS displays quotations in the ADF and, as a result, all NMS Stock ATSs would be subject to the competition requirements of proposed Rule 615. Commenters will certainly highlight the disparity between treatment of certain low-volume national securities exchanges and NMS Stock ATSs.

B. Segmented Order

Proposed Rule 615 would apply to orders falling within the definition of "Segmented Order." A Segmented Order would be defined as an order for an NMS Stock for an account (1) of a natural person or an account held in legal form on behalf of a natural person or group of related family members, and (2) in which the average daily number of trades executed in NMS stocks was less than 40 in each of the six preceding calendar months.

While not in the definition of "Segmented Order," the exceptions to Rule 615 distinguish between market orders and limit orders. While all market orders meeting the above definition would be subject to Rule 615, limit orders priced more favorably than the midpoint of the NBBO (i.e., buy orders priced lower than the NBBO midpoint and sell orders priced higher than the NBBO midpoint) would not be subject to Rule 615.

C. Originating Brokers

The proposal places certain obligations on "Originating Brokers," which is defined as 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. In the event that there is more than one broker meeting the definition for a particular customer account, the broker responsible for approving the opening of accounts for customers (typically the introducing broker) would be considered the Originating Broker. The identity of the Originating Broker would need to be appended on auction messages (discussed below) or the Originating Broker would need to provide a certification 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, with such certification being communicated to the open competition trading center conducting the qualified auction.

Originating Brokers would subject to the following regulatory obligations:

1. Originating Brokers would be required to establish, maintain, and enforce written policies and procedures reasonably designed to identify the orders of customers as segmented orders;
2. Originating Brokers 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; and
3. An Originating Broker that makes the certification referenced above 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.

D. Order Competition Requirement

The general prohibition in proposed Rule 615(a) would prohibit a restricted competition trading center from executing internally a segmented order until after a broker-dealer has exposed the order to competition at a specified limit price in a qualified auction. If the segmented order is not executed in the qualified auction, the restricted competition trading center may execute the order internally at a price that is equal to or more favorable than the specified limit price.

In the example provided by the Commission, a wholesaler receiving a segmented order would route the order to a qualified auction at a specified limit price. The wholesaler could participate in the auction after receiving an auction message. If the segmented order was not executed in full during the qualified auction, the wholesaler would then be permitted to execute the segmented order at or better than the specified limit price, could further handle the order in a manner consistent with proposed Rule 615, or could return the order back to its client unexecuted.

E. Qualified Auctions

Proposed Rule 615(c) lists the requirements for the operation of a qualified auction. These requirements include:

1. Auction messages that contain specific types of information, which are disseminated in consolidated market data and the identity of the Originating Broker (unless the certification is provided by the Originating Broker);
2. The auction must accept auction response 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 such dissemination. Auction responses must remain non-displayed.
3. Auction responses must be priced in increments of no less than $0.001 for segmented orders and auction responses with prices of $1.00 per share or more and no less than $0.0001 for prices of less than $1.00 per share. Auction responses may also be priced at the midpoint of the NBBO.
4. The auction cannot charge for the submission or execution of a segmented order and cannot charge for the submission of auction responses. Executions of auction responses can be charged $.0005 per share for responses priced at $1.00 per share or more and .05% of the auction response price for auction responses priced less than $1.00 per share. Rebates are subject to the same caps.
5. The auction must have specified priority rules, including price priority, priority of customer accounts over broker-dealer accounts, and priority related to displayed orders resting on the continuous order book of the open competition trading center operating the qualified auction.

F. Exceptions

Proposed Rule 615(b) contains certain exceptions from the order competition rules. In particular, proposed Rule 615(a) does 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 has a fractional share component and no open competition trading is operating a qualified auction that accepts orders with a fractional share component (only the fractional share component of such order is excepted from proposed Rule 615(a)).

IV. REGULATION BEST EXECUTION

The SEC's fourth proposal would adopt Regulation Best Execution to require brokers-dealers to use reasonable diligence to obtain the best available price for customer orders in all types of securities, and adopt, enforce, and periodically review and revise written policies and procedures governing their handling of customer orders.

Although the SEC acknowledges that it and various courts have provided considerable guidance about a broker-dealer's "duty of best execution," and that both the Financial Industry Regulatory Authority ("FINRA") and the Municipal Securities Rulemaking Board ("MSRB") have long-established best execution rules, the Commission nevertheless believes that "having Commission rules providing a policies and procedures-based best execution framework, along with regular reviews and related documentation, would help broker-dealers maintain consistently robust best execution practices and result in vigorous efforts by broker-dealers to achieve best execution, including in situations where broker-dealers have order handling conflicts of interest with retail customers."

Regulation Best Execution would add a complex layer to broker-dealer compliance obligations when executing customer orders. It would apply to markets that have varying levels of trade execution information, such as government securities, over-the-counter securities, and crypto asset securities. Moreover, it would apply to institutional as well as retail investor orders.

A. The Elements of Regulation Best Execution

Regulation Best Execution consists of three rules:

• Rule 1100 sets forth the best execution standard: "In any transaction for or with a customer, or a customer of another broker or dealer, a broker or dealer, or a natural person who is an associated person of a broker or dealer, shall use reasonable diligence to ascertain the best market for the security (including crypto asset securities), and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions."
• Rule 1101 requires a broker or dealer that engages in any transaction for or with a customer or a customer of another another broker or dealer to establish, maintain, and enforce written policies and procedures reasonably designed to comply with the best execution standard in Rule 1100.
• Rule 1102 requires such brokers and dealers to, at least annually, review and assess the design and overall effectiveness of their best execution policies and procedures. The review must be documented and a report of the review must be presented to the broker's or dealer's board of directors (or equivalent governing body).

B. Exceptions From Compliance with the Best Execution Standard

Rule 1100(a)-(c) describes three situations where a broker or dealer will not be subject to the requirements of the best execution standard:

• Another broker or dealer is simply executing a customer order against the broker's or dealer's quotation;
• An institutional customer (undefined in the proposal), exercising independent judgment, executes its order against the broker's or dealer's quotation; and
• The broker or dealer receives an unsolicited instruction from a customer to route that customer's order to a particular market for execution and the broker or dealer processes the order promptly and in accordance with the terms of the order.

C. Policies and Procedures

Although the SEC maintains that Regulation Best Execution "does not include specific requirements regarding the manner in which broker-dealers would comply with the best execution standard," Rule 1101 and the Proposing Release are replete with required elements of the policies and procedures. For example, the policies and procedures required by Rule 1101(a) "shall address" how the broker or dealer will:

• identify the markets that may be reasonably likely to provide the most favorable prices, referred to as "material potential liquidity sources" (each an "MPLS");
• incorporate MPLSs into its order handling practices;
• ensure that the broker or dealer can efficiently access each such MPLS;
• determine the best market and make routing and execution decisions by:
  • assessing reasonably accessible and timely information with respect to best displayed prices, opportunities for price improvement, including midpoint executions, and order exposure opportunities;
  • assessing the attributes of customer orders considering the trading characteristics of the security, size of the order, likelihood of execution, accessibility of the market, and customer instructions, in selecting the market most likely to provide the most favorable price; and
  • balancing the likelihood of obtaining better prices in various markets against the risk that delay could result in a worse price.

D. Conflicted Transactions

Rule 1101(b) addresses conflicts of interest that would cause a transaction for or with a retail customer to involve a "conflicted transaction" and be subject to heightened requirements. A "conflicted transaction" is one where the broker or dealer:

• Executes an order as principal, including riskless principal;
• Routes an order to, or receives an order from, an affiliate for execution; or
• Provides or receives "payment for order flow" as defined in Exchange Act Rule 10b-10(d)(8).

In those contexts, the broker's or dealer's best execution policies and procedures must include additional elements, such as:

• Identifying a broader range of markets beyond those identified and an MPLS pursuant to Rule 1101(a)(1);
• How the broker or dealer will evaluate the broader range of markets beyond MPLSs that might provide the most favorable prices, including markets that may be smaller or less accessible than those identified as MPLSs;
• Documenting its compliance with the additional requirements; and
• Documenting any arrangement, written or oral, concerning payment for order flow.

E. Introducing Brokers

Proposed Rule 1101(d) provides specific regulatory obligations on an "introducing broker" that routes customer orders to an executing broker. The term "introducing broker" is specifically defined in Rule 1101(d)(1)-(3) as a broker or dealer that:

• does not carry customer accounts and does not hold customer funds or securities;
• has entered into an arrangement with an unaffiliated broker or dealer that has agreed to handle and execute on an agency basis all of the introducing broker's customer orders; and
• has not accepted any monetary payment, service, property, or other benefit that results in remuneration, compensation, or consideration from the executing broker in return for routing the customer orders to the executing broker.

Such introducing brokers do not have to separately comply with Rule 1101(a)-(c) if the introducing broker establishes, maintains, and enforces policies and procedures that require it to:

• regularly review the execution quality obtained from its executing broker with the execution quality being specific to the orders routed by the introducing broker to that executing broker;
• compare that execution quality with the execution quality it might have obtained from other executing brokers; and
• revise its order handling practices accordingly.

The SEC acknowledges that the introducing broker "would need to obtain execution quality information concerning other executing brokers that could handle and execute the introducing broker's customer orders." The SEC implicitly recognizes that this could present challenges. The SEC stated that it believed "other executing brokers would have an incentive to provide the introducing broker with accurate and comparable execution quality information that the introducing broker could use to evaluate its existing arrangement due to their financial interest in potentially providing the introducing broker with order handling and execution services." The SEC also alludes to executing broker data provided pursuant to Regulation NMS Rule 605 that could assist the introducing broker in making its assessment.