In March 2018, the SEC issued a proposed rule, Rule 610T of Regulation NMS that would create a Transaction Fee Pilot for National Market System (“NMS”) stocks. The Pilot was first proposed in July 2016 by a committee of market experts selected by the SEC (Equity Market Structure Advisory Committee or “EMSAC”), which excluded the NYSE and NASDAQ.
The 60-day comment period for the Proposed Rule began on March 26, 2018. Comments were due by May 25, 2018. However, the NYSE recently urged its listed companies to consider submitting a letter to the SEC, even now, past the due date for comments.
The SEC is expected to vote later this year on whether to institute the Pilot program.
The Pilot is designed to generate data to facilitate analysis of the effects that transaction-based fees and rebates may have on broker order-routing behavior, execution quality, and market quality in general.
Specifically, it’s intended to address criticism over the “maker-taker” system of rebates, which is when an exchange or other trading center pays its broker-dealer participants a per share rebate to provide (i.e., “make”) liquidity in securities and assesses them a fee to remove (i.e., “take”) liquidity. Under this structure, trading centers typically realize revenue from the difference between the fee paid by the “taker” of liquidity and the rebate paid to the provider or “maker” of liquidity. The SEC currently regulates exchange access fees. Rule 610(c) under Regulation NMS imposes a 30-cent per share cap to prevent high access fees from undermining Regulation NMS’s price protection and linkage requirements. Some market participants have expressed concerns that this fee cap has artificially pegged exchange fees at this rate, with most of the fee funding taker rebates, while market forces and technological advances have otherwise driven down transaction fees.
The “maker-taker” practice is currently the predominant fee model in the U.S. equities markets. However, this model can create conflicts of interest for broker-dealers that are required to seek best execution for their customers’ orders, but may have a conflicting economic incentive to avoid fees and/or earn rebates. Thus, it’s controversial since this system could distort the order routing behavior.
Other trading venues, such as alternative trading systems (“ATS”), such as “dark pools,” won’t be subject to the limits.
Under the Pilot, regulators will collect data on whether lower fee caps for different groups of stocks (NMS stocks that have a share price of at least $2) will alter the order routing behavior for brokers. The SEC plans to use the data to determine whether and how to amend Regulation NMS to address these concerns.
The Pilot will force exchanges to reduce the fee cap that currently allows them to pay up to 30 cents per 100 shares. To do this, there will be three test groups comprised of 1,000 stocks each (3,000 stocks total) and the unaffected stocks will be the control group.
- Test Group 1 (1,000 stocks): 15-cent trade fee per 100 shares with rebates allowed
- Test Group 2 (1,000 stocks): 5-cent trade fee per 100 shares with rebates allowed
- Test Group 3 (1,000 stocks): Ban on rebates along with the existing 30-cent per 100-share cap on fees for removing liquidity. This group will generate the most interest.
- Control Group (5,200 stocks): Not included in Pilot
The SEC proposes a two-year term for the Pilot, with an automatic sunset at the end of the first year, unless the SEC determines the Pilot should continue for another year. The effective date is not yet specified.
In its requests for comments, the SEC asked about the appropriateness of the restrictions on each group, and whether ATS’s and other non-exchange trading centers should be included in the final rule, among other questions.
ARGUMENTS FOR AND AGAINST THE PILOT
- Buy-side firms, consumer advocates and other critics say the rebates cause conflicts of interest by incentivizing brokers to route their orders to the highest rebate exchanges, and not necessarily to the exchange that will provide the best execution.
- The Council of Institutional Investors and several large institutional shareholders, such as Blackrock, Vanguard, CalPERS, and the Ontario Teachers’ Pension Plan, voiced strong support for the Proposal during the comment period.
- According to one buy-side firm, “We believe that forcing out some of the conflicts in order routing will improve market quality and lower investor costs.”
- Other institutional shareholders, such as State Street, expressed support for the concept of the Pilot generally, but suggested specific modifications to the Pilot’s design in order to increase its usefulness and mitigate potential risks associated with it.
- The NYSE, CBOE and Nasdaq strongly oppose the plan, saying it would make stocks harder to trade.
- The Pilot and any resulting Rule 610 changes could create costs:
- Exchange costs could include complying with the rule’s data collection, preparation and posting requirements, plus changing fee structures and perhaps losing revenue based on the changes to the fee and rebate structures.
- Broker-dealers may face increased costs to conform their fee and rebate structures, and may lose revenue from rebate restrictions.
- Investors may ultimately bear at least some of these increased costs to the extent that they are passed from exchanges, to their members, and then on to the ultimate investor, in return for the collection of data.
- The Pilot could cause spreads to widen for those securities selected for the test groups. Companies conducting a repurchase program or secondary offering could have higher costs. This could disadvantage one security versus another due to differing investor transaction costs.
- NYSE: “We believe the pilot would impair market quality by widening spreads in stocks, adding costs to both investors and companies. We find a $1 billion cost from the proposed Pilot, rising to $3.8 billion should such limitations be applied across the market.”
- Market makers will be willing to buy at slightly lower prices and sell at slightly higher prices. As a result, investors building a position in pilot securities will pay more and receive less when they exit.
- The exchanges also said that without the ability to pay rebates, it would be harder for them to compete with private broker-run trading venues, known as dark pools, which have fewer regulatory burdens.
- According Patrick Healy of the Issuer Network, since the NYSE and Nasdaq were excluded from the EMSAC, this served to exclude issuer representation and how it might affect public companies picked to participate in the test groups. Points include:
- The pilot may disadvantage companies selected for one of the test groups while their peers or competitors could escape that fate.
- As currently envisioned, it does not appear that companies can opt-out of the pilot. However, given the exclusion of issuers from participation in the pre-proposal discussions renders the “Opt Out” option absolutely essential.
- Companies haven’t been generally aware of the Pilot until now, and are concerned about the potential liquidity impact upon their stocks’ trading.
CLERMONT PARTNERS’ THOUGHTS:
- Much like the Tick Pilot program that was launched in October 2016, this Pilot is likely to proceed – especially given the apparent support of the buy side and frankly, all the effort that’s gone into the Pilot to date.
- While the NYSE, Nasdaq and CBOE are understandably fighting this Pilot tooth-and-nail because of their financial interest in the current maker-taker system, it does not appear that the impact on issuers – who the NYSE and Nasdaq represent – was given huge consideration in the design of the Pilot.
- For issuers, this is a roulette wheel. If you aren’t selected to participate, then it’s trading as usual for your company. But if you’re one of the 3,000 stocks selected to participate – and you have an approximate 3-in-8 chance of that – then you will be scrambling to determine how the Pilot will affect you.
- If you feel this Pilot is not in the best interests of your company, you can find example letters from Procter & Gamble and Apache, which were provided in the recent outreach by the NYSE to NYSE-listed companies.
- In the SEC’s proposal rule, one of the questions for comment was whether issuers should be allowed to “opt out.” Even though such an option may negatively impact the extent and quality of the data, one suggestion for any comment letter you decide to submit is to request the “opt out” option.