More Patchwork: SEC Equity Market Structure Subcommittee Initial Results

The first sets of preliminary recommendations by the subcommittees of the Securities and Exchange Commission's Equity Market Advisory Committee were released yesterday on the SEC's website. The full 17-member committee is scheduled to reconvene for the fourth time on April 26, 2016 at SEC headquarters in Washington, D.C. The meeting will follow a March 3 Senate Banking Committee hearing, the key action of which was the regulator promise that with the work of and recommendations from the Equity Market Structure Advisory Committee, the SEC would get the ball rolling on market structure and regulatory reform, whatever that entails, before the end of the current U.S. election cycle.

One would have thought that the focus of these committees would have been to conceptualize the market that these industry thought leaders might have designed from the ground up and build a plan to transition to it. Instead, it seems that the can continues to be kicked forward. These discussions and recommendations fall well short of “a holistic review of equity market structure” promised by Chairwoman Mary Jo White. Indeed, in his remarks for the Equity Market Structure Roundtable on July 28, 2014, global market structure and exchanges expert Joe Gawronski said the U.S. equities market was “not the work of a master builder, directed by a brilliant architect. Rather, it’s the patchwork of a thousand carpenters, whose blueprints were constantly changing.”

Most of the subcommittees have met seven times since November 16, 2015. In their apparent rush to deliver actionable recommendations, they risk both misplaced focus and further rule-related market disruption, with limited benefit. For example, to simultaneously run an access fee pilot along with the upcoming tick-size pilot, as proposed by the Regulation NMS Subcommittee, will potentially distort results and undermine the industry’s (and the SEC’s) ability to effectively execute on each. The suggested changes to limit up/limit down rules, too, are mere tweaks to an existing, potentially flawed solution.

Below is a summary of the subcommittee memorandums and Aite Group’s take on them.

The Regulation NMS Subcommittee:

• Focus: Potential access fee pilot, impacts of lower access fees to liquidity provisioning (market-making) and liquidity taking (broker routing decisions)
• Findings: Implement a pilot program to reduce the access fee cap (and corresponding liquidity rebates) to determine the influence and impact of access fees to market quality and marketplace behavior; an access fee pilot can be run in parallel to the upcoming tick pilot program.
• Recommendations: An access fee pilot of one to two years with four buckets (control, 20 mils, 10 mils, 2 mils), apply the access fee pilot to both displayed and non-displayed exchange liquidity among a random sampling of stocks with less than US$3 billion in market cap

Our take:

• Maker-taker evokes impassioned debate, and this topic is likely to occupy a significant portion of the April 26 full committee meeting. Rep. Stephen Lynch proposed a bill in March 2015, “H.R. 1216, the Maker-Taker Conflict of Interest Reform Act of 2015” to effectively ban maker-taker. Gary Stone at Bloomberg, a member of the committee, has lobbied hard in the past for the SEC to reduce the cap, and that the SEC is unable to leave it to venues to lower the fees themselves—he refers to this as the market’s own version of a “Prisoner’s Dilemma.” Nasdaq ran a pilot in 2015 and proved the impact of unilateral fee reduction in market share losses.
• Not only would running a simultaneous access fee pilot and the tick-size pilot distort any otherwise meaningful results, but doing so seems borderline reckless—and more than the SEC and the industry can handle. These changes will introduce new complexity and configuration into an already overly complex and fragmented market. If all this goes through as proposed, participants in the U.S. market should brace themselves for volatile times.
• It’s going to be very interesting to see what happens to venue market share. This committee is showing that it is not taking sides between exchanges and ATSs, and it wants to see if volume shifts away from broker-sponsored dark pools once the incentive to save on exchange access fees is de minimus.
• We’re seeing a regulatory race condition. The tick-size pilot, which is supposed to evaluate how to increase liquidity in small cap stocks, but really won’t, was thrust through the rule-making pipeline before the Equity Market Structure Advisory Committee had a chance to chime in. It’s hard to find anyone who thinks it is worth the effort, but that train has already left the station. Care should be taken not to repeat that mistake.

Market Quality Subcommittee:

• Focus: Issues of market quality, examining the effects of August 24, potential changes to the limit up/limit down, market-wide circuit breakers, and market opening procedures
• Findings: (1) The primary functioning of limit up/limit down works—preventing runaway stocks and panic selling. (2) The re-opening process does not function well: a lack of centralized liquidity around the opening and closing process contributing to stock triggers on August 24 and beyond.
• Recommendations: Alter limit up/limit down in two ways: (1) no trading halt in response to a stock being “stuck” in limit up/limit down, only pause for a brief period of time. (2) Extend the current pause of 15 seconds to 30 seconds to allow more time for market participants to correct prices. Also, they are recommending no changes be made to the current market-wide circuit breaker mechanism.

Our take:

• The committee is walking a fine line on how to improve the market’s existing guardrails without adding additional complexity and placing onerous burdens on exchanges and market participants.
• Market complexity and a relatively small set of empirical data make it difficult to know what to do. Regulators around the world are trying to wrap their heads around circuit breakers, and the events of August 24, 2015 are still front of mind.
• As markets get more complex, more dislocation events are inevitable. The market “guardrails,” likewise, need to be more sophisticated. The U.S. markets are more efficient and more liquid than any other equity market worldwide. But there is little mention in these memorandums about market fragmentation, complexity, and systemic risk. Market crashes and outages that once were rare now seem to happen monthly.
• The fear of unintended consequences keeps the SEC cautious, and rightly so, and the committee recognizes that change for change’s sake is not the goal. Expect small tweaks to limit up/limit down and perhaps to the market re-opening process, but the rules are likely to be left alone.
• It’s disappointing to learn about debated tweaks to circuit breakers—arbitrary rules for price bands and trading pauses—while financial market participants embrace modern predictive analytics to make more informed trading decisions. Cornell University Professor Maureen O’Hara, a member of the subcommittee, is a co-creator of the (patent pending) VPIN Flow Toxicity metrics—quantitative approaches to monitor for market triggers. While not all academics will agree on the model’s utility just yet, it may have potential to predict liquidity-induced market crashes. Why not propose a pilot program to run these models in real-time and alongside existing circuit breakers? There’s no mention in the subcommittee’s status report of Professor O’Hara’s work, or, for that matter, any new and innovative approaches about how to upgrade the market’s safeguards.

Trading Venues Regulation Subcommittee:

• Focus: Review the current regulatory model for trading venues
• Findings: Overall, the current regulatory structure for trading venues works well and generally is operating fairly and effectively; a significant overhaul of the current structure is not needed.
• Recommendations: (1) Consider increasing liability to exchanges if they engage in activities that have increased risk of negative financial exposure on participants if mismanaged, such as IPOs, openings, and closing auctions. (2) Change to NMS Plan governance and increase the scope of NMS Plan Advisory Committees. (3) Publication of rule changes that require technical specifications should be linked. (4) Centralization of common regulatory functions across SROs into a single regulator.

Our take:

• Recommendation #4 seems like a very good idea. With the shift to for-profit exchanges, the risk and appearance of conflicted interests is high. And it’s easier to coordinate cross-market activities to a single centralized regulator while surveillance and exchange specific responsibilities will stay with the SRO exchange.

Customer Issues Subcommittee:

• Focus: Retail investor perspectives, investor confidence and sentiments, retail investor use of stop orders, execution quality statistics (e.g., Rule 605/606), and payment for order flow
• Findings: (1) Stop limit orders are a useful tool for investors but, when not used properly, introduce risks. (2) More transparency may instill additional confidence but will also increase regulatory burdens and costs.
• Recommendations: (1) Firms should consider preventing customers from entering stop orders without limit prices. (2) Rule 605 (market center execution quality reports) should be extended to cover most broker-dealers.

Our take:

• Note that the committee has not yet considered Rule 605/606 from an institutional perspective. Also, there is no consensus yet on what to do, if anything, about the controversial practice of payment for order flow.
• Even though most firms seem to be in favor of providing additional transparency in order to rebuild the industry’s reputation, the SEC will need to take unilateral action to mandate additional reporting. No firm would show its full hand without assurances that the rest of the industry will be required to do the same.

Now that the subcommittees have made their initial recommendations, the full Equity Market Structure Advisory Committee will need to provide its approval. Once that happens, it’s up to the SEC to approve any changes and publish the plan for public comment.