The SEC’s 1,656 pages of complicated proposals interact with the existing ruleset, pending proposals, and each other. We assess their implications through the lens of 4Vs – i.e., Volume, Velocity, Veracity, and Variety. The result is an upside-down smile curve shifting downward, largely resembling the existing shape (i.e., remain status quo) of a “frown”. The Commission’s prescription is the wrong medicine to untangle the industry value chain. Our testimonials:
On page 6 of proposal 34-96493 – Disclosure of Order Execution information (thereafter referred to as ①) and according to 75 FR 3597, “The goal of promoting opportunities for the most willing seller to meet the most willing buyer and the goal of promoting competition among markets, can be difficult to reconcile”. The SEC is aware of the “willing seller willing buyer standard” while using “price improvement” almost interchangeably with it. It is, however, inappropriate because of the over emphasis on “most favorable price” which undermines the other aspects of the 4Vs.
Having the SEC prescribe or endorse the statistics in ① may indeed be a contradiction with the standard investor disclaimer – “Past performance is NOT indicative of future results”. ① essentially publicizes some Consolidated Audit Trail (CAT) data that would otherwise be confidential. Giving away vast amounts of information to free riders (e.g., activists, MEME stock insurgents, and foreign adversaries) increases vulnerabilities. These free riders have no skin in the game while they use market modeling for mischief. Increasing MEME events and other irrational exuberance is detrimental to rational price discovery (i.e. worsen the veracity outcomes). Policy and market incentives should direct creative efforts to decipher “outliers” (footnote 236). Discovery of unknowns and timely warning of irregularities make the market safer.
Regarding the ‘Minimum Pricing Increments’ provisions in proposal 34-96494 (thereafter referred to as ②), what problem is it trying to solve? The Commission is forcing almost all stocks to trade at least 4-8 ticks wide, while NASDAQ and other researches indicate a stock has optimal trading with a 2-3 tick spread. The SEC is attempting to close any minor differences between the different market centers’ capabilities in sub-penny trading that may be used as tactics to disrupt the quote priority. Yet, artificially altering the queue (equal waiting line at all checkout counters) may affect the “apparent”, NOT the real supply and demand for securities. Policy makers should consider Market Makers (MM), Alternative Trading Systems (ATSs), single dealer platforms (SDPs), and Self-Regulatory Organizations (SROs) as different streaming platforms in order to have the right focus. Making all ‘streamers’ the same is a detriment to the variety factor of the 4Vs because it undermines the different roles they play and the frienemy dynamics they have in fabricating the fragmented market under Reg. NMS.
The SEC is proposing the access fee cap of 10 mil (currently at 30 mil) for all stocks, except the 1/10th cent tick group to a cap of 1/20th cent, or 5 mils according to the access fees provision in proposal 34-96494 (thereafter referred to as ③). Aggregated 606 payments for Q1 2022 to 52 Retail Broker-Dealers by wholesalers, exchanges and other trading venues amount to $849,738,235. The SEC foresees firms would reduce using Payment for Order Flow (PFOF) agreements for both NMS stocks and listed options. If annualized the 606 payment and cutting it by half, it is approximate $1.7 billion, plus the SEC’s expected a reduction in access fee rebates under ③ of $1.857 billion (80.3%), it would mean trimming of incentives in total of $3.557 billion to go around in the market. If annualized the aggregated net income for the 3,498 broker-dealers that had a valid FOCUS Report, it is $45.4 billion. Where can they squeeze their margin to cover an 8% loss?
The proposed accelerated implementation of odd-lots/ round-lot (603(b) of Market Data Infrastructure Rule [MDIR]) under the ‘Transparency of Better Priced Orders’ provision of 34-96494 (thereafter referred to as ④) is problematic. Ingesting a lot of data raises the concern about bandwidth connectivity. What you see may not be what you get. Lacking depth-of-book data undermines the usefulness of Odd Lot data. The SEC’s economic analysis (page 193) acknowledged
that “the proposal could increase the demand to purchase depth of book data … result in more market participants purchasing data from exchange depth of book proprietary data feeds than do currently.” How sad that the industry has no say over market data (contents) that they provided, or arguably “owned”, given the court struck down the CT-Plan.
We estimate the market size for US Equity and Option market data including SIP, prop feeds, and vendor solutions plus ticker plants, connectivity to be over $4.5 billion and it keeps going up each year. Think about what gives rise to arbitrage or pick offs on price. Anyone would have done it if they did not have to bear the corresponding cost in using others’ copyrighted materials. The SEC should NOT be taking the stand to protect the exchanges’ “agency market business model”. We argue that for-profit exchanges are indeed operating a “Jukebox model” to extract rent. Letting these streamers divide the cake by selectively paying rebates and other perks to the elites hurts the other “content” creators. The situation is worse in the futures market as CME and ICE hold duopoly power. To end the endless pursuit of ever faster velocity, the SEC should mandate the use of time-lock encryption to make market data available securely in synchronized time.
There is a new 600(b) requirement to identify the best odd-lot orders under ④. Compilation of protected quotes is complicated. An odd-lot NBBO creates ambiguity. The SEC would get lambasted, while free riding speculators ask for evermore “indicators” that they amply herd behaviors by using the echo chamber to disrupt the US market. On a separate note, page 129 of ④, what are or are not ‘unnecessary costs’ to the SROs should not be subjectively dictated by the SEC. The matter about SIP impending retirement is like someone trying to change the Social Security and Medicare benefits. Impairment on rights and obligations should get appropriate compensation.
Regarding the proposal for ‘Order Competition Rule 615’ under 34-96495 (thereafter referred to as ⑤), the concept of using a discrete-time (periodic batch) auction to replace continuous–time limit order books (CoB) to deemphasize speed as a key to trading success is NOT a novel idea. Professor Eric Budish had been one of the biggest proponents of Auctions. However, according to this 2014 CFA post, it points out that “pre-trade transparent constantly updating price in real-time, providing true price discovery, which complicate the auction process … Budish agreeing that latency arbitrage could continue on parallel continuous market exchanges. In this case, the proposal is similar to IEX’s speed bump, which is designed to protect traders only on the IEX platform.”
The long list of cumbersome parameters in ⑤ that the SEC attempts to prohibit gaming or latency arbitrage on parallel continuous market seems ineffective. No control over interaction with derivative trading that is under the CFTC’s jurisdiction is the fatal flaw. Also, their enforceability is doubtful. Benchmark reference price arbitrage would persist due to multiple-NBBOs. Auction only works in an “all or nothing” mode, i.e. mutually exclusive with CoB. A poorly functioned batch auction model at best would create yet another speed bump like the IEX. This is NOT what the industry or market needs. Nevertheless, reference to 79 FR 5592 footnote 711, it said “The Agencies are not adopting a 'transaction-by-transaction' approach because the Agencies are concerned that such an approach would be unduly burdensome or impractical and inconsistent …” ⑤ seems to be in conflict with it, and the SEC’s policy direction is confusing.
Auctions may not have a price guarantee, and price improvement on auction may only occur briefly for few orders being filled. The frustration is analogy to deeply discounted items on ‘Black Friday Sales’. The 3 big exchange groups + MEMX, IEX, UBS ATS, SIGMA X2, and Intelligent Cross are the eight current incumbents meeting the 1% average daily volume to operate a qualified auction under⑤. The Commission has acknowledged that there are additional complexity and connectivity costs to market participants arising from the introduction of qualified auctions.
We foresee widening of spread (likewise, per NASDAQ). The proposed fees and rebates determinable at the Time of Execution (ToE) under ③ may push trading venues to be more defensive, or MMs retaliating against the skewed structure. Block trading activities would be reduced if the NBBO is narrowly defined or there are insufficient incentives to go around.
The additional market complexity, as well as the increased MEME events and other irrational exuberances mentioned earlier, would convolute the US market. All these leading to NOT yielding the SEC desired volume growth.
Technology advancements do NOT reduce “flickering” concerns (footnote 195 of ②) because tech in itself is neutral. In contrast to the Commission’s belief, the ‘phantom quotes’ phenomenon has been exacerbated ever since IEX goes all-in on Data Revenues, Quote Fade and (Virtual) Rebates. Investors’ frustration and complaints will rise. People will shift focus to passive strategies and/or derivatives trading. Asset maximizers (‘farmers’: fund industry, retirement, insurance sectors) will have a hard time achieving economy of scale without losing out to the ‘hunters’ amid the NMS tectonic shift, leading to further consolidation of asset managers. Without sufficient diversity or variety of participants in the market, price discovery or veracity leaving up to the auction process may indeed intensify “gamification”.
A vicious cycle is created when the echo chamber generates more bifurcated behaviors. It will cannibalize the market. The SEC exacerbates the gap between the ‘haves’ and ‘have-not’ by not curbing the tier rebate in ③, letting NYSE launched 100G colocation service since April 2020 when MDIR is based on 10G connectivity, and imposing disproportional burdens on small players, such as the proposed ‘Regulation Best Execution’ (thereafter referred to as ⑥).
Under proposed Rule 1100 or ⑥, “the term ‘market’... encompass the wide range of mechanisms … this description of ‘market’ is expansive …” We believe the Commission may be having the Proposed Investor Protections in Communication Protocol Systems (CPSs) and ATSs and Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange” in mind. Per our 2022 comment letters to the SEC, ESMA, and FCA, the regime difference pertains to the characteristics or principles in determining when a “subject” or “object” meeting certain condition(s) would be considered “what”. Both the US and EU’s changes are between a rock and a hard place.
MiFID-II calls for ‘sufficient steps’ to ensure favorable execution of client orders, while the US under ⑥ requires ‘reasonable steps’ that is more bureaucratic and subjective. Ebb and flow would cause the US market to lose a competitive edge, further reducing overall trade volume. Please be reminded of Jérôme Kerviel whom bought into Daniel Bouton’s lip service about Société Générale’s internal control strengths with a $7.2 billion loss in 2008. Heighten disclosure in the beautified name of “improve transparency” may indeed be bad policies for an uneven playing field. Malicious targeting or selective enforcement only benefits the middlemen, big law and consulting firms. Yet, conflict would persist.
① + ⑥ basically require demonstration of ‘where’ an order should be routed but not ‘when’. The SEC’s proposed definition or characterization of “conflicted transactions” is inappropriate because there are additional factors beyond the 3 subjective conditions on page 100 of ⑥ to affirm the ‘suspicious activities’ are indeed in ‘conflict’ or not. “Selective timing” to get in-and-out of market, or if firms may classify a trade as dealing with “clients” versus “counter-parties”, somehow banks outsource trading to execution service vendors, and these vendors have another set of third parties to review order routing and execution quality. God knows if rubber stamping on BestEx reports is any good as compared to thorough assessment of market makers’ risk profile and market timing.
The SEC use of Difference-In-Differences (DID) regression model for their analysis is slick. This World Bank blog pointed out that “Equality of pre-treatment trends may lend confidence but this cannot directly test the identifying assumption … DID implicitly involves other assumptions instead of Parallel Paths, which may influence the estimate of the treatment effect .. These assumptions concern the dynamics of the outcome of interest, both before and after the introduction of treatment, and the implications of the particular dynamic specification for the Parallel Paths assumption.” Although DID is intended to mitigate the effects of extraneous factors and selection bias, depending on how the treatment group is chosen or omitted, DID may still be biased. According to Schwab, “Order routing revenue and price improvement are NOT ‘zero-sum’. Conversely, we have seen progressive improvements to execution quality while payment rates remained relatively stable.”
The SEC’s linguistic camouflage, such as page 408-409 of ⑥ that stated the “initial aggregate cost of $54.12 million and total ongoing aggregate cost of $17.33 million per year”, however, the amounts merely reflect a small portion of the outside/ external costs for Paperwork Reduction Act (PRA). After crunching the numbers hidden in various footnotes, the dollar cost burden for ⑥ turns out to be: $216.89 million for initial internal implementation burden; $169.93 million in annual internal burden; $177.98 million for initial external cost burden; $92.23 million for annual external cost burden. The outside counsels (incl. paralegal) will rig in a total of $267 million, and outside compliance services is going to get $3 million in ⑥. So lucrative and tempting for the SEC’s “revolving door”! Using data directly from the SEC’s 1,656 pages (① $56,131,194 + ② $56,394,000 + ③ $855,000 + ④ $6,833,594 + ⑤ $100,706,631 + ⑥ $657,023,412)), the total combined initial and annual internal and external cost for four proposal packages is near $1 billion.
How bureaucratic rules became a cottage industry, while the list of roles and their corresponding hourly rate(s) suggested by the SEC under various footnotes are also “enthralling”. The four proposal packages use four inconsistent rates for Attorney and Compliance Manager; what an irony that the SEC is asking for BestEx across many different trading venues! Also, can legal and compliance teams work in a silo without involving any business-line personnel or technical staff under① and ③? Trade strategies and risk models all need to be upgraded. All players would need significant changes to their trade reports. The SEC underestimated the costs to comply with the various proposal packages by a wide margin.
The conscience within the Commission warned about the adverse effects or consequences throughout all four proposal packages, yet the final proposals downplayed the negative effects. Repeating the word “However” 561 times and using circular reference to self-articulated sections or declining to provide estimates on many occasions would not turn linguistic camouflage into truths. Although the Commission views the wholesalers (MMs internalizers) as the middleman, intermediary costs in reality encompass: connections with more trade venues (including auction markets), increase market data subscription fees, demonstrating BestEx, the inelastic demand of Transaction Cost Analyzer (TCA), the reliance on liquidity sourcing, execution services and other ‘tools’, for example, the use of split, cancel, derivatives and other means to adjust to the more convoluted market environment.
Where to find money to cover the $3.557 billion loss in net income for the 3,498 broker-dealers mentioned earlier; pay for the superficially low estimate of compliance cost that is near $1 billion; plus the rising market data, connectivity, and intermediary costs? Where to find the SEC claimed $2 billion of cost savings for retail (or Bloomberg lower the estimate to $800 million each year) when all 4Vs pointed negative? We argue the social burden is at least 10 times greater.
Gains in market efficiency will only be achieved by Pareto improvement (someone better off without anybody worst off or win-win for all). The number of FINRA registered firms continues to drop year over year. Healthy markets need both farmers and hunters. Do not shoot the messenger (principal trading firms). Without a consistent copyright licensing mechanism to align and address the economic viability of a constituent to exploit its economy of scope and/or economy of scale, there is NO harmonization of different market centers. Rather than attempt to price control or inadvertently calibrate the wrong prescriptions, the SEC should consider principle-based rules, like the Four-Part Test that uplifts the “willing seller willing buyer standard” per 75 FR 3597.
The noumenon of rebate incentives serves as royalty payments for the use of others’ copyrighted material. We need mechanisms that reward “content” creators. Then “streamers” would be based on who they want to serve, how many subscriptions they are going to get and determine whether to carry a broader or narrower “catalog”. The broader the “catalog”, the platform would pay a wider range of broker-dealers, featured traders, algo developers in royalties. That is how the playing field should be aligned. Variety helps reach a wider audience, reduce unknowns, and grow the overall pie.
See this diagram for a summary of our assessment. Stay tuned for our comment letter to the SEC that is due on March 31.
