Securities Regulation Daily ‘[T]ime to put the ‘exchange’ back in the Securities and Exchange Commission’
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Thursday, September 20, 2018

‘[T]ime to put the ‘exchange’ back in the Securities and Exchange Commission’

By Mark S. Nelson, J.D.

SEC Commissioner Robert Jackson said that regulatory incentives and the for-profit business model had weakened competition among the nation’s stock exchanges. Speaking to an audience at George Mason University, Jackson explained that he sees a "rare bipartisan opportunity" to reconsider how exchanges are structured, disseminate information, compensate injured investors, and rout orders.

Early reaction by one markets group was generally positive. "SIFMA supports reforms on market data dissemination, including to ensure that the public market data feeds are robust and efficient and that fees for proprietary market data product, as Commissioner Jackson urged, do not unduly burden competition, are fair and reasonable," said Kenneth Bentsen, Jr., SIFMA president and CEO. "In addition, SIFMA supports reforms to the construct of exchanges as SROs, particularly the need to formally establish that exchanges are precluded from applying regulatory immunity to their commercial activities and that exchanges should no longer be protected by artificially low liability limits."

The root problem and its progeny. According to Jackson, the current state of U.S. stock exchanges has its roots in a decision by the SEC to allow them to be both self-regulatory organizations and operate on a for profit basis. The commissioner suggested that the temptation for exchanges to put profits ahead of regulatory goals can be exacerbated by SEC rules designed for non-profit exchanges. Jackson pointed to four areas of concern:

  • Market structure of exchanges—Jackson noted that three companies own 12 of the 13 U.S. public exchanges. He also cited exchanges’ connectivity practices as an example of how market structure impacts investors. According to Jackson, technological advances have made connectivity cheaper, but the SEC continues to approve exchange rules that can keep prices high. In a footnote, Jackson cited research by his own staff that showed no SEC disapprovals of exchanges’ connectivity-related rule change proposals in 99 filings by equity exchanges made between 2016 and the present, although six proposals were either withdrawn or modified. Jackson, however, noted the recent move by the SEC to suspend and institute proceedings regarding three similar proposals by BOX Options Exchange LLCMiami International Securities Exchange LLC, and MIAX PEARL, LLC.
  • Data feeds—According to Jackson, the two-tiered data feed system presents a conflict of interest for exchanges. By law, exchanges must provide a public feed, but they also can provide a better quality private feed for a fee.
  • Compensating injured investors—On this point, Jackson said the SEC has tended to deal with exchanges by resorting to enforcement measures characterized by "not-for-profit kid gloves." He explained that exchanges may claim regulatory immunity to the extent their actions are an exercise of their regulatory authority. Exchanges also may adopt rules that limit their liability when they are unable to assert regulatory immunity.
  • Best execution and order routing—In theory, Jackson said, the best national best bid or offer should be the price an investor pays for shares bought on an exchange. But in practice, he said exchanges take advantage of gaps in SEC rules that allow them to charge higher fees in some instances, raising a potential conflict of interest. Specifically, he cited research by Robert Battalio, professor of finance and presidential faculty fellow at the University of Notre Dame's Mendoza College of Business, finding that broker-dealers send orders to exchanges that pay the highest rebates.
  • In 2014 testimony before the U.S. Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs regarding conflicts of interest in U.S. equity markets, Battalio summarized the findings he and two co-authors made in a paper that was later published in the Journal of Finance (May 23, 2016) (Jackson cited both the paper and Battalio's testimony):
  • "In my paper with Shane Corwin and Robert Jennings, we present evidence from Rule 606 filings that four popular retail brokers made order routing decisions in the fourth quarter of 2012 that appear to maximize the liquidity rebates generated from limit order executions. Specifically, these brokers appear to route their customers’ standing limit orders to a single exchange that pays the maximum liquidity rebate. To the best of our knowledge, none of these brokers makes it a practice to directly pass exchange fees/rebates through to their customers. As a result, we argue that limit order execution quality, not liquidity rebates, should determine where these brokers route their limit orders" (footnotes omitted).

Fixing U.S. exchanges. Jackson did not cite the SEC’s 2010 concept release on equity market structure. That release discussed a range of issues including liquidity rebates, data feeds, and high frequency trading. The release also discussed alternative trading systems, which the Commission recently addressed in final rules regarding the transparency of NMS stock ATSs.

Previously, former Commissioner Michael Piwowar lamented the SEC’s being slow to address market structure issues after "unsolicited prompting by a bestselling author" (a likely reference to Michael Lewis’s book Flash Boys, which prompted Congressional hearings about high-frequency trading and market structure after Lewis appeared on CBS’s 60 Minutes and said the U.S. stock market is "rigged"). Piwowar delivered his remarks at Notre Dame's Mendoza College of Business and cited an earlier version of the Battalio paper that Jackson cited. Moreover, then-Chair Mary Jo White had separately noted that the SEC brought its first cases against high-frequency trading firms, and saidU.S. markets are neither "fundamentally broken" nor "rigged."

Still, Jackson said progress in reforming U.S. exchanges may be on the horizon. For one, the SEC proposed a pilot program regarding rebates and market conditions that will include data on what happens in markets when rebates are unavailable. He said three other items also should be part of a larger, market-wide discussion: (1) disclosure of exchanges’ revenues; (2) how exchanges exercise their rulemaking authority and set prices; and (3) whether for-profit exchanges should continue to be immune from civil liability.

Jackson ended his remarks where he had begun them by noting that a diverse set of SEC commissioners, lawmakers, and current Chairman Jay Clayton had, over the years, expressed interest in taking a closer look at how U.S. exchanges operate. "I believe the Commission is finally ready to take off the kid gloves we’ve been using on our stock exchanges—and start to ask hard questions about our country’s stock market structure," said Jackson.

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