“when the list was released I was surprised about how much made it into the agenda, and I felt that the proposals were very ambitious.”
SEC Equity Market Structure Proposals: A Buy-Side View
With Michael Warlan, Head of Global Trading, Third Avenue Management
From your seat as a buy-side trader, what was your reaction to the SEC’s equity market structure proposals put forth in December 2022?
Leading up to the SEC’s December release of market structure proposals there were already some conversations or speculation about what Chair Gensler and the SEC would be proposing. However, I had the sense that most thought it would be a less aggressive list both in number and in substance. So, when the list was released I was surprised about how much made it into the agenda, and I felt that the proposals were very ambitious.
Among areas that the SEC is addressing, which should be addressed?
The SEC should always address areas where there are structural deficiencies, lack of clarity or transparency, inequities, or threats of systemic risk. From the proposals released, there are merits and good intentions. However, like all rules that try to govern a very diverse group of participants, there will inevitably be conflicts and unintended consequences.
I believe the Rule 605 changes were intended to modernize disclosure of the information that can be helpful to all market participants. As markets have evolved we have become much more data-dependent and, maybe to a fault, dependent on the access and subject to the quality of this data. This proposal should be a step in the right direction towards increased transparency, inevitably leading to better decisions and outcomes.
With Rule 605 and disclosures being less controversial, there has been considerable debate about tick size and access fees. Access fees have been the foundation of the exchange rebate programs. From their introduction, exchanges have used these fees to attract various participants which some have argued has led to lower market quality and in some cases predatory trading behavior. With the debate heating up in recent years, it was inevitable that the SEC address these concerns in some form.
While I was initially intrigued by the rule defining “Best Execution,” it did seem to come up short when I read its content. In my experience, creating a singular definition of best execution has proved difficult, when painting all participants with a broad stroke. Each individual, whether retail or institutional, may have a different expectation or thought on best execution. From the responses it is clear that there will continue to be some daylight between the various market participants.
Rank the four proposals from most to least helpful for buy-side traders?
1. Reg NMS, Minimum Pricing Increments, Access Fees: The foundation of the maker-taker model, institutional traders would benefit from lower incentives or a higher cost for counterparties to use exchanges to gain access to information about trades being routed to certain venues. However, creating a lower and single and consistent access fee cap would benefit investors through reduced costs. Additionally, a lower overall trading increment would benefit institutional investors through more effective opportunities to interact with retail and across trading venues.
2. Rule 605: Access to increased transparency and higher-quality data should allow more opportunity to compare execution decisions.
3. Best Execution: As mentioned, this is appealing conceptually but I have concerns that this rule may fall into one of the areas of unintended consequences.
4. Order Competition: While increasing access to previously inaccessible liquidity would be helpful, there are questions on how efficient the process would be.
The sell side and exchanges have been vocal about the SEC proposals, mostly not constructive. What are the primary areas in which the buy-side view would differ from sell side / exchanges?
That is correct. I think based on the expected economic impact of the proposals, some sell-side and to some extent exchanges felt targeted, and perhaps underappreciated in the role that they play in the financial ecosystem. This is not new – floor brokers and market makers eventually found themselves under attack for their role in the market as we moved into the early 2000s and eventually had their roles diminished by technology. The method of introduction or execution shifted, but institutional investors and retail alike still interacted with the liquidity provided by an intermediary or a risk taker. The vacuum left by the diminished role of specialists, or market makers, allowed a new participant to rise: high-frequency traders.
Where I believe there is the most daylight between buy-side and sell-side/exchanges centers around access fees. With much of the fragmentation and competition across exchanges, and brokers, there has been a need to attract or offer ways to attract liquidity. Rebates have enabled exchanges to attract more order flow from brokers, who in turn offer customers reduced trading costs or even rebates as well. This process, however, has led to a degradation in “real” liquidity and has effectively transferred some of this cost to investors; the majority of that is borne by buy-side institutions.
Risk takers and liquidity providers contribute to an orderly market – most of the time. It’s safe to say that without brokers and exchanges markets would be much less efficient and more volatile. There are bad actors, of course, and modest changes to enhance the perception of fairness in markets will be a greater benefit to all. Most institutional investors recognize there is “no free lunch,” but as stated earlier, when the regulators see an area of inefficiency or exploitation, they should use their authority to address.
What area(s) of equity market structure, outside of what the SEC is addressing, do you think need regulatory attention?
I’m wary to answer, as I wouldn’t want to be blamed for another round of proposals! However, based on what is currently being discussed I could see in the near term something related to ESG. As has been conveyed in the past year-plus, ESG guidelines geared towards investment mandates are expected. I would not be shocked if they looped the trading component of the investment process into the policy. •
