By Mark Davies, CEO, S3
Wall Street has turned into a foam debating the merits of regulators’ proposal to enforce retail auctions as part of a broader overhaul of US stock trading.
But the SEC’s best execution proposal, widely dismissed as duplicating an existing FINRA order, could have far-reaching implications for options, bond and cryptocurrency trading firms, as well as stocks — especially since it’s one of the most likely proposals implemented.
Overlooked rule
For the past few months, I’ve devoured every article, podcast, and webinar I could find on the quadruple strike of regulation that the SEC dropped on December 14th. As expected, the auction rule received the most scrutiny, with disagreements emerging from most corners of the industry, followed by the tick-size rule, with some interesting debates on both sides.
Rule 605 has been the subject of much analysis, although there has been relatively little disagreement; The industry has been pushing for improvements to Rule 605 since at least 2014. But the regulation on best execution (Rule 1101) has been largely ignored.
“It’s basically what FINRA already has,” I hear people say. “Most companies are already stricter than the requirements. They ask for quarterly meetings, but most companies do them monthly,” I hear.
Certainly there was some debate. The NYSE, Citadel and Schwab joint comment letter called for this rule to be withdrawn. The concerted opposition of a triumvirate of powerful market participants with diverse interests suggests the proposal has wider implications than many realize.
I was glued to my computer screen on December 14, listening to each of the Commissioners comment on these proposals and curious to see how each would vote. Two things surprised me.
First, they voted unanimously to support the tick size rule. This suggests that there is broad support for some sort of tick-size update, but it’s clear the commissioners want feedback from the industry on how to proceed (and I’m sure it will be plentiful).
The second surprise was that the Best Execution Regulation did not receive unanimous support. Gensler’s comments on this regulation were that while similar rules already exist at the self-regulatory level (FINRA and MSRB), such a fundamental requirement should come from the top regulator. This appears to have been an easy unanimous decision for the commissioners. As the CEO of a company that provides best-ex services to much of the industry, I had a personal interest in understanding why that wasn’t the case.
New commitments
During the holidays I spent hours sitting in front of the fireplace and brooding over the proposed regulations, particularly the regulation’s best execution and Rule 605. The commissioners had good reason to question the regulation’s best execution. The rule has some very significant requirements that go beyond current FINRA and MSRB regulations, particularly in relation to “conflicting transactions”.
At this point you may be thinking, “We have no conflicting transactions” or “We are not a retail broker” or “We do not accept payment for order flow”. But the SEC’s rule goes beyond what you’re likely to think of as bulk payment for order flow.
Yes, the transaction conflicts part of the Best Execution Regulation only applies to “retail client” orders. And yes, taking PFOF makes an order contradictory. But imagine you are an agency broker-dealer who only trades other broker-dealers’ corporate bonds, and instead of simply routing orders elsewhere, you decide to use risk-free capital orders to fill your order.
You may be thinking, “Surely that doesn’t apply to me.” However, if your broker-dealer clients are taking orders from retail dealers, they are likely subject to the new conflicting transaction rules. (See Section IV.C.5 of the Best Execution Regulations, which proposes disclosure of conflicting corporate bond transaction information.)
SEC Rule 1101, like FINRA 5310, applies to all transactions “for or with” an individual. Whether you are the direct broker or a downstream broker, you are involved in the transaction as the order is for the retailer.
Second, it’s now a contradictory transaction because you’re trading against these orders as capital, even risk-free capital. The SEC has included capital trading as a defining characteristic of conflicted transactions in addition to payment for order flow.
compliance challenge
This example is just that – an example. I’m not sure if this particular scenario was the SEC’s intent or an unintended consequence.
The conflicting transactions include transactions in stocks, options, corporate and municipal bonds, and cryptocurrency securities. They include payments to retail brokers from both the retail broker and wholesaler perspective. They include discounts from exchanges. They include orders executed as principal, including risk-free principals.
The SEC estimates that this rule will cost the industry $165 million in one-time costs plus $129 million annually. As the leading best execution provider for all SEC-regulated asset classes, S3 will be ready to handle the final version of the rule and will work with FINRA and the SEC to ensure our clients comply with best execution regulations.
It is in everyone’s best interests that the new rule be well scrutinized by the entire capital markets industry. If not, there will be countless unexpected results.
