ONPOINT / A legal update from Dechert's Financial Services Group

April 2018

SEC Proposes Transaction Fee Pilot for NMS Stocks

The U.S. Securities and Exchange Commission (SEC) voted unanimously on March 14, 2018 to propose Rule 610T under Regulation NMS (Proposed Rule), which would create a transaction fee pilot program for NMS stocks (i.e., exchange-listed stocks) (610T Pilot). As drafted, the Proposed Rule would: (1) impose temporary ceilings on certain stock exchange transaction fees, as discussed below; and (2) require the national securities exchanges to prepare and publicly post data gathered over the course of the 610T Pilot.

SEC Determination of a Need for Action

In the release proposing the 610T Pilot (Proposing Release),1 the SEC addressed a number of concerns expressed by various market participants and other commentators about the different fee-and-rebate pricing models used in connection with executing transactions in NMS stocks on national securities exchanges and alternative trading systems (ATSs, together with national securities exchanges “trading centers”) – in particular, the so-called “maker-taker” (and “taker-maker”) fee models. A “maker-taker” pricing model rewards broker-dealers that provide liquidity by giving them a rebate, but charges a fee to broker-dealer participants who remove liquidity from the trading center. A “taker-maker” pricing model conversely rewards market participants to remove liquidity and charges a fee to those who provide liquidity to the trading center. The SEC observed that these types of fee models could create conflicts of interest for broker-dealers that are required to seek best execution for their customers’ orders, but may have a conflicting economic incentive to avoid fees and/or earn rebates. The SEC also noted that the variety of order incentives and pricing models offered by trading centers create market fragmentation and complex order routing by broker-dealers trying to maximize the rebate pricing they receive. The SEC plans to use the empirical data that it would gather under the 610T Pilot to determine whether, and if so how, to amend Regulation NMS to address these concerns.

From time-to-time, the SEC has considered trading centers’ various pricing models, beginning over 30 years ago with the formation of the first electronic communications networks (ECNs) as an alternative to trading on traditional stock exchanges.2 The SEC has periodically reconsidered the issue in detail, including in connection with the regulation of ATSs under Regulation ATS in 1998 and the creation of Regulation NMS in 2005.3 Most recently, in 2016, the SEC’s Equity Market Structure Advisory Committee (EMSAC) proposed an access fee pilot for NMS stocks (EMSAC Pilot) to “study the impact of transaction fees on market quality and order routing behavior.”4 While many of EMSAC’s recommendations are reflected in the Proposing Release, the proposed 610T Pilot differs from the EMSAC Pilot in several significant ways, a number of which are discussed below.

Proposed Rule 610T Pilot

Unlike the EMSAC Pilot, which would have applied only to maker-taker exchanges, the 610T Pilot would apply to all “national securities exchanges that are registered with the [SEC] and that trade NMS stocks” (Eligible Exchanges).5 However, ATSs and other non-exchange trading centers would not be subject to the Proposed Rule. The SEC has requested comment as to whether ATSs and other non-exchange trading centers should be included in the final rule and whether the scope of the 610T Pilot is appropriate.

Unlike current Rule 610, which includes stocks that have a share price of at least $1, the 610T Pilot would include all NMS stocks that have a share price of at least $2 per share. If during the 610T Pilot an NMS stock closes below $1 per share, the stock would be removed from the program. In addition, the Proposed Rule would apply only to those NMS stocks that have a duration until at least the end of the 610T Pilot, so that the results of the pilot would not be impacted by changes to the test groups due to securities expiring and dropping out of the pilot.

The 610T Pilot contemplates three test groups and one control group, which would continue to operate under the requirements of current Regulation NMS Rule 610(c). The first two test groups would limit fees for removing and providing displayed liquidity to $0.0015 and $0.0005, respectively, with no cap on rebates. The third test group would prohibit rebates and linked pricing for removing and providing displayed and undisplayed liquidity. For this third test group, Rule 610(c)’s current fee cap of $0.0030 for removing displayed liquidity would remain in place. The Proposed Rule would allow Eligible Exchanges to charge varied transaction fees for NMS stocks in the 610T Pilot, subject to the fee restrictions for each test group and the control group currently set forth under Rule 610(c).6 The EMSAC Pilot similarly recommended one control group and three test groups, but the proposed fee caps for removing and providing displayed liquidity differed from Proposed Rule.7 The SEC is seeking comments about the appropriateness of the restrictions on each group.

Under the 610T Pilot, the SEC would assign each eligible NMS stock to one of the four groups, through a “stratified sampling by market capitalization, share price, and liquidity.” The three test groups would each contain 1,000 NMS stocks, and the control group would consist of the remaining NMS stocks. The configuration of each group would not change during the 610T Pilot, except for changes due to mergers, delistings, or a stock closing below $1 per share. In the Proposing Release, the SEC indicated it would publish on its website, one month before the start of the 610T Pilot, a list of the securities assigned to each of the four groups.

The Proposed Rule would require the Eligible Exchanges to post to their websites downloadable pilot and benchmarking data throughout the duration of the 610T Pilot, including data from the six-month periods before and after Proposed Rule’s pricing restrictions. The primary listing exchange8 of each security included under the Proposed Rule would be required to post to the exchange’s website (in “pipe-delimited ASCII format”) a list of the securities in the 610T Pilot for which it is the primary listing exchange. Furthermore, at least once a month, each exchange would be required to post “aggregated and anonymized” order routing data and an XML dataset of standardized information as to the exchange’s transaction fees and rebates.

The 610T Pilot would last two years, with an automatic sunset after the first year. The SEC would be able to suspend the sunset, and this decision would be based, in part, on the quality and sufficiency of the data collected during the first year of the 610T Pilot.9 The SEC has not yet specified the effective date for the 610T Pilot, but stated that it would issue a notice in the Federal Register one month prior to the six-month pre-pricing restrictions period.

Costs to NMS Participants

The SEC acknowledged that, if adopted, the Proposed Rule would create real and potential costs for the Eligible Exchanges, broker-dealers and market participants.

Although the Proposed Rule is only a pilot program and ultimately the SEC could determine not to amend Rule 610, the SEC noted that the Proposed Rule would create costs for Eligible Exchanges in: complying with the rule’s data collection, preparation and posting requirements; changing their fee structures, and filing of Form 19b-4 (fee filings) with the SEC.10 Moreover, the SEC anticipates that exchanges may lose revenue based on the changes to the fee and rebate structures contemplated by the Proposed Rule.

The SEC acknowledged that broker-dealers may similarly face increased costs to conform their fee and rebate structures, and may lose revenue from rebate restrictions. Moreover, investors may ultimately bear at least some of these increased costs to the extent that they are passed from exchanges, to their members, and then on to the ultimate investor, in return for the collection of data that the SEC views as valuable and otherwise unavailable.

Notwithstanding its discussion of costs, the SEC noted that it is unable to estimate all of the economic costs of the 610T Pilot, and asked for commenters to provide information about the potential economic impacts of the pilot.

Conclusion

The 60-day comment period for the Proposed Rule began on March 26, 2018, and comments are due by May 25, 2018. Broker-dealers and investment managers, as well as the stock exchanges that will be directly subject to the 610T Pilot, should consider the compliance and operational challenges associated with the 610T Pilot. These and other market participants may want to consider submitting comments as to the direct and indirect consequences of the Proposed Rule.