by Jim Toes
President and CEO, STA
This Wednesday, the US Securities and Exchange Commission will propose a series of highly anticipated rules and rule amendments that have the potential to fundamentally reshape the structure of the US equity markets. While the US equity markets are operating efficiently and remain the most liquid in the world, they are not perfect. Therefore, regulatory proposals that seek to improve operational resiliency, increase transparency and investor protections or foster capital formation, should be met with open minds and clear eyes.
For over 80 years, the industry and the Commission have engaged extensively on rulemaking proposals. Those engagements have come in many forms from one-on-one meetings and public roundtables prior to a rule’s draft and then followed by notice and comment periods that provided meaningful time to respond. In total these opportunities allowed for industry participants to raise concerns and provide meaningful input which better ensured that rules were adequately designed and that interested parties could engage in a process viewed as fair and transparent.
This is not the situation as it pertains to the Commission’s expected proposed new rule under Regulation NMS titled the Order Competition Rule, which would “require certain equity orders of retail investors to be exposed to competition in fair and open auctions before such orders could be executed internally by any trading center that restricts order-by-order competition.”
The concept of introducing a regulatory designed auction mechanism(s) and perhaps mandating its use either directly or indirectly for some portion of equity retail orders is by definition a new and radical concept. One that was never even a consideration until this past summer following SEC Chair Gensler’s June speech. For comparison, Regulation NMS was first proposed in February 2004, however, the Commission’s engagement with the industry on key components of it began in October 2002 with a series of Market Structure Roundtables and public hearings. While there was disagreement on the rule’s final version which was implemented in August 2005, almost all agreed that the Commission had engaged in a thorough, deliberate, and open rulemaking process that provided at every point an opportunity for public participation and debate.
See SEC Market Structure and Reg NMS Roundtables here
While STA and other associations have expressed broad concern that the notice and comment process of rulemaking has been devalued recently, this specific proposal, in our opinion, is a most egregious example. We therefore doubt that a typical comment period of 60 or even 90 days will be enough time to provide meaningful input on such a significant shift.
But like other associations, we will do our best. Perhaps surprisingly, our first area of focus will not be on cost/benefit analysis. Instead, our attention will initially be on the possible systemic risk this proposal could bring to the marketplace in the form of stress on our infrastructure caused by message traffic.
To get a sense of how much message traffic exists today, FINRA CAT reported having processed an average of 296 BILLION records per day across our equity and options markets. While the details of how the SEC’s mandated auction mechanism(s) will operate are unknown, it/they will have certain characteristics that every auction has.
Investor confidence is influenced by several factors, none more than the operational capability of the markets. Failures of that capability, even as a rare or limited occurrence, destroy investor confidence, much more so than any other regulatory or market structure minutia. Fostering greater operational capability should be the foremost consideration of any regulatory entity that has oversight or influence on our financial markets. It is imperative that our regulators ensure no demands are made on the operational capacity of the industry that could result in its being unable to deliver the services it purports to offer.
To get a sense of how much message traffic exists today, FINRA CAT reported having processed an average of 296 BILLION records per day across our equity and options markets. While the details of how the SEC’s mandated auction mechanism(s) will operate are unknown, it/they will have certain characteristics that every auction has. Broker Dealer A enters an order into an auction, messages are sent alerting certain participants that an auction will take place, some of those participants will send a message back, a determination on the best price is made by the auction operator; messages are sent to those who submitted prices and then finally, Broker Dealer A receives an execution message. Each of these incremental messages will be CAT reportable events. Now, compare this work flow to what is done today, where Broker Dealer A sends an order to Broker Dealer B and receives a fill.
See FINRA CAT; Processing Updates, February 2022 page #2 here
To be clear, our markets can function with delays or even temporary outages of CAT. However, heavy message traffic stresses algorithms that need to keep up with live prices and order flow across a portfolio of orders being worked. It also increases latency in busy (or “fast”) markets, as the ports and wireless networks are capped in how many messages they can transmit per millisecond.
These are realities we hope the Commission appreciates and addresses in its proposal. We look forward to engaging with staff and the industry in the months ahead on what may become a seminal moment in the history of equity market structure. We will do our best to offer constructive criticism and work with the Commission to ensure that all points of view are fully considered.