In December 2022, as most institutional investors well know, the SEC proposed a set of trading reforms detailing significant changes on vital features such as tick size, the access fee cap, and competition for retail orders. Nasdaq, which operates the largest U.S. equity exchange by trading volume, is among the most influential companies in financial services to voice their support, concerns, and suggestions during the SEC’s “public comment period” for the proposed changes (which closed on March 31).
Overall, Nasdaq supports many of the principles and aims of the SEC’s proposed changes, but it believes that the means the regulator has chosen to achieve these objectives are more far-reaching than needed, and don’t include either an adequate analysis of the potential combined impacts of the rule changes or a thoughtful approach to their implementation.
We spoke with Chuck Mack, the Exchange’s Head of Strategy for North American Markets, and Brett Kitt, Principal Associate General Counsel, about Nasdaq’s feedback to the SEC. (View Nasdaq’s full March 30th letter here and a web overview of the proposals here.)
Nasdaq’s response to the SEC makes it clear that you support the broad principles behind several of the proposed changes, but think the regulator is being more aggressive than necessary in some cases in attempting to achieve them…
Chuck Mack: It’s important to understand that these are the biggest changes the SEC has proposed in a long time, and they touch on many aspects of market structure. We think markets currently work quite well. There’s always room for improvement, and we must evolve as technology changes, but the SEC’s proposals could drastically change how things work – including how much liquidity is available, which is probably the top concern of every institutional firm.
To be sure, many of the underlying principles of these proposed changes align with our principles. But we believe they may not accomplish what the SEC is trying to accomplish, and they could have unintended consequences that harm liquidity.
Brett Kitt: This is a common refrain throughout the industry. The SEC is proposing many changes simultaneously, without having conducted a full analysis of how those changes will interact and what their impacts would be. In fact, in certain cases they acknowledge this shortcoming expressly.
As there’s no emergency or crisis that the SEC is responding to that would necessitate doing everything quickly and simultaneously, many professionals don’t quite understand the need for them to proceed this way. What many of the responding organizations are suggesting is that if the SEC wants to implement major changes, they should sequence the proposals rather than do them simultaneously and pause periodically to assess the impacts and determine whether additional reforms are warranted. That approach may solve some problems they identify with less extreme actions – and allow them to change course as data and results dictate. This is what we’ve recommended.
Let’s get more specific. Which proposed changes did you address in your letter?
Mack: The proposal to change tick size is a focus for us. Currently, traders quote tick sizes in pennies, which isn’t always optimal. We have suggested updates to tick sizes including moving some securities to a half-penny tick size. But the SEC proposed a more complex structure with tick sizes as small as a tenth of a penny, which many people feel is too small. An unintended consequence of this, and our biggest concern, is that we’ll end up with almost all the activity in the industry being in a smaller tick size than we have today. Under the SEC proposal, there would likely be more than 5,000 securities moving over to these smaller tick sizes.
The negative aspect is that stocks end up having too many ticks in the spread. So if you’re a market maker and you’re putting your price out there to the world – which is highly beneficial to everyone – having a tick that’s so small will let somebody jump in front of you for an economically insignificant amount of money and risk. And you won’t get the trade. Naturally, that greatly diminishes your motivation to put out the quote, and we’ll end up with a lower quality NBBO.
As I mentioned, Nasdaq recommends not going below half a penny, for now, and implementing a larger tick – such as two pennies or a nickel – for securities that need it at the high-end. Going smaller than half a penny could potentially worsen existing problems. Institutional investors will find it more complex and difficult to get liquidity, and they’ll pay more for it due to deterioration in market quality.
Nasdaq also responded to the SEC’s proposal to reduce the access fee cap…
Mack: Yes. To support a robust displayed market and NBBO – or the National Best Bid and Offer – we’ve been highly effective in using a rebate as an incentive that drives liquidity and market quality. The rebate is the flip side of the access fee cap. If the fee is reduced, you’re going to force down the rebate, and that’s what chiefly concerns us.
When participants put out their quote on a fair-access market, anybody can trade against them. Because public quotes are available for anyone to trade against, at times market makers providing quotes can end up with negative trades – sometimes referred to as adverse selection. Over time the rebate provides a cushion against this. If you reduce the cushion by two thirds, as the SEC wants to do, participants and investors may think differently about the risk they’re willing to take. This will lead to wider spreads and reduce liquidity for large investors.
Many of these investors have advocated for lower fees. What they may not appreciate is that the wider spreads and lower liquidity are likely to increase their trading costs by more than the reduction in transaction fees.
Kitt: We don’t oppose reducing the access fee cap by a reasonable amount, per se. As we said in our letter and a recent white paper, it may be necessary to reduce that cap to accommodate the introduction of a new smaller tick size – not down to a tenth of a cent, but down to half a penny, per our recommendation. You don’t want the access fee to be outsized and become an obstacle to trading on exchanges, particularly when the increments are becoming smaller. It eats up opportunities within the spread for price improvement and other positive aspects.
So yes, we don’t object to reducing the access fee cap – provided that the reduction is proportionate to the extent reasonably necessary to accommodate a reasonably lower tick size. We are concerned, however, to the extent that the SEC wants to go far beyond what’s needed for that purpose.
Let’s finish by talking about Nasdaq’s response to the SEC’S proposal to adopt the Order Competition Rule. Why is Nasdaq against it?
Mack: The SEC wants to enhance competition for retail orders by forcing broker-dealers to submit those orders, in many cases, to a new auction mechanism, to be conducted on lit markets like exchanges, rather than going directly to wholesalers to execute, as they do today.
At a high level, they’re trying to create more opportunities for different participants to interact with retail orders, which currently interact largely with wholesalers. Generally speaking, we are supportive of competition. But what the SEC has put together is a very detailed, specific proposal on a particular mechanism in the market, and it leaves little room for innovation and doesn’t support the NBBO. It’s difficult to see how it will drive a process that will benefit the market in the long run. And we believe it may cause some significant unintended consequences.
Alternatively, we suggest that regulators set principles and guidelines, and then allow the market to compete and innovate to meet those principles and guidelines.
Nasdaq operates lots of auctions, both in equities and options. We think they’re great mechanisms. Broadly speaking, there’s room for improvements to our markets, but changes must allow the market to evolve over time. We believe the SEC could help put guidelines in place that spur more participants to trade against each other, increasing competition, and then allow the market to solve problems in creative and innovative ways. That’s the approach we suggest.
Kitt: Importantly, this doesn’t mean that exchanges are free to do whatever they want. The SEC still oversees our proposals through the review and approval process. If we want to design an auction (or any market mechanism for that matter) differently from the way the SEC envisions, we have to submit that to the SEC for approval and public comment and it will determine whether that proposal is consistent with the Exchange Act. So they’d still weigh in. But in that scenario, if our idea is bad and our auction doesn’t do well – but our competitor executes an auction in a way that’s really attractive – the entire market doesn’t suffer from our failure, and over time we’d adapt to do something more successful.
But if everybody has to do auctions in precisely the way the SEC prescribes, and they fail, the entire market may face unintended damage. That’s a lot of unnecessary risk. So again, we’re saying to the SEC, “Just put the core principles in place, and then let the market innovate to solve problems in ways that are consistent with those core principles.”
Mack: Nasdaq is certainly not against change. Markets and trading need to evolve and continue to get better. But we need to be careful, methodical and data driven as we move it forward. Because the markets work quite well. Evolutionary change could be really positive in the long term, and we’re highly supportive of that. But we want to see the regulator set the broad principles and guidelines, and then have different constituents of the market innovate to create the incremental, practical improvements that deliver the greatest benefits while avoiding unnecessary risks and problems.