The U.S. Securities and Exchange Commission (SEC or the Commission) proposed amendments on December 14, 2022, to Regulation National Market System (NMS) that, if adopted, would significantly alter the way certain orders in NMS stocks from individual investors are handled and executed. The amendments would also impose additional operational and compliance requirements for broker-dealers, national securities exchanges, and national securities associations.[1]

In sum, Proposed Rule 615 of Regulation NMS (Proposed Rule 615)[2] would require that certain trading centers expose marketable orders of individual investors to competition in fair and open auctions before they may execute those orders internally. As summarized below, Proposed Rule 615 would also impose requirements on broker-dealers, including retail broker-dealers, that are not “trading centers” under Regulation NMS with respect to processing retail customer orders in “NMS stocks.”[3]

SEC staff has already begun to receive comments on Proposed Rule 615 and will accept comments until March 31, 2023.[4]

Takeaways

If adopted, Proposed Rule 615 will likely have a substantial effect on the capital markets as it would require a significant shift in the current market structure surrounding the routing and execution of retail customer orders. The SEC acknowledges this potential impact on broker-dealers, national securities exchanges, and national securities associations in Proposed Rule 615.[5]

However, the impact of Proposed Rule 615 is stated to be counterbalanced by its benefits. The SEC notes that Proposed Rule 615 “is designed to benefit individual investors by promoting competition and transparency as means to enhance the opportunity for their orders to receive more favorable prices than they receive in the current market structure, as well as to benefit investors generally by giving them an opportunity to interact directly with a large volume of individual investor orders that are mostly inaccessible to them in the current market structure.”[6] To this end, the Commission estimates a range of $1.12 billion to $2.35 billion in total average annual savings in individual investor transaction costs if Proposed Rule 615 were to take effect.[7]

As noted in the proposal, the Order Protection Rule is highly likely to generate wide-ranging costs on market participants. For instance, if Proposed Rule 615 were adopted, retail broker-dealers may incur increased routing expenses, need to obtain exchange memberships or NMS alternative trading system (ATS) subscriptions in order to directly access the capital markets, or need to seek alternative ways to access qualified auctions. The Proposed Rule 615 also may cause wholesalers to decrease payment for order flow (PFOF) or charge retail broker-dealers fees for order handling or routing services. This change in practice could lead certain broker-dealers that currently offer zero-commission trading to retail investors to begin charging commissions for trades on NMS securities and exchange-traded funds (ETFs).[8]

Unlike the proposed Regulation Best Execution, which mirrors existing best execution rules,[9] many of the requirements of Proposed Rule 615 are new. As a result, broker-dealers, national securities exchanges, and national securities associations would be required to establish, implement, and maintain policies and procedures to comply with the Proposed Rule 615. Exchanges and NMS ATSs would need to establish qualified auctions and develop policies and procedures to comply with the Proposed Rule 615. Broker-dealers that facilitate trading in NMS stocks for natural persons would need to undergo a thorough compliance review of their practices for handling retail customer orders to determine whether they have policies and procedures that are sufficiently detailed to both define and identify “segmented orders” (see “Key Definitions” below) and implement appropriate practices to satisfy the specified criteria in the Proposed Rule 615. 

The SEC issued Proposed Rule 615 alongside numerous other proposed rules aimed at industry practices related to securities order handling and execution.[10] The SEC’s rulemaking efforts in this area suggest that issues surrounding price competition, transparency, and market access may continue to be a priority for the SEC over the coming years. Many of these proposals, if adopted, will fundamentally change equity market structure. 

Background

The SEC staff states that its analyses of current market practices for executing retail “segmented orders” (defined below) were a primary motivation for the changes made by Proposed Rule 615. Currently, retail broker-dealers use one of two avenues to access the market for trading services in NMS stocks to fill customer orders. Broker-dealers can directly access the market if they have their own exchange memberships or ATS subscriptions. However, retail brokers who do not have their own memberships or subscriptions fill customer orders by routing orders to wholesalers or other broker-dealers with direct access to exchanges, ATSs, or other trading venues.[11] Specifically, retail broker-dealers route more than 90% of customer orders in NMS stocks to a small group of six off-exchange dealers (commonly known as “wholesalers”).[12]

Wholesalers primarily trade bilaterally as principal with customer orders rather than providing an opportunity for another market participant, including institutional investors, to compete to provide a better price for the order. The impact of this practice, according to the SEC’s analysis of trading data, is an annual estimated $1.5 billion competitive shortfall to retail customers.[13] Accordingly, the SEC explained that Proposed Rule 615 is intended to require order execution processes that it believes will lead to better pricing for retail investors, and will benefit investors generally by giving them an opportunity to interact directly with a large volume of individual investor orders that are currently inaccessible to them. The SEC previously signaled that it was considering banning PFOF altogether.[14] While the proposal stops short of barring PFOF, the Commission acknowledges that Proposed Rule 615 could lead to a “significant decline or perhaps disappearance of PFOF in the markets for NMS stocks.”[15]

Scope of the Rule

Proposed Rule 615 introduces key definitions that must be understood for purposes of determining the scope of the Proposed Rule 615. For purposes of Proposed Rule 615, Proposed Rule 615 separates “trading centers” into five categories: (1) national securities exchanges operating self-regulatory organization (SRO) trading facilities; (2) alternative trading systems that trade NMS stocks (NMS Stock ATSs); (3) exchange market makers; (4) wholesalers; and (5) any other broker-dealer that executes orders internally by trading as principal or crossing orders as agent.[16] The Proposed Rule specifically defines “segmented order,” “open competition trading center,” “restricted competition trading center,” “originating broker,” and “qualified auction” (defined further below), each of which is a new term proposed to be defined in Rule 600(b) of Regulation NMS. 

Segmented Order

This term is designed to encompass orders of individual investors with low adverse selection costs and includes orders for stocks listed on U.S. securities exchanges (i.e., NMS stocks) that are made for an account (1) of a natural person (or an account held in legal form on behalf of a natural person or group of related family members); and (2) in which the average daily number of trades executed in NMS stocks was less than 40 in each of the six preceding calendar months. 

Open Competition Trading Center; Restricted Competition Trading Center

Proposed Rule 615 defines “open competition trading centers” as certain national securities exchanges or NMS stock ATSs that meet proposed requirements for transparency, access, and volume. The SEC explains that the definition of an open competition trading center is significant for purposes of Proposed Rule 615 as it identifies which trading centers are authorized to operate qualified auctions and specifies which trading centers will be subject to the order competition requirement of Proposed Rule 615 because a “restricted competition trading center” is defined by Proposed Rule 615 as any trading center other than an open competition trading center or a national securities exchange. 

Originating Broker

Proposed Rule 615 defines “originating broker” to mean any broker with responsibility for handling a customer account, including, but not limited to, opening and monitoring the customer account and accepting and transmitting orders for the customer account. Retail broker-dealers that do not fall within any of the categories of “trading center” may nevertheless be subject to Proposed Rule 615 if they are originating brokers.

Rule Exceptions 

The following types of segmented orders are excluded from Proposed Rule 615: 

• Segmented orders received and executed when no qualified auction was being operated for such orders. 
• Segmented orders with market values of at least $200,000.

• Segmented orders executed at prices that are equal to or more favorable for the orders than the midpoint of the national best bid and offer (NBBO) when the orders were received. 
• Segmented orders with customer-selected limit prices that are equal to or more favorable for the orders than the midpoint of the NBBO when the orders were received.
• The fractional share portion of a segmented order received and executed when no qualified auction was being operated for such order that would accept the fractional share portion. 

“Qualified Auction” Definition and Requirement 

Under Proposed Rule 615, a restricted competition trading center must first expose a segmented order to a “qualified auction” operated by an open competition trading center before the trading center could execute the segmented order internally.[17]

Proposed Rule 615 defines “qualified auction” to mean an auction that is operated by an open competition trading center pursuant to Proposed Rule 615. 

Proposed Rule 615 sets out requirements for an auction to be considered a “qualified auction,” including the following: 

• Auction messages must be widely disseminated in consolidated market data. 
• The duration of auctions must be between 100 milliseconds and 300 milliseconds.
• The minimum pricing increment must be no less than $0.001 for segmented orders and auction responses with prices of $1.00 or more per share. 
• No fee can be charged for submission of a segmented order. Any permissible fees and rebates will be capped at $0.0005 per share for segmented orders and auction responses with prices of $1.00 or more per share. 

• Execution priority requirements would, among other things, prohibit giving priority to the fastest auction response or to the auction response submitted by the broker-dealer that routed the segmented order to the auction.[18]
• A restricted competition trading center may, as soon as reasonably possible, execute the order internally at a price that is equal to or more favorable for the segmented order than the specified limit price in cases where a segmented order does not receive an execution in the qualified auction at a specified limit price or better. 

Broker-Dealer Requirements

Certain requirements under Proposed Rule 615 apply to broker-dealers, even where the broker-dealer does not fall within the definition of “trading center.”

All Broker-Dealers

Rule 615 sets out two requirements for all broker-dealers (including originating brokers) with respect to segmented orders: (1) Any broker-dealer that receives an order identified as a segmented order would be prohibited from routing the order without identifying the order to the routing destination as a segmented order; and (2) any broker-dealer with knowledge of where a segmented order is to be routed from would be prohibited from submitting an order, or enabling an order to be submitted by any other person, to the continuous order book of an open competition trading center or of a national securities exchange that could have priority to trade with the segmented order. In addition to the requirements for broker-dealers set forth in Proposed Rule 615, broker-dealers remain subject to all other existing obligations with respect to customer orders, including best execution. 

Originating Broker Requirements

Rule 615 sets out three requirements for “originating brokers”: (1) An originating broker would be required to establish, maintain, and enforce written policies and procedures reasonably designed to identify the orders of customers as segmented orders; (2) an originating broker would be prohibited from routing a customer order identified as a segmented order without also identifying the order to the routing destination as a segmented order; and (3) an originating broker who prefers not to disclose its identity in an auction message must certify that it has established, maintained, and enforced written policies and procedures reasonably designed to assure that its identity will not be disclosed, directly or indirectly, to any person who could participate in the qualified auction or otherwise trade with the segmented order. 

Companies and individuals are encouraged to contact experienced securities regulatory counsel with any questions about how these developments might apply to them or their business. 

Endnotes

[1] SEC, Press Release: SEC Proposes Rule to Enhance Competition for Individual Investor Order Execution (December 14, 2022) [Press Release].

[2] See Order Competition Rule, Exchange Act Release No. 34-96495, 88 Fed. Reg. 128 (January 3, 2023) [Rule Proposal].

[3] Rule 600(b)(55) of Regulation NMS defines “NMS stock” as any “NMS security” (i.e., any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective NMS plan for reporting transactions in listed options) other than an option.  17 CFR 242.600(b)(54)-(55).  Over-the-counter, or OTC, securities are not included in the definition of NMS stock.  See Rule Proposal at 131 n. 16.

[4] SEC, Order Competition Rule: Submitted Comments (last visited February 3, 2023).

[5] See Rule Proposal at 179 (acknowledging “considerable uncertainty in the costs that would arise from Proposed Rule 615” and anticipated costs (1) to the operations of wholesalers and some retail brokers generally, (2) to retail brokers from wholesalers altering the costs associated with handling orders, (3) to open competition trading centers associated with creating qualified auctions, and (4) to broker-dealers and trading centers related to establishing policies and procedures to ensure compliance with the Proposed Rule 615). 

[6] See Rule Proposal at 129.

[7] See Rule Proposal at 178.

[8] See Rule Proposal at 218.

[9] Regulation Best Execution, Exchange Act Release No. 96496, 88 Fed. Reg. 5440 (January 27, 2023).

[10] See Disclosure of Order Execution Information, Exchange Act Release No. 34-96493, 88 Fed. Reg. 3786 (January 20, 2023); Regulation NMS: Minimum Pricing Increments, Access Fees, and Transparency of Better Priced Orders, Exchange Act Release No. 34-96494, 87 Fed. Reg. 80266 (December 29, 2022); Regulation Best Execution, supra note 9.

[11] See Rule Proposal at 225.

[12] The SEC notes that Regulation NMS does not formally define the term “wholesaler”; however, it refers to an over-the-counter market makers that seek to attract orders from retail broker-dealers.   See Rule Proposal at 132.

[13] See Rule Proposal at 130. 

[14] See Lydia Beyoud and Katherine Doherty, SEC Set to Let Wall Street Keep Payment-for-Order-Flow Deals, BNN Bloomberg (September 22, 2022).

[15] See Rule Proposal at 218.

[16] See Rule Proposal at 131.

[17] See Press Release; Rule Proposal at 146.

[18] See Proposed Rule at 158-159.