SEC market overhaul to boost exchanges, hurt brokers

A proposed overhaul of U.S. market structure will likely benefit exchanges while weighing on certain broker-dealers, according to initial assessments.

Last week, the Securities and Exchange Commission (SEC) proposed sweeping reforms to the rules that govern U.S. markets, including changes to order-handling requirements, best-execution standards and minimum trading increments.

In a pair of new reports, Fitch Ratings and Moody’s Investors Service both concluded that the proposals, if adopted, would favour exchanges over brokers, particularly firms that are engaged in wholesaling and off-exchange market marking.

Specifically, Fitch said the SEC’s proposals could “reduce the scope and economics of payment for order flow for retail brokers, while increasing their best-execution obligations and disclosure requirements for retail orders.”

Among other things, the regulators are proposing that smaller equity orders be sent to auction rather than being captured and executed internally.

“This could potentially benefit exchange volumes, as trades would no longer be routed to, and concentrated at, wholesalers,” Fitch said.

By curbing the practice of wholesalers internalizing retail volume by paying for that order flow, the regulators are hoping to increase competition, transparency and execution for retail trades, Fitch noted.

“However, some large trading firms argue that order-by-order auctions could increase execution risk and trading uncertainty, resulting in worse outcomes for smaller trades,” it said, noting that the practice of allowing payment for order flow has underpinned the reduction of retail trading commissions.

At the same time, the proposal to allow exchanges to execute trades in smaller trading increments would be a positive for exchanges, Fitch said.

“Allowing sub-penny increments at exchanges, as currently traded by wholesalers and off-exchange market makers, would level the playing field and could drive volume back to the exchanges,” it said.

The advantage has helped grow market share for wholesalers and off-exchange market makers, which captured 44% of trading volume in 2021, up from 30% in 2011, Fitch added.

In its report, Moody’s said the proposed reforms to both order handling requirements and trading increments would benefit exchanges at the expense of certain broker-dealers, such as Robinhood, which generate significant revenue from payment for order flow arrangements under the current regulatory structure.

“We expect wholesalers will likely seek to recoup lost revenue and profitability by adapting their practices to meet the changed regulatory requirements, but with less certain results,” Moody’s said.

Additionally, it noted that changes to market structure rules carry a risk of unintended consequences.

“The complex machinations of the existing market infrastructure mean that any significant change to its component parts could have unforeseen and unintended consequences for each type of market participant,” it said.

The proposals are out for public comment until March.

Fitch said final rules are expected in late 2023, but any changes would likely be phased in over several years.