The SEC’s Transaction Fee Pilot: A troubling experiment

Angelo Evangelou, Chief Policy Officer, Cboe Global Markets, writes about the SEC's current Transaction Fee Pilot, and its potential impact on U.S. securities markets.

Everyone has an opinion when it comes to the U.S. securities markets.

While these markets operate efficiently and serve investors quite well, narratives that call for some form of major structural change continue to make the rounds. The latest - that certain equity exchange transaction pricing models need to be curtailed - has picked up some traction within the industry. In March, the U.S. Securities and Exchange Commission (SEC) proposed a restrictive Transaction Fee Pilot for equity securities that would encompass 3,000 stocks currently traded today.

The Pilot’s stated purpose is to gather data to study the impact of transaction fees and rebates on order routing behavior, execution quality and market quality. While the SEC’s efforts to analyse current market structure and propose thoughtful improvements are necessary and important, this Pilot is severely flawed and, if implemented, could adversely impact market quality and the investor experience.

Exchanges compete vigorously to display the best prices for investors. To encourage liquidity and aggressive pricing, some exchanges have adopted a fee structure that charges a fee to the taker of liquidity on a trade (the inbound order) and rebates a portion of that charge to the maker of liquidity (the resting order). This fee structure encourages tighter spreads and better prices for customers. It is not the only fee model in use in the equities market.

The Pilot, which could last for up to two years, would divide the 3,000 stocks traded today into three test groups. Test Group 1 and Test Group 2 would lower the current U.S. equity access fee cap of $0.0030 per share to $0.0015 and $0.0005 per share, respectively. Test Group 3 would prohibit all exchange rebates and linked pricing while maintaining the existing $0.0030 per share fee cap. The existing $0.0030 per share fee cap, which has its supporters and detractors, was somewhat arbitrarily set over a decade ago to ensure transaction fees were not too predatory. It was designed to prevent excessively high transaction fees when the Order Protection Rule forced orders to an exchange posting the best price.

The Pilot would lower the existing fee cap considerably - by 50 to 83 percent - for 2,000 stocks and ban rebates entirely for 1,000 stocks for the duration of the Pilot period - possibly two years. Further, the inclusion of 3,000 securities, plus exchange-traded products (ETPs), could have sweeping, negative implications for the U.S. equities market. As exchange spreads would likely widen with reduced or no rebate incentives, investors could receive worse execution prices and more orders would migrate to opaque off-exchange venues. This is a dangerous experiment considering the SEC has not provided meaningful evidence that existing fee practices are actually harming investors, adversely impacting market quality or interfering with fair competition.

The U.S. equities market has many interconnected parts, yet the Pilot focuses on only one component of a multi-faceted interrelated rule framework - the fee cap. A holistic review of the entire framework is warranted before any action is taken. Furthermore, excluding non-exchange venues from the Pilot renders the proposal woefully incomplete, as nearly 40 percent of total U.S. equity volume is transacted off-exchange. Additionally, the inclusion of ETPs, such as exchange-traded funds and less actively traded stocks, is a mistake. Those securities have attributes that warrant different rules than actively traded stocks.

As previously noted, the SEC is seeking to gather data to study ‘potential’ conflicts of interest in broker order routing through these proposed fee cap changes. Yet most rebates accrue to proprietary market making firms that do not handle customer orders and have no broker obligations. Potential broker conflicts of interest can be studied and addressed in less intrusive ways. As stated in Cboe’s comment letter on the proposal, the Pilot appears to be a solution in search of a problem. Execution costs are down and spreads are narrow – all to the benefit of investors. Implementing a Pilot that could disrupt a well-functioning marketplace is unwarranted and ill-advised. Regulators must carefully dissect narratives calling for structural market changes before acting on them. There is too much at stake.