On Wednesday, December 14, the U.S. Securities and Exchange Commission (the “SEC”) affirmatively voted to advance some major changes to U.S. stock-market rules, perhaps the biggest changes to such rules in nearly 20 years. Although the affirmative vote opens the proposed rules to public comment until at least March 31, 2023, before they can be adopted and finalized, meaning the proposed rules are just that—proposals—one in particular sheds light on the SEC’s desire to protect the public from what the SEC sees as unfair advantages to certain trading firms. This article sheds light on that proposed rule, the “Order Competition Rule.”
The SEC’s Order Competition Rule Explained
The Order Competition Rule would “prohibit a restricted competition trading center from internally executing certain orders of individual investors at a price unless the orders are first exposed to competition at that price in a qualified auction operated by an open competition trading center.” As the name of the rule suggests, at the heart of this proposal is encouraging greater competition for such individual retail investor’s orders on the national markets, thereby resulting in such investors getting better prices for their trades. It is believed this rule derived from the “Meme Stock” mania that occurred last year, where retail investors invested (and, at times lost) millions of dollars into companies like GameStop Corp. and AMC Entertainment Holdings, Inc.
To set the stage, most retail trading right now (according to the SEC, more than 90 percent of it looks like this: (1) an individual makes a trade, often through a retail broker-dealer (e.g. Robinhood, or E-Trade); (2) the broker-dealer then sends the trade to what’s known as a wholesaler, who actively quotes two-sided markets in a particular security, for the retail broker-dealers; (3) the wholesalers profit off the difference between the individual trader’s proposed price and the price the wholesaler actually makes the trade for; and (4) the wholesaler pays to the retail broker-dealers a small fee for giving it the right to make the trade. Importantly, those small fees paid to the retail broker-deals under that fourth point add up and can make up a large portion of such broker-dealers’ revenue, and further, the market for executing the trades is effectively closed off and managed solely by the wholesaler.
The Order Competition Rule, however, proposes to alter this process (albeit with some exceptions, discussed below) in a big way. Particularly, instead of the wholesaler executing the deal itself, under the rule the wholesaler must first send the trade to a “qualified auction” operated by an “open competition trading center” accessible to a broader market, allowing for and encouraging a more competitive market. While there are nuances and prohibitions to these definitions and the rule beyond the scope of this article, generally speaking, the proposed rule is ultimately “designed to benefit individual [i.e., retail] investors by promoting competition and transparency to enhance the opportunity for their orders to receive more favorable prices than they receive in the current market structure, and to benefit investors generally, including institutional investors, by giving them opportunities to trade directly with individual investor orders that are mostly inaccessible to them in the current market structure.” The upshot is, at least in theory, that the trades retail investors make align more closely with trades being placed on and available at the national exchanges (e.g., NASDAQ and NYSE).
As noted above, the Rule does include some exceptions and nuances to the auction and open market process. Notably, it would apply to “segmented orders,” meaning orders for stocks listed on U.S. exchanges with the following conditions: (1) the trades are made for a natural person’s account or held on behalf of a natural person or related family members, and (2) the average number of daily trades in such U.S. exchanges, executed by such account, was less than 40 in each of the preceding six months. Further, the Rule would not apply in certain situations, such as (1) when a segmented order is received and executed when no open competition trading center is operating a qualified auction, (2) when the trade is a segmented order of value greater than or equal to $200,000, and (3) when the segmented order has a customer-selected limit price equal to or more favorable for the segmented order than the midpoint of the national best bid and national best offer when such order is received by the trading center.
Viewpoints on the Proposed SEC Rule
Early opinions on the proposed rule vary as to whether it will result in its intended effect, and whether the rule itself is even necessary. Interestingly, the SEC commissioner’s vote was a narrow 3-2 ruling in favor of advancing the rule, and it’s important to note that the SEC’s rulemaking process can result in a long journey from advancing a proposal to actually finalizing and codifying it. As noted in the introduction, the next step for this rule is to solicit public comment, and pundits believe this rule will receive a lot of attention and interest from such commenters. Because of this, it’s worth exploring, even at a high level, some of the initial arguments both detractors and proponents may have in respect of the proposal.
SEC Commissioner Hester M. Pierce, who voted against the proposal, noted in a statement that she feels the SEC has “not done the work necessary to justify the extensive changes we are considering”, that the markets are just fine as is, and that, while part of the impetus of the rule was to save retail investors money, it may have the reverse effect, with “the possibility that retail customers will pay higher commissions than they do now.” Relatedly, wholesalers are likely to oppose the rule, as the process the rule contemplates is likely to hurt their bottom line, whether through the broader market being flooded with entrants and/or the intended result of more equitable trade pricing. Finally, retail broker-dealers are likely to oppose to the new rule, as the fee structures in place with wholesalers would likely be turned on their head when the wholesaler is unable to control the trade, diminishing the broker-dealer’s profits as well. In all likelihood, opposing viewpoints to the rule—no matter which market participant raises such issues—will cite that there is no problem that needs solving and that the rule will harm rather than benefit retail investors.
On the other hand, proponents of the rule are likely to cite some of the principles the SEC has noted in its proposal, namely enhanced competition and fairness, as well as increased transparency. As it stands now, and as the SEC’s release notes, two firms capture approximately 66 percent of the executed share volume of wholesalers (as of the first quarter of 2022). Further, “wholesalers do not display or otherwise indicate in real-time the prices at which they are willing to trade with individual investor orders.” Instead, a retail broker-dealer often chooses a wholesaler by some internal formula that depends on, among other factors, past execution quality of the wholesaler and its relationship with the broker dealer. And finally, the wholesaler’s execution of the order faces no competition whatsoever—it typically executes the order internally without providing any opportunity for other market participants to compete for more favorable pricing. Thus, allowing—or rather, mandating—that the order be sent to auction on an open market will increase competition by adding participants, provide fairness to the retail investor, as such market, in theory, leads to better pricing, and improve transparency, as the execution of the trades will no longer be handled internally.
As retail investing has become easier than ever and more popular with the advent of apps and websites that allow for quick (and perhaps reckless) trading and forums on which such traders can express their views and potentially concoct pump-and-dump schemes (a group of social media influencers were charged with securities fraud by the DOJ and SEC for a similar scheme that netted them north of $100 million the same day the SEC issued the Order Competition Rule), the SEC has been doing its part to protect individual investors. While it remains to be seen what a final rule will look like, the Order Competition Rule and the comments the SEC solicits regarding such rule will be undoubtedly be worth following.
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 Order Competition Rule, Release No. 34-96495 (proposed December 14, 2022) (to be codified at 17 CFR pts. 240 and 242).
 Order Competition Rule, Release No. 34-96495, at 105 (proposed December 14, 2022) (to be codified at 17 CFR pts. 240 and 242).
 Id. at 83.
 Order Competition Rule, Release No. 34-96495, at 7 (proposed December 14, 2022) (to be codified at 17 CFR pts. 240 and 242).
 Id. at 8.
 Id. at 9.
 Id. at 9.