SEC criticised for belt-and-braces ban on volume-based pricing

Legal experts say the US Securities and Exchange Commission has included unnecessary and duplicative anti-evasion measures in its proposed ban on exchanges offering volume-based transaction pricing.

The proposed rule would forbid exchanges from offering preferential prices for brokers that submit large volumes of agency trades on behalf of clients, but would still allow volume-based pricing for proprietary trades. An exchange that offers volume-based pricing on proprietary orders would have to report the number of members that qualify for each pricing tier. The exchange would also need written policies designed to “detect and deter” members from receiving volume-based pricing on agency orders disguised as proprietary trades.

“It would be impossible to do this on any scale,” says Steven Lofchie, special counsel at law firm Fried Frank. “A significant volume of incoming customer orders are electronic and time-recorded and often go directly to the exchange, and the SEC and exchanges have access to the broker-dealer’s records, so evasion is a non-issue.”

It would be impossible to do this on any scale

Steven Lofchie, Fried Frank

He adds that the SEC already has information “to the fraction of a second” as to the receipt of orders by broker-dealers, their execution, and the pricing of the orders. To make the evasion worthwhile, it would have to involve thousands or tens of thousands of trades: “I just don’t see how that could be done,” says Lofchie.

Mismarking orders to obtain an illicit pricing advantage would be securities fraud, says Stephen Morris, a partner at law firm Katten Muchin Rosenman. As such, existing rules promulgated by the SEC and Financial Industry Regulatory Authority already prohibit it, and exchanges would therefore already have compliance programmes in place to prevent it.

“The proposed rule says: ‘On top of that, we want specifically tailored policies and procedures as well’,” says Morris. “The anti-evasion piece of the proposed rule is classic regulator belt-and-suspenders.”

A market structure industry source agrees such deception would already be covered by existing rules, making the anti-evasion measures superfluous.

“It would be highly unlikely that any reputable market participant would do such a thing,” says the industry source. “There would be a big problem if they got caught falsifying information.”

The rule also prohibits volume-based pricing for so-called riskless principal trades, where the broker-dealer fills the order on its own balance sheet but on behalf of a client. Morris notes the comment in the SEC release that not all exchanges necessarily have the means at present to distinguish between riskless principal, agency and proprietary orders: “To the extent that they do, it would begin with the order placer accurately marking the order.”

Bulk discount

Exchanges and their members have already cast doubt on the reasoning behind the prohibition on volume-based pricing. The industry source says it is unclear what problem the SEC was trying to solve in taking aim at volume pricing. SEC chairman Gary Gensler said in a statement when the proposal was announced: “Volume-based transaction pricing along with related market practices raise concerns about competition in the markets.”

This has prompted market participants to assume the intended target is non-bank market-makers that have come to dominate the execution of retail equity orders for online brokers like Robinhood. The SEC has already taken aim at the same group of firms – such as Citadel Securities or Jane Street – in a set of proposed reforms to how retail equity orders should be handled.

“The markets have done a good job of gathering liquidity, which lowers the cost of capital for issuers and benefits investors because it lowers their costs to get in and out of positions,” says the industry source. “There are concerns that this [proposed] change could upset that.”

Volume discounts are used throughout the economy, he adds, so “it’s odd that in this circumstance, the SEC is deciding it’s not good”.

Editing by Philip Alexander
 

This story originally appeared in Central Banking’s sister publication, Risk.net