Broker-dealers would find themselves filling out a lot more paperwork and turning to third-party service providers under the SEC's proposed stock market overhaul.
The biggest securities market revamp since 2005, detailed in more than
The Wall Street regulator is aiming to make sure that brokers who buy or sell stocks or bonds on behalf of clients are doing their utmost to find the best deals. SEC Chairman Gary Gensler has estimated that U.S. investors could save $1.5 billion a year if the industry eliminates conflicts of interest and lowers transaction costs.
Both the Financial Industry Regulatory Authority, the broker-dealer industry's self-regulator, and the Municipal Securities Rulemaking Board, which regulates brokers and banks dealing in municipal bonds, separately have their own
The SEC would require brokers to make sure they are getting the best deals for their clients by taking into account factors like the price of the stocks or bonds they are buying or selling, their ability to buy the number of shares their customers want and the speed at which they are able to trade. These factors can vary widely, depending on where securities sales are being completed: at a large public exchange like the New York Stock Exchange or through commission-free trading apps like Robinhood.
Robinhood, Fidelity, Charles Schwab and similar brokerages can offer free trades because they make money from payments they receive for routing orders to private wholesalers like Citadel Securities or Virtu Financial. Largely because of this "payments for order flow" system,
Dave Lauer, the CEO of Urvin Finance, a research and analytics system for retail investors, said the proposed regulation will most likely be welcomed by financial advisors who work with brokers to execute stock trades. If nothing else, it will provide additional assurance that those brokers are putting clients' interests first.
"This is just another way to make sure you are doing what you say you are doing," Lauer said.
A related SEC proposal would require companies like Robinhood to conduct auctions for their buy and sell orders rather than automatically sending them to Citadel or another favored wholesaler. As with Regulation Best Execution, the idea is to ensure investors are receiving the best deals possible.
Gensler has said that he was surprised to learn when he joined the SEC in 2021 that the agency had no Regulation Best Execution.
"I believe a best execution standard is too important, too central to the SEC's mandate to protect investors, not to have on the books as commission rule text," Gensler said in an official statement on Dec. 14. "Today, equities often trade on off-exchange dark venues that have different business models and are less transparent than the familiar lit exchanges."
Sandoval said the proposal goes beyond what FINRA and the Municipal Securities Rulemaking Board already require. One big difference is that the SEC regulation would require broker-dealers to be much more on the lookout for conflicts of interest.
Payments for order flow is up for particular scrutiny. In that system, wholesalers like Citadel and Virtu make money from buying stock for slightly less than they sell it to investors or by selling it for slightly more. The difference in price often comes down to fractions of a penny. Defenders say payments for order flow allow investors to avoid paying commissions. Critics question if the rebates brokers receive give them an incentive to put their own interests ahead of their customers.
Under the proposed rule, brokers would have to review their trades every quarter to make sure they are still getting the possible deals. One way they'll have to do this is by looking at other ways they could have made the same trades to see if they could have gotten better deals for their customers. If they could have, they'll have to adjust their trading practices. And they'll have to report the reasons for their decisions to their boards of directors or other governing bodies each year.
"This creates a heightened standard that can easily be second-guessed" by regulators, Sandoval said.
Susan Light, a partner at the New York-law firm Katten Muchin Rosenman, noted that Gensler had once expressed an interest in banning payment for order flow. An SEC Regulation Best Interest, along with the proposed auction rule, could prove to be a different way of reaching the same goal.
"Right now, under FINRA and the MSRB, payment for order flow is alive and well," Light said. "But this could make it so difficult that funds might not be able to use it."
Hester Peirce, a Republican SEC commissioner, said the regulation could backfire and end up costing investors more. Just before voting on Dec. 14 against recommending the proposal, she reminded her fellow regulators that the payments-for-order-flow business model is what allows commission-free stock trading in the first place. Brokers, she warned, could find themselves "relying more heavily on other revenue sources, including commissions, paid by the customer."
But for brokers, Sandoval said, the main upshot will be a lot more paperwork. He added that smaller brokers might find themselves forced to pay outside vendors for software needed to stay in compliance.
"There's a lot more data out there that you are going to have to scrape and cull and put into black box and say, 'What's the best venue to send that to?" Sandoval said. "Obviously some brokers are not going to have the capacity to build that in-house. And that's where the vendors are going to come in."
The regulation would exempt so-called "introducing brokers" from many of these rules. Introducing brokers work directly with clients to take buy or sell orders and then turn to larger brokerage firms to complete the transactions. But Sandoval cautioned that the exemption isn't total. Introducing brokers would still have to review deals made by their larger broker partner to determine if they might have done better working with another partner.
Industry groups warned of unnecessary complexity. The Securities Industry and Financial Markets Association, a trade group for broker-dealers, said in a release: "We strongly believe the SEC needs to be extremely careful in its approach. Any changes being proposed in the name of competition which may tilt the playing field at the expense of investors should be weighed carefully, be subject to a robust cost benefit analysis, and considered holistically with a view to ensuring there are no negative, unintended consequences for investors."
Some securities industry experts think brokers will find that they already meet the requirements of the SEC's proposal. James Angel, an associate professor of business at Georgetown University with expertise in financial regulation, said FINRA already looks closely at brokerage firms to make sure they are living up to their best-execution duties.
"Major firms are already examined for this pretty close," Angel said. "So I don't really see what this is really adding at this point."
The SEC's market reform proposals come partly in response to the "short squeeze" of shares in the video game company GameStop and other companies last year. Retail investors, many of them encouraging each other on social media, ran up those businesses' stocks in part to punish hedge funds that had bet the prices would instead fall. Most of these trades were done through brokerage services like those offered by Robinhood. Although an SEC review found no evidence of market manipulation, regulators nonetheless expressed worries that the "payment for order flow" system had given rise to conflicts of interest.
The public has at least until March 31 to
