United States: SEC's Equity Market Structure Advisory Committee Considers Market Volatility And Customer Issues

The Equity Market Structure Advisory Committee (EMSAC or Committee) held its third meeting at the Securities and Exchange Commission (Commission or SEC) in Washington DC on February 2, 2016.1 The Committee is considering whether various regulatory or industry initiatives would improve the function of the US equity markets. At this meeting, the Committee focused on issues (1) accompanying the market volatility occurring on August 24, 2015; and (2) primarily affecting retail customers, including how certain order types used by retail customers operate, payment for order flow, and execution quality and order routing disclosures.2 In addition, the four subcommittees of the EMSAC, which were created after the last meeting, provided updates on their respective areas of focus.

As an advisory committee to the SEC, EMSAC is organized and operates pursuant to the Federal Advisory Committee Act.3 Accordingly, the Committee's proceedings are open to the public, and, while not a formal rulemaking body, it ultimately will make recommendations to the Commission for possible action. Accordingly, market participants with interest in any of these topics should consider whether and how (e.g., a white paper or comment letter) to make their views known to the Committee in a timely manner.4

Opening Remarks

Each Commissioner gave opening remarks discussing their views on the agenda items. Chair White highlighted that the SEC has taken action with regard to one discussion point from the prior EMSAC meeting, issuing a rule proposal to enhance the transparency of alternative trading systems.5 Chair White also noted that the SEC staff completed a research note analyzing the operation of US equity markets under the stressed conditions of August 24.6 The research note provides detailed data and other information to help assess trading on that day, continuing the SEC's empirical approach to its regulation of the US markets. Chair White also requested comment on potential improvements to the execution quality and order routing disclosures required by Rules 605 and 606 of Regulation NMS, and noted that the SEC staff is developing a rulemaking proposal to enhance the required disclosures, including enhancing transparency of broker-dealers' order routing practices related to institutional investors. Commissioner Stein expressed interest in whether certain market structure features (e.g., order types, payment for order flow) favored certain investor groups. Commissioner Piwowar commented that the SEC Staff's research note regarding August 24 was a good starting point for a study of market volatility.

Market Volatility and the Events of August 24

The Committee first discussed the regulatory issues raised by the market volatility of August 24. To frame the issues for this panel, the SEC Staff summarized the highlights of its recent research note regarding the market volatility on August 24. Among the issues addressed in the note are the opening and re-opening processes at the primary listing exchanges, the effects of market volatility on trading in certain exchange-traded products and corporate stocks, and the operation of the limit up/limit down pilot plan on a day with market-wide volatility. The note provided solely empirical data; the SEC Staff plans to supplement this data with a separate note providing analysis and recommendations.

After the SEC Staff's presentation, the panel and Committee proceeded to discuss: (1) the successes of August 24, (2) how to refine the limit up/limit down trading mechanism, and (3) how to incentivize market makers to continue to provide liquidity during periods of market volatility.

Panelists and EMSAC members generally agreed that, despite the heightened volatility and increased message traffic experienced on August 24, there were noticeable improvements in how the market functioned, especially as compared to the Flash Crash of May 2010. On August 24, market technology operated well. For example, market data delivery systems and post-trade systems did not experience technology issues. Additionally, the new market mechanism to address extraordinary market volatility—limit up/limit down—operated as designed.

Committee members went on to note that, while limit up/limit down may have operated as designed, it may not have operated as intended in light of the difficulties experienced during the re-opening process. Accordingly, panelists and EMSAC members offered several suggestions for improving the function of the limit up/limit down mechanism, focusing primarily on the re-opening auction process. Specifically, several panelists and Committee members suggested amending the rules to address repeat pauses, recoveries after a pause, and significant price imbalances after a pause. However, other panelists and Committee members suggested that, rather than trying to tweak the rule to address that auction process after a reopening, it might be easier to eliminate auctions and re-opening auctions around limit up/limit down altogether. Instead of re-opening auctions, these panelists and Committee members suggested incorporating floating price bands that readjust periodically as well as providing market participants with time to assess the price of the security.

In addition to discussions related to re-opening auctions, the Committee and panelists considered how, if at all, to adjust the limit up/limit down price bands. Several EMSAC members and panelists suggested adjusting the bands such that an incremental shift in the price of a stock could be countered by a congruous incremental shift in the price bands to avoid triggering additional pauses when the stock is rallying from a significant price fluctuation. Additionally, some Committee members and panelists suggested harmonizing the wider opening limit up/limit down bands with the tighter bands applicable for the remainder of the trading day by having consistently wide bands throughout the day. A few EMSAC members and panelists disagreed with widening the bands and noted that the bands are appropriately set and reiterated the need to focus on steps that should be taken to find an accurate equilibrium point after a limit up/limit down pause.

Agreeing that the absence of liquidity was a significant factor in the market volatility of August 24, panelists and EMSAC members discussed the need to incentivize the provision of liquidity during times of market volatility. Many panelists discussed the interplay between the clearly erroneous bands and the limit up/limit down bands noting that the lack of consistency between the two regimes created uncertainty for market makers as to whether their executions would be busted as clearly erroneous and, as a result, disincentivized the provision of liquidity. In response, panelists and Committee members proposed: (1) harmonizing clearly erroneous bands and the limit up/limit down bands to clarify what executions will stand and what executions may be busted,7 (2) encouraging exchanges to adjust clearly erroneous executions rather than bust those executions, or (3) eliminating the clearly erroneous procedures altogether.

Unrelated to the limit up/limit down plan, one EMSAC member noted that current Regulation SHO interpretations and restrictions hinder a market maker's ability to provide liquidity because they impede a market maker's capacity to engage in arbitrage between various markets/products, e.g., exchange traded products and individual stocks. Several Committee members noted that a lack of transparency on the part of primary exchanges also contributes to the lack of price discovery and ultimately disincentivizes the provision of liquidity. Specifically, Committee members suggested additional transparency, across exchanges, around the exchanges' auction processes. They also suggested that exchanges provide information regarding order imbalances as well as indicative prices until the open.

Issues Affecting Customers in the Current Equity Market Structure

Next, the Committee discussed certain market structure issues that affect retail customers. The Committee primarily focused on three areas during its discussion: (1) the risks raised by certain order types (i.e., market orders and stop orders), especially during periods of short-term market volatility; (2) conflicts of interest raised by the receipt of payment for order flow by broker-dealers handling customer orders; and (3) the adequacy of current execution quality and order routing disclosures. These risks are highlighted in the SEC Staff's memorandum to the Committee.8

In discussing the use of market and stop orders by retail investors, the Committee and panelists identified the risks associated with these order types and identified potential alternatives to address the risks. Generally, these orders prioritize immediacy of execution over, for example, the use of a limit price to provide some protection against adverse price movements, particularly those movements that may occur rapidly during times of market volatility. To address the risks associated with these order types, the EMSAC and panelists discussed: (1) prohibiting these order types, (2) providing greater investor education, and (3) limiting the use of these order types during particular periods or relating to particular securities.

Some Committee members and panelists supported a prohibition against the use of market and stop orders. However, many Committee members and panelists preferred the alternative of providing investor education in the form of pop-up warnings when such orders are entered and/or information sheets on client online accounts as well as through conversations between broker-dealers and retail clients. Proponents of investor education reiterated the importance of these order types to retail clients in light of their limited ability to monitor intra-day price movements, as well as the fact that, more often than not, these order types operate as intended. Another subset of Committee members and panelists suggested that investor education alone would be insufficient and that limitations on the use of these orders would strike a better balance between reducing the risk associated with the order types and maintaining customer choice and access to order types. Examples of limitations include: (1) requirements to incorporate limit prices, (2) the addition of maturity or expiration dates for stop orders to remind retail clients of the existence of the stop order, or (3) creating a true stop order by tying the order to an out of the money put.

Panelists and EMSAC members also discussed the benefits and concerns associated with payment for order flow arrangements. In terms of benefits, panelists noted that the firms entering in these arrangements have experienced enhanced execution quality for the orders of retail investors; it was noted that approximately 82% of such orders receive some level of price improvement, approximately 90% of orders execute at the national best bid or offer, and the current spread capture rate is approximately 20%. Other panelists and Committee members noted that, despite these benefits, payment for order flow arrangements also: (1) provide economic incentives that create conflicts of interest; (2) provide nominal price improvement that takes executions away from displayed liquidity providers and provides disincentives for over-the-counter market makers to provide competitive quotations (i.e., tighter spreads); and (3) increase over-the-counter executions, which, consequently, minimizes the incentive to display quotations, and/or provide price transparency or liquidity. The discussion focused on whether the conflicts of interest created by payment for order flow arrangements can be addressed sufficiently through disclosures or whether such arrangements should be eliminated.

Several panelists and Committee members suggested that there is no level of disclosure that could adequately address the conflicts of interest created by payment for order flow arrangements, preferring to eliminate the practice. Many other panelists and Committee members noted that while payment for order flow arrangements are imperfect, retail investors are better off with these arrangements in place. Specifically, proponents of maintaining payment for order flow arrangements noted, among other things, that: (1) in fact, the number of such arrangements is not tending to increase and (2) the elimination of payment for order flow arrangements will not eliminate internalization, which involved conflict of interest concerns similar to those raised by payment for order flow. As an alternative to the elimination of payment for order flow, these Committee members and panelists suggested enhancing disclosures by requiring broker-dealers receiving payment for order flow to provide customers with information on the amount a broker-dealer received as payment for routing the client's order(s) to a particular venue and/or passing payments to retail investors.

Order execution and order routing disclosures also were discussed at the meeting. Generally, EMSAC members and panelists agreed that Regulation NMS Rule 605 and 606 reports should be enhanced to include more detailed metrics including, but not limited to, more granular execution speed and timestamp data; information regarding institutional orders, odd lot orders and limit orders (i.e., whether the limit order is marketable or non-marketable); and spread capture rates. Moreover, Committee members and panelists suggested combining the Rule 605 and 606 reports to allow customers to assess the execution quality received from particular venues as well as the amount of order flow routed to those venues. As stated, Chair White has directed the SEC Staff to consider preparing a rule proposal to amend the requirements of Rules 605 and 606.

Updates from EMSAC Subcommittees

During its last meeting, the Committee formed four subcommittees, each to consider a specific area of interest: Regulation NMS, trading venue regulation, customer issues and market quality. Each of the subcommittee chairs provided an update on their respective efforts to date.

The Regulation NMS Subcommittee intends to address access fees and whether there should be a pilot program related to access fees, market data and the Order Protection Rule. The Market Quality Subcommittee plans to use the events of August 24 to focus on (1) the opening mechanism and achieving consistency across markets, (2) the interplay between the limit up/limit down and the clearly erroneous process, (3) market data, and (4) the appropriate balance of responsibilities and benefits associated with market making. The Trading Venue Regulation Subcommittee plans to prepare a comparative analysis of issues relevant to exchanges and alternative trading systems and build upon the Commission's recent proposal to amend Regulation ATS by considering the regulatory framework across exchanges, ATSs and broker-dealers engaged in analogous activity. Additionally, the Trading Venue Regulation Subcommittee will address national market system plan governance with the intention of having effective industry participation of both buy- and sell-side firms. Finally, the Customer Issues Subcommittee has reviewed data on investor participation, attitudes and education, and has created a sub-group focused on enhancements to Rules 605 and 606. Going forward, the Customer Issues Subcommittee intends to review and address the payment for order flow section of the SEC Staff's memorandum.

Next Steps

The Committee has scheduled its next meeting for April 26, 2016, and the various subcommittees will hold meetings in the coming months.

Footnotes

1 The EMSAC is comprised of senior executives from large institutional broker-dealers, self-regulatory organizations, an ATS, technology firms and the AARP, along with academics with specialties in economics, finance, financial engineering, computer science and artificial intelligence, and law. See EMSAC Spotlight page, SEC (last modified Feb 1, 2016).

2 The Committee focused on the Order Protection Rule of Regulation NMS in its first meeting, and access fees and the regulatory structure of trading venues in its second meeting. See Andre Owens, Bruce Newman and Mahlet Ayalew, WilmerHale, SEC Equity Market Structure Advisory Committee: Assessing Complexity in the U.S. Equity Markets (May 21, 2015); and Andre Owens, Brandon Becker, Cherie Weldon and Mahlet Ayalew, WilmerHale, Access Fees and Regulatory Structure of Trading Venues, (Nov. 5, 2015).

3 See Federal Advisory Committee Act, 5 U.S.C. app. §§ 1-16 (2015).

4 Comments submitted to the Committee to date are available on the SEC's EMSAC Spotlight page, as are instructions for submitting public comments.

5 Mary Jo White, Chair, SEC, Opening Remarks to the Equity Market Structure Advisory Committee (Feb 2, 2016); see Andre Owens, Bruce Newman, Brandon Becker, Cherie Weldon, Jeremy Moorehouse and Mahlet Ayalew, WilmerHale, SEC Proposes Significant Regulatory Changes for Alternative Trading Systems, (Jan. 4, 2016).

6 Staff of the Office of Analytics and Research Division of Trading and Markets, Research Note: Equity Market Volatility on August 24, 2015 (Dec. 2015).

7 One Committee member clarified that if the limit up/limit down bands are widened as suggested by some, the clearly erroneous bands should not mirror the limit up/limit down bands because that would create additional market risk by making the threshold for breaking a trade much higher.

8 Memorandum from the Sec. & Exch. Comm'n, Div. of Trading & Mkts. To the Equity Mkt. Structure Advisory Comm. (Jan. 26, 2016).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.