Investors hail SEC guidelines on exchanges

Recent actions by the SEC to bring greater transparency into exchange fees and practices — despite legal pushback from the major exchanges — are raising institutional investors' hopes that meaningful change is on the horizon.

The most encouraging signs to date came May 21, when, among other things, Securities and Exchange Commission staff issued new guidelines requiring stock exchanges to provide significantly more details before being allowed to raise fees for market data or connectivity or to offer discounts to favored traders.

"We do see this effort as beneficial to investors in holding future exchange filings to a higher standard," said Don Pontes, investment director for financial markets with the $358.6 billion Sacramento-based California Public Employees' Retirement System.

That same day, the SEC raised hopes higher by moving forward on a transaction fee pilot program designed to provide a wholesale review of how exchanges charge their customers, and specifically study how maker-taker rebates to some broker members for order flow impact equity trade execution.

While the two-year pilot program approved by the SEC in December has been on hold pending the outcome of a court challenge from New York Stock Exchange, Nasdaq and Cboe Global Markets Inc., the SEC is forging ahead with a six-month "pre-pilot" that beginning July 1 will require exchanges to compile — but not yet submit or disclose — data on their fee and rebate practices.

The stay order did not address the merits of the legal challenges, which the exchanges said has the potential to harm both investors and publicly listed companies. The stay also left in place the requirement for data collection, which will be used for a baseline if or when the pilot program launches.

"We are heartened that the SEC is going to move forward with the pilot. Any opportunity to have a measured thoughtful approach on this makes sense," said Dennis Simmons, executive director of the Committee on Investment of Employee Benefit Assets in Washington, whose members are chief investment officers managing more than $2 trillion of retirement assets for Fortune 500 companies.

Even some of the most outspoken critics of exchange fee and rebate practices were pleasantly surprised by the SEC's detailed approach in the extensive staff guidance, officially called SRO Rule Filings Relating to Fees.

Now, exchanges will have to clearly describe proposed fees and prove that they are "reasonable, equitably allocated, not unfairly discriminatory and not an undue burden on competition," the SEC guidance said. Going forward, before an exchange can offer a discount to some brokers, it "must explain why that structure represents an equitable allocation of fees."

For investors grumbling that exchanges find new ways to deliver and charge for multiple services, the guidance now requires exchanges to explain how new products compare to similar ones already offered, and how they might impact different market participants.

"This SEC seems very focused on how fees and rebates impact both investors and the brokers who serve them," said Tyler Gellasch, executive director of Healthy Markets in Washington, an investor-focused non-profit organization whose members include several large public pension funds.

Joe Wald, CEO of agency broker Clearpool Group in New York, considers the guidance "the strongest signal yet that the commission is taking a proactive role in ensuring that markets are fair and that costs are allocated on a fair and equitable basis."

Mr. Wald added that he would not be surprised if exchanges take legal action to stop it.

The moves are also being welcomed by money managers. "We're pleased the SEC is taking this significant step to increase transparency around future market data fee increases, which will help ensure they are fair, reasonable, and in line with the letter and spirit of the law," said Jennifer Han, associate general counsel of the Managed Funds Association in Washington.

Nasdaq and Cboe Global Markets declined to comment on the guidance or the pre-pilot. NYSE said in a statement that it "provides tremendous value to investors, listed companies and our members. Every aspect of our operations, including fees, has been and continues to be reviewed by the SEC for consistency with the Exchange Act."

The biggest effect of the guidance is likely to play out when the exchanges seek to make changes in pricing or rebates. "We see it as likely that market participants will start aggressively objecting to future transaction fee changes that don't adequately address the higher standards related to reasonableness, discrimination and competition," CalPERS' Mr. Pontes said.

While it is less clear how the guidance will help investors challenge previous filings, such as pricing tiers, the potential is there.

"The SEC has historically avoided weighing in on pricing tiers, in part because they don't want to be fee setters. That seems to be changing," said Mr. Gellasch, who concedes that SEC staff now will have to reconcile thousands of unique, customized fees and rebates with the obligations of the underlying statute, the Securities and Exchange Act of 1934.

Investors and other market participants are also hopeful that other countries are watching, including in Canada, where a similar pilot study of trading fee rebates and their impact on execution quality and market routing behavior is being considered, along with temporary pricing restrictions on some trading fees.

The data-driven approach of the SEC and the Canadian Securities Administrators is strongly backed by investors including the C$97 billion ($72.1 billion) Ontario Municipal Employees' Retirement System, Toronto.

The Ontario fund, in its January comment letter, noted dryly that "from an institutional investors' perspective, often the costliest order is the order that is delayed, or never completed at all."

Europe could be next, thanks to pressure from groups such as the Managed Fund Association and Alternative Investment Management Association, which have joined forces with European counterparts to convince the European Securities and Markets Authority to pay closer attention to market data fees and other exchange revenue practices.