Court derails SEC efforts for market reforms

Investors' hopes for major reform of exchange practices and fees are dimming considerably, following two recent legal setbacks for the Securities and Exchange Commission.

On June 16, a much-anticipated transaction fee pilot program designed to examine the "maker-taker" system, where some brokers are charged fees and others are offered rebates, came to an abrupt halt. In a challenge brought by the exchanges, the U.S. Court of Appeals for the District of Columbia said the SEC "clearly exceeded" its authority to launch the program, which had been widely supported by market watchdogs and investor groups, including scores of U.S. and Canadian pension funds. The court agreed with the exchanges that more than just a "benign quest for data," the pilot could have hurt liquidity and widened stock price spreads.

The decision was "disappointing … and frustrating," said Mehmet Kinak, Baltimore-based vice president and global head of systematic trading and market structure at T. Rowe Price Group. Mr. Kinak spent eight years advocating for the pilot, including three years on the SEC's equity market structure advisory committee. "Every time we had a discussion around market conflicts and market complexity, it kept coming back to fees and rebates. We said, instead of treating the symptoms, let's treat the actual illness," he said. The decision "basically dismisses everything we've been advocating for eight years to show the root cause," Mr. Kinak said.

Less than a week before the pilot ruling, the same federal court overturned an SEC challenge to some of the exchanges' fee increases for access to "depth-of-book" market data, ruling that the agency ran afoul of administrative procedures by rejecting fees already in effect. The order threw cold water on investor optimism that had been sparked in 2018 when the SEC rejected increases by Nasdaq and NYSE Arca and remanded more than 400 fee filings for further justification after a challenge from the Securities Industry and Financial Markets Association.

The legal setbacks were particularly discouraging to investor groups because other potential reforms, including rules designed to let institutional investors see how brokers prioritize orders, were put on hold in favor of the fee pilot.

Investors are hanging modest hopes on SEC staff guidelines issued in May 2019 that require exchanges to provide significantly more detail when asking to raise data or connectivity fees or offering discounts to some traders. However, they want the SEC to be more aggressive about what they see as systemic conflicts of interest among exchanges and brokers that put investors at a disadvantage.

"Investors still don't know the answer to a basic question: Is my broker routing orders in ways that maximize my profits or theirs?" said Tyler Gellasch, executive director of Healthy Markets, an investor-focused non-profit organization in Washington whose members include pension funds.

"Rather than take a position, the (SEC) decided to not take a position and study it. The commission should move on from the fee pilot and just address the problem. Investors and the commission have learned a lot since the conflicts of interest in order routing really jumped into the spotlight nearly a decade ago," Mr. Gellasch said.

While the pilot's findings could have been useful to investors and other market participants, the court's decision "leaves open further regulatory action based on a finding that stock exchange rebates cause harm to investors," said Jeff Mahoney, general counsel of the Council of Institutional Investors, a Washington-based association of pension funds and asset owners with a collective $4 trillion in assets.

With the pilot out of the way, "there's nothing to prevent the SEC from mandating better disclosures and directly addressing the conflicts of interest today," Mr. Gellasch agreed.

It could even get there faster by not having to wait for the pilot results, said Joseph Wald, CEO and co-founder of agency broker-dealer Clearpool Group in New York and managing director at parent company BMO Capital Markets.

"I think there are some real things out there that are going to help, particularly Rule 606 and CAT (the consolidated audit trail)," he said.

Amended 606 rules from the SEC's Regulation NMS now require broker-dealers to give investors detailed information about the way they handle investors' orders. Those new reports should start rolling in next month, and "there is a lot of data in there that will expose potentially conflicting order routing," Mr. Wald said. After years in the works following the 2010 "flash crash," the SEC's CAT is now live for broker-dealer reporting, although deadlines for exchanges have shifted because of the COVID-19 pandemic. Once fully operational, the single database for all U.S. equity and options trades should let regulators track illegal or manipulative trades. "The CAT will be just an incredibly rich source of data around the life cycle of an order that people will be able to analyze," Mr. Wald said.

Mr. Kinak of T. Rowe Price thinks the SEC could take other steps, such as updating access fees set in 2005. He also credited other agency actions, including making future core data fee changes subject to public comment and proposing infrastructure changes to allow more competition. "They understand there's a lack of competition in market data," Mr. Kinak said. "I think the SEC is doing anything they can. They have been outstanding in trying to address these industry issues; they have been listening to participants."

SEC Chairman Jay Clayton said after the court's fee pilot ruling that he expects to move forward addressing the questions the pilot was designed to answer. At a June 22 market event, he acknowledged the complaints about data costs and said his agency "has a compelling regulatory responsibility to analyze concerns about the fairness and reasonableness of exchange fees for proprietary data," adding that "the status quo is not acceptable."

At that event, the SEC and the Department of Justice's antitrust division signed a pact to monitor exchange fee practices to ensure adequate competition. The move was welcomed by SIFMA President and CEO Kenneth E. Bentsen Jr. because "the for-profit exchanges exclusively control the distribution and sale of market data, which has led to unchecked fee increases" unrelated to actual costs, he said.

Nasdaq in a statement welcomed additional reviews "as we are fully confident in the integrity of our market data business," while other exchanges did not comment.

That move might look good, investor advocates said, but what really matters is if Mr. Clayton and other SEC officials have the will and energy to get tougher on exchanges, while also fighting other battles.

One of those battles involves SEC efforts to expand exempt offerings in private markets to more types of investors, including retail, as part of Mr. Clayton's push to address the 2-to-1 imbalance of private fundraising vs. public offerings. That could put American investors at risk from companies in China and other countries with weaker auditing practices, according to Better Markets, a non-profit market watchdog group in Washington that filed an amicus brief supporting the fee pilot.

Stephen W. Hall, Better Markets legal director and securities specialist, is doubtful. The SEC under Mr. Clayton "has a pattern of taking measures that are inadequate, or doing nothing at all," he said.

When it comes to meaningful reform of exchange practices to protect investors, SEC officials "had enough evidence to conclude there was a problem. I am concerned that the leadership is not going to move forward aggressively and really tackle the problem the way it needs to be done. They are not fulfilling their mission unless they do," Mr. Hall said. In the meantime, said Mr. Wald of Clearpool, exchanges are already changing because of the drumbeat from investors. Exchanges "have started to behave in a way that is going to be scrutinized and challenged. I don't believe that market participants are going to just give up and walk away," he said.