SEC Proposes New Rules Regarding Stock Trade Execution

While most investors’ eyes oriented toward Washington, D.C., yesterday were focused on the Federal Reserve, there were other announcements worthy of attention. The U.S. Securities and Exchange Commission (SEC) proposed new rules governing how buy and sell orders for stocks are executed.

Yes, things like the “Order Competition Rule” are nowhere near as interesting to discuss as yesterday’s 50-basis-point (0.50%) rate hike by the Fed, but it could impact every trade you place with your broker. The SEC says the proposed rule “would require some equity orders of retail investors to be exposed to comp[etition] in fair & open auctions before they can be executed internally by trading centers that restrict order-by-order comp[etition].” 

Before your eyes glaze over, let’s back up and consider what has changed over the past two decades behind the scenes when you click the button to buy or sell a stock. In 2000, there were nine registered national securities exchanges and one registered national securities association according to the SEC. This meant there was a very small number of venues where your buy and sell orders could be routed.

Since then, a very large amount of fragmentation has occurred. During the first quarter of this year, exchange-listed stocks “were traded on 16 national securities exchanges, and off-exchange at 32 NMS Stock ATSs and at over 230 other FINRA members,” according to the SEC. (NMS stands for the National Market System, which governs the operations of stock trading. An ATS is an alternative trading system, but neither have members nor take on the regulatory responsibilities that exchanges do.)

Put another way, there is currently a very high likelihood that your order to buy or sell will not be filled on the New York Stock Exchange (NYSE) or the Nasdaq. It’s possible that your broker fills your order or routes it to specific firms. Which firms your orders are routed to can be influenced by payment for order flow. As the name indicates, firms provide compensation to brokers to have orders routed to them.

How dependent a broker is on such revenues varies. In its regulatory filings, Robinhood Markets Inc. (HOOD) says “a majority of our revenue is transaction-based, in that we receive consideration in exchange for routing our users’ equity, option and cryptocurrency trade orders to market makers for execution.” Conversely, order flow revenue for Charles Schwab Corp. (SCHW) accounted for just 8% of its total net revenues during its third quarter.

Payment for order flow has allowed investors to enjoy commission-free trading. The downside is that we’re getting potentially worse execution prices. A frequent criticism of payment for order flow is the allegation of individual investors not getting the best prices when they buy or sell stocks because many trading venues aren’t able to compete for the right to fill those orders.

The SEC’s proposed Order Competition Rule would require some orders to be exposed to a wider group of trading venues before they can be executed by the broker’s preferred trading center. Orders could be subject to auctions where the best price would determine who fills it.

Sub-penny execution could become more widespread under Regulation NMS, which covers minimum pricing increments for stocks. Some of you are already experiencing sub-penny execution. When I bought shares of Invesco Russell 1000 Equal Weight ETF (EQAL) for my Roth IRA recently, Fidelity listed the transaction price as $41.0799 per share. Not all trading venues offer this level of decimalization though. The Wall Street Journal notes that exchanges, for instance, can only provide quotes in one-cent increments. This proposal would change that.

The Regulation Best Execution would require more thorough documentation on the pricing that a broker’s clients receive.

The intent of these changes is to give investors better execution prices on their trades as well as create more transparency. My expectation is that there will be pushback by industry participants on implementing these proposals—especially by those firms most likely to lose market share and/or profits should the rules be put in place. The savings may be small on individual trades but the benefits from improved execution prices will be cumulative over time. As Depeche Mode famously sang, everything counts in large amounts.

You can view and comment on the proposed rules at www.sec.gov/rules/proposed.shtml. (Look for proposed rules with the date of December 14, 2022.) The comment period will last through at least March 31, 2023. The SEC has told us expressly that they want to hear from individual investors, so please share your thoughts with the commission.