The Securities and Exchange Commission (SEC) has recently proposed what's known as a "Transaction Fee Pilot" - a two-year pilot program intended to examine the inner workings of broker routing behavior. Here is an explanation of this pilot and our analysis of how it may negatively impact the efficient functioning of equities markets for listed companies and investors.

Background

Trading in securities markets has become increasingly complex in the U.S. A broker can now trade a company's stock on 13 licensed exchanges and more than 50 off-market venues, or "dark pools," run by investment banks and brokers. When brokers are routing an order, they must consider each of these different venues with the aim of ensuring the best trade execution for their client.

A core role for regulated exchanges, like the New York Stock Exchange, is to attract trading interest and set prices in a transparent manner. The prices displayed on regulated exchanges are relied upon by investors and their brokers when trading on our markets, other exchanges or even dark pools.

To fulfill our mission, the NYSE and its competitors, use a range of tools that are subject to regulatory oversight, including trading fees and rebates, to attract participation and activity to our markets. These mechanisms are designed to benefit investors and issuers by establishing high quality, transparent prices for securities.

The SEC Transaction Fee Pilot

The SEC is proposing to undertake a pilot to better understand how the exchange's price mechanisms and tools may impact broker routing behavior.

To conduct its experiment, the SEC proposes to create three test pilot groups, each composed of 1,000 listed stocks, or 3,000 stocks in total. Each test group would employ varying levels of allowable access fees and rebates. The 5,200 remaining stocks not selected for a test group would comprise the control group.

Anticipated effects of a Transaction Fee Pilot

We believe the pilot would impair market quality by widening spreads in stocks, adding costs to both investors and companies.

For our listed companies

The pilot may also disadvantage companies selected for one of the test groups while their peers or competitors could escape that fate. As currently envisioned, it does not appear that companies can opt-out of the pilot.

In particular, by causing spreads to widen for those securities selected for the test groups, companies conducting a repurchase program or secondary offering would have higher costs.

Example:

Consider two hypothetical companies which are similar in profile. Both are large listed financial institutions with similar size, business profile and market capitalization.

Company A is included in one of the SEC's Transaction Fee Pilot. Company B is not included and still benefits from an exchange rebate program. We would expect Company A's average bid-ask spread to widen due to the reduced or eliminated exchange rebates.

This may result in the following negative consequences:

  • All else equal, Company A will now be a less appealing investment than Company B, as a wider bid-ask spread means that investors' transactions costs will be higher when trading Company A's stock compared to Company B's stock
  • If Company A looks to issue a secondary offering, it can expect its required discount to market price to be greater relative to Company B
    • NYSE has found that companies with wider spreads must provide a larger discount to market price for secondary offerings than companies with tighter spreads

If Company A conducts a share buyback, its transactions costs could be higher than those of Company B as wider spreads often result in larger intra-day price movements.

For Investors:

We believe the impact of reducing incentives to liquidity providers is straightforward: market makers will be willing to buy at slightly lower prices and sell at slightly higher prices. As a result, investors building a position in pilot securities will pay more and receive less when they exit.

The cost is high. We estimate the added burden on investors could exceed $1 billion. While all investors would absorb the costs of wider spreads, the benefits from the proposed reduction in access fees would accrue primarily to sell-side brokers and proprietary traders