March 14, 2018
U.S. Securities and Exchange Commission Open Meeting
- The Commission unanimously approved proposing a rule under Regulation NMS to conduct a transaction fee pilot for NMS stocks to study the effects that transaction-based fees and rebates, and changes to those fees and rebates, may have on order routing behavior, execution quality, and market quality.
- The transaction fee pilot proposal will:
- Last two years with an automatic sunset at the end of the first year
- Include all registered exchanges and NMS stocks
- The pilot will place all NMS Stocks, with minimal carve-outs, into the following four buckets:
- Bucket 1—Control bucket
- Bucket 2—$0.0015 access fee cap
- Bucket 3—$0.0005 access fee cap
- Bucket 4—Prohibit rebates and linked pricing
- The data will be provided to the public.
- The transaction fee pilot proposal will:
- Item 2: In a 3-2 vote, the Commission approved proposing amendments to Form N-Port and Form N-1A related to disclosures of liquidity risk management for open end management investment companies.
- The proposal amends public liquidity-related disclosure requirements for certain open-end investment management companies. Under the proposal, funds would discuss in their annual report the operation and effectiveness of their liquidity risk management program, replacing a pending requirement that funds publicly provide the aggregate liquidity classification profile of their portfolios on Form N-PORT on a quarterly basis.
Transaction Fee Pilot
SEC Chairman Clayton began by giving background information on the Transaction Fee Pilot Proposal, He described the fee model most frequently used by exchanges today, the maker-taker fee model, which pays rebates to those that provide liquidity and charges fees to those that take liquidity. The maker-taker model has attracted much criticism because of the economic incentives for broker-dealers to avoid fees and capture rebates potentially conflicts with broker-dealers’ best execution obligations. However, Chairman Clayton raised some positive effects of the maker-taker model, which allows exchanges to compete with other execution venues and narrow spreads. Chairman Clayton recognizes this complex debate and believes the proposed pilot will help the Commission make more informed policy decisions to better retail investors.
Brett Redfearn, Director of the SEC’s Division of Trading and Markets, recommended the Commission adopt the proposed pilot program because it will provide data to understand the execution and economic quality of market structure from reducing the access fees cap. This transaction fee pilot has been desired and anticipated, with consistent support across market participants, and was largely based on the Equity Market Structure Advisory Committee (“EMSAC”) recommendations. Redfearn reiterated concerns with the maker taker model execution concerns, complex order types, creates inflated fees to subsidize exchanges rebates to pay liquidity providers, and leads to a complex market. Redfearn stated that the proposed pilot will provide sufficient data to make informed decisions on access fee caps by testing the effects of lower access fee classes and prohibition on rebates. While the EMSAC recommendation did not include a prohibition on rebates, many commenters on EMSAC’s proposal suggested that the Commission considered whether lower or no rebates will lead to traders more frequently capturing the spread and improving market quality.
Richard Holley, SEC’s Division of Trading and Markets Staff, further elaborated on the benefits and consequences of the maker-taker model and gave an overview of the proposed pilot. Holley raised market participants concerns that the maker-taker model leads to potential best-execution concerns when rebates are not passed through to customers, as well as lack of transparency on the cost of execution, market fragmentation, and indirect sub penny quoting. Some market participants discuss the benefits of the maker taker model foster exchanges’ competitiveness, subsidize quoted prices and help less liquid markets.
Holley then went into some of the details of the proposed pilot, which builds on the EMSAC recommendation and gives the opportunity for the Commission to gather data. The pilot will last two years with an automatic sunset at the end of the first year, which the Commission can extend. The pilot has pre and post review requirements, including a six-month post pilot review, so that the pilot may last two to three years. All exchanges, including those that operate a maker taker model and a taker maker model, will be included in the pilot but ATSs will not be included. The pilot will place all NMS Stocks, with minimal carve-outs, into the following four buckets: (1) Bucket 1—Control bucket; (2) Bucket 2—$0.0015 access fee cap; (3) Bucket 3—$0.0005 access fee cap; (4) Prohibition on rebates and linked pricing. The data will be provided to the public to facilitate the debate.
Jeffery Harris, the SEC’s Chief Economist and Director of the Division of Economic and Risk Analysis, described the economic effects of the pilot. Harris stated that without the pilot, the Commission lacks sufficient information to make informed decisions, and the proposed pilot would better inform the Commission on ways to benefit main street investors of rebate programs. The proposed transaction fee pilot will allow the Commission to see if reducing the cap on transaction fees will facilitate any causal effects on execution quality, market quality, and lead to any investor harm. While the proposed pilot imposes temporary compliance costs on broker-dealers for providing the data, tracking securities, and updating its order routing, the benefits include allowing the Commission to make a more informed decision and potentially aid market participants during the pilot.
Commissioner Stein thanked the staff for their work and described this proposal as being based on the principle that best decisions are supported with data. Stein reiterated the concerns with the maker-taker model and the benefits of the proposal. Commissioner Stein appreciated the public disclosure of the data and is glad the proposal includes a no rebate bucket. Commissioner Stein also stated that the proposal provides an outline that will make the pilot efficient and provide transparency and improve the markets.
Commissioner Piwowar supported the proposal and finds it as no surprise because these issues were raised, and have remained unaddressed, since adoption of Regulation NMS in 2005. Piwowar discussed the impacts the maker-taker model has on routing decisions and supports longer discussion on fees and rebates while recognizing that markets functioned well prior to adoption of the maker-taker model. Piwowar also expressed his support for adopting a proposal at the Commission level, to allow notice and comment, rather than adoption under Regulation NMS.
Commissioner Jackson expressed his support for the proposal for its thoughtful design to provide adequate data to aid the Commission in tailoring the rules to benefit investors. Jackson also appreciated the proposal including a bucket to test the effects of no rebates.
Commissioner Peirce expressed her support for the proposal but does not support Commission efforts to micromanage the markets. Commissioner Peirce said she looked forward to commenters on lower access fees and no rebates and requested commenters consider whether the pilot is an effective use of the Commission’s resources. Peirce understands that data is useful but queries whether the costs and legal risk of conducting a pilot impacts the need for data.
The Commission then voted unanimously yes to propose the transaction fee pilot.
Investment Company Liquidity Disclosure
Chairman Clayton gave an overview of the liquidity risk management rule. The SEC’s systemic risk and liquidity risk management rule manages liquidity risk at the fund level and informs the Commission by providing information on the mutual funds’ liquidity risk. Chairman Clayton discussed the four-bucket approach which will give insight of funds’ liquidity risk and detailed reporting of data. While the Commission seeks transparency, Clayton said this must be balanced with the importance of protecting sensitive information and there are some concerns with disclosing the liquidity risk as the liquidity risk measurements are fund specific and the variabilities would not be apparent to retail investors. Chairman Clayton went into the proposal to replace the four liquidity buckets with a new requirement that each fund discuss the funds’ liquidity management in its annual report. Chairman Clayton agreed with the Staff that the liquidity risk data will benefit investors but fears this benefit does not outweigh the risk of the data being misused by investors and the compliance burden. Chairman Clayton stated that the Commission will review the non-public data for risk, and that this information should only be disclosed to investors when it will be useful for investment decisions and can be easily disclosed.
Dalia Blass, Director of the SEC’s Division of Investment Management, gave an overview of the liquidity proposal and described the process. The Commission adopted the liquidity rule to promote effective liquidity risk management programs in the fund industry. Since adoption, Staff has engaged in extensive outreach to identify potential issues associated with the effective implementation of the rule, which led to a series of actions from the Commission. The Commission previously adopted a rule that extends the compliance date by six months for the classification of Rule 22e-4 reporting requirements. Staff also provided substantial guidance to aid funds’ ability to comply. This proposal will require funds to discuss liquidity management in annual reports rather than providing liquidity buckets and provide the Commission with the data.
Jeffery Harris then discussed the economic implications of the proposal. Harris stated that the replacement of the four-liquidity bucket requirement with a narrative discussion of liquidity risk management in the annual report will remove the risk of investors comparing across all funds because the proposal involves subjective factors. Harris believes the direct and indirect costs from the proposal will be less than the liquidity buckets.
Zeena Abdul-Rahman discussed the specific requirements of the proposal. The proposal will require funds to provide a brief narrative discussion of liquidity risk management in the open-end fund’s annual report and will rescind the requirement to disclose the liquidity buckets on N-PORT. The Commission will still receive the liquidity profiles broken out into the four buckets by June 2019. This proposal will alleviate the funds’ costs of compliance while providing investors with sufficient liquidity information.
Commissioner Stein did not support amending the liquidity rule. Stein opposed this proposal as it will take away funds disclosure of liquidity. Liquidity is an important factor in deciding whether to invest in certain mutual funds because some investments take longer to sell than others (e.g., corporate junk bonds v. large capitalization stocks) and investors have a legal right to receive their funds within seven days after a redemption request. Stein compared this disclosure to food labels providing the contents of the food or beverage just as the liquidity buckets gives investors some indication of the liquidity profile of what is in the fund to decide whether appropriate. Prior Commissions unanimously approved the proposal to take a measured approach to provide this information, and she argued that there are no new arguments against the proposal, the only difference is a new administration and Commission. Commissioner Stein emphasized that the proposed amendment is a rollback of transparency and thus she does not support the proposal.
Commissioner Piwowar supported this recommendation to improve disclosure of liquidity. While Piwowar supported the initial rule, he now sees this information does assist investors as the rule intended because the information now is misleading and does not provide sufficient context. Piwowar highlighted the importance of conducting retrospective rule review to ensure the liquidity disclosures provide adequate information. This review showed the one-size-fits-all is more costly and complex than originally understood and there are better ways to disclose a fund’s liquidity management. As demonstrated by the Treasury Report, funds should use their own liquidity methodologies rather than costly commission mandated liquidity requirements. Commissioner Piwowar recommended a principals-based approach to reduce the cost of the disclosure requirements, which will ultimately be passed onto the funds.
Commissioner Jackson opposed the proposal because he fears liquidity issues with less liquid mutual funds. Jackson does not agree with favoring the qualitative disclosure over quantitative disclosures because he does see how this will cause less confusion for investors. Jackson states that there is no data to support the claim that fund liquidity disclosure will have unintended consequences of misleading investors and proposes the Staff analyze the consequences of the current requirements and then decide on changes.
Commissioner Peirce supported the amendments but did not believe the proposal goes far enough to reducing the costs of disclosure, which is ultimately born by retail investors. Peirce did not support disclosing liquidity information to the public because, since adoption, funds have raised concerns that the implementation is more complex and costly than anticipated. Peirce raised the Treasury report statement that the over-prescriptive buckets will not help funds manage the subjective nature of liquidity risk. Funds will continue to use their own methodologies for managing liquidity risk and therefore Peirce supports a principles-based approach. While Peirce supports the proposal, she thinks it does not go far enough and would support removing the requirement to include a written discussion of the liquidity risk.
The investment company liquidity disclosure proposal was approved with Commissioners Clayton, Piwowar, and Peirce voting yes and Commissioners Stein and Jackson voting no.
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