SEC Proposes Four New Rules, Adopts One | Chief Investment Officer

Proposals

The Securities and Exchange Commission proposed four rules on Thursday that would influence securities trading if approved.

In sum, the rules represent what would be the biggest reforms to equity markets in the U.S. since SEC rule changes made in 2005. They have also raised questions among industry associations, who all agree the proposals would bring major changes to how stocks are bought and sold but have differing to no opinions yet on whether to support the changes.

The first, known as the “best execution” rule, would require broker/dealers to use reasonable diligence to identify the best market and price for their customer under current market conditions during securities trading. Broker/dealers also must maintain or institute policies to ensure they are executing trades on the most favorable terms for their clients.

Under this rule, broker/dealers must also document their compliance with the best-execution standard for “conflicted transactions,” in which a broker/dealer executes an order as principal; routes or receives an order from an affiliate; or provides or receives payment for order flow.

The second proposal seeks to enhance disclosure of order execution. The proposal would expand the number of entities that must produce monthly quality-of-execution reports to include “broker/dealers with a larger number of customers.” It would also require new measures of execution quality, such as “average effective over quoted spread” and “a size improvement benchmark.”

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The third proposal would change minimum price increments for National Market System (NMS) stocks from a full cent to sub-penny increments.

The last proposal requires that certain retail orders must be exposed to a fair auction process before being executed. Retail orders normally go to wholesalers, who typically do not have a competitive pricing process and simply execute at the best available price at the moment, according to the SEC.

The proposal would require restricted competition trading centers, such as wholesalers, to auction orders for a period of time from 100 to 300 milliseconds before executing the trade. This process is designed to find a better price for the retail investor by allowing institutional investors to bid on the order. It could also potentially increase trades between retail and institutional investors, since the current market structure limits their contact, according to the SEC factsheet. The SEC estimates this could provide $1.5 billion in price benefits to retail investors.

Ken Bentsen, the president and CEO of the Securities Industry and Financial Markets Association, said in a statement that the proposed rules are very complex and the industry will need a significant comment period to adequately consider the proposals.

A spokesperson for the Investment Company Institute said in an emailed statement: “A reduced tick size could present a sensible first step toward relieving tick-constrained stocks and promoting competition. We will review the proposal to assess whether the proposed pricing increments present the most efficient way to achieve these goals. These are significant proposals with far-reaching implications for the securities markets and investors. ICI looks forward to reviewing the proposals, including the interplay between—and cumulative impact of—the four proposals.”

Adoption

The SEC also adopted one new rule at the hearing regulating insider trading, by a unanimous vote. The new rule requires a “cooling-off” period for Rule 10b5-1 plans.

Some insiders use 10b5-1 plans, which allow executives and directors to trade in their own company’s stock with liability protection against insider trading. Since executives typically have access to non-public information about their company, the trades they execute on that stock might therefore be suspect.

10b5-1 plans allow an insider to pre-define parameters, such as price and date, in which company stock is to be bought or sold, so that the trades are put on auto-pilot. Since the parameters are set ahead of time, the plan can be used as a defense against the charge of insider trading, since the executive did not possess material non-public knowledge at the time the parameters were set and therefore could not have informed the trades in question.

The previous rules did not have a “cooling-off” period, however, meaning an insider could set the parameters just before they intended to trade stock anyway, though many firms require a cooling-off period.

The new rules now require a period of three months to pass before trades can take place under a 10b5-1 plan for executives and directors, to be sure that the plan itself was not informed by insider information and ideally to prevent abusive and suspiciously timed trades.

10b5-1 plans are not required for insiders in order to trade company stock, but they can provide an affirmative defense against insider trading. Employees who are not a director or executive would only have to wait 30 days before trading under a 10b5-1 plan.

“The SEC amendments will better protect public investors from the misuse of these plans and strengthen confidence in corporate management teams and the capital markets generally,” said Amy Borrus, executive director of the Council of Institutional Investors, in an emailed statement.

Tags: broker-dealer, execution, Insider Trading, SEC, trading

WTW included outsourcing and derisking among its recommendations for pension funds and retirement plans, in its “Top Investment Actions in 2023” report. Other recommendations were for defined benefit pension funds to consider outsourcing their investment operations and for defined contribution plans to contemplate utilizing pooled employer plans.

“Don’t let resource constraints limit your return potential,” the WTW report stated. “Leverage a team of full-time investment professionals to manage the details while you focus on the big picture. DC sponsors should go a step further and investigate the potential benefits of a PEP (pooled employer plan).”

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Overall, the firm’s report noted that in 2023, there will be a continued focus on defined contribution plans, rather than defined benefit plans, as the primary retirement benefit for many employees.

The WTW report said corporate pension funds should “re-evaluate (their) primary objectives and long-term goals” after the American Rescue Plan Act and Infrastructure Investment and Jobs Act adjusted pension funding rules.

Plan sponsors may be planning for their eventual exit strategies, contemplating the impact of the new funding rules. WTW wrote, “DB sponsors should evaluate a ‘hibernation’ strategy that seeks to minimize risk while still leveraging asset returns to reduce the cost of exiting the plan over the long term. DC sponsors should embrace the meaning of a DC ‘retirement plan’ and kick off the new year by considering ways to move the needle (by reviewing plan structure, on DC plans.”

In 2022, the value of both pension assets and pension liabilities has declined significantly because of the dramatic rise in the discount rate as risk assets sold off. The reduction of liabilities, with a higher discount rate, outpaced the reduction in asset values, leading to higher funding ratios.

Though higher interest rates have led to better funding ratios, higher discount rates will increase the interest cost of liabilities going forward. In lieu of higher interest rates and inflation, the WTW report emphasized that “assets must work harder to keep up as liabilities grow faster and spending needs soar. Update return targets for pension assets and add financial wellbeing resources and income solutions to support DC participants.”

The WTW report advocates for pension funds to use active management, derivatives for liability hedging utilizing LDI strategies and private assets when available. The report calls active management more valuable in times of uncertainty and market volatility.

In the report, WTW also warned that plans hedging liability solely with long-term bonds are leaving themselves exposed to duration risk more obliquely following this year’s rate hikes, as the yield curve inverts with the 30-year treasury pegged below 4%. Private-market allocations are attractive, as they allow pension funds to take long positions that insulate them from short-term market volatility.

The report claimed investors often of private assets and suggested, “Don’t limit your potential. Ttake advantage of the rich opportunity set in private markets and utilize more-efficient hedging instruments.”

With an outlook of a moderate recession in 2023, the WTW report advised that pension funds orient portfolios toward income-generating assets, such as real assets and diversified credit.

In fixed income, the WTW report advised pension funds not to lend and when risks overlap with their equity portfolio holdings. To alleviate concentration risk, pension fund investors could diversify across the capital markets beyond corporate bonds to include , sovereigns, emerging markets and private debt.

“With uncertainty ahead, stable income from high-quality cash flows can increase stability and resilience,” the firm wrote.

The WTW report recommended that pensions build a robust portfolio that can withstand a broad range of market environments, saying hedge fund allocations are a way of obtaining true diversification. “Find out how the new generation of hedge funds can help you access true diversification,” the report advocated.

Finally, as long-term investors, the WTW wrote that pension funds should have a long-horizon mindset while integrating environmental, social and governance factors and effective stewardship to, “protect and enhance portfolio outcomes,” according to the report.