Looming Reforms to Turn up Heat on Financials
January 28, 2022
Capstone believes the Securities and Exchange Commission (SEC) will pursue an aggressive regulatory agenda in 2022 that presents meaningful risks and opportunities for companies across the financial services sector. SEC Chair Gary Gensler has made clear he plans to be a proactive regulator, directing commission staff to review several key areas for potential rulemaking—including market structure, digital engagement practices (DEPs), and the legal treatment of special-purpose acquisition companies (SPACs). There will be more corporate losers than winners, with broker-dealers and market makers facing the biggest challenges. Gensler is dealing with an ESG disclosure mandate from the Biden administration and pressure from consumer advocates to reevaluate Regulation Best Interest (Reg BI).
The SEC will pursue holistic market structure reform, pressuring retail broker-dealers and wholesale market makers while benefitting exchanges.
- Winners: Intercontinental Exchange, Inc. (ICE), Cboe Global Markets Inc. (CBOE), Nasdaq, Inc. (NDAQ)
- Losers: Robinhood Markets Inc. (HOOD), Charles Schwab Corp (SCHW), Interactive Brokers Group, Inc. (IBKR), Virtu Financial, Inc. (VIRT)
The surge of retail investor-driven trading volatility in meme stocks unveiled ways the framework governing equity and options markets has become outdated. Throughout 2021, US Securities and Exchange Commission Chair Gary Gensler often made public comments indicating the commission intends to reform market structure rules to foster greater competition among market players and give greater transparency to investors. The SEC’s Fall 2021 regulatory agenda shows it plans to modernize rules related to “order routing, conflicts of interest, best execution, market concentration, and the disclosure of best execution statistics” in a rulemaking slated for April.
Capstone believes the SEC is likely to include several market structure reforms related to key topics that pose the greatest risks to certain broker-dealers (BDs) and wholesale market makers (wholesalers), most notably Robinhood Markets Inc. (HOOD) and Virtu Financial, Inc. (VIRT).
Even absent an outright ban of payment for order flow (PFOF) (to which we assign a 20% probability of occurring within President Biden’s current term), the reforms that we view as most likely would lead to greater price improvement for retail investors and less overall spread capture for BDs and wholesalers while modestly benefitting exchanges.
We believe a proposed rule will most likely increase disclosure requirements for broker-dealers and wholesale market makers about their PFOF arrangements, tighten best execution guidance for BDs, expand trades included in the National Best Bid and Offer (NBBO), and reduce exchange tick sizes. We expect these reforms to be introduced via rulemaking in early-to-mid 2022.
An ongoing SEC investigation of BD and investment adviser use of digital engagement practices pose unique risks to Robinhood’s retail trading platform
- Winners: N/A
- Losers: Robinhood Markets Inc. (HOOD)
Stock market volatility in early 2021 raised additional questions for the commission about digital engagement practices (DEPs), which it defines as “behavioral prompts, differential marketing, game-like features (gamification), and other design elements or features designed to engage with retail investors on digital platforms, as well as analytical and technological tools and methods.”
On August 27, 2021, the SEC issued a request for information and public comment on the use of DEPs to determine how BDs and investment advisers use them. The SEC is concerned that broker-dealers’ use of DEPs may be leading investors to trade more often or take greater risks than they otherwise would. In its request for comment, the commission cited its concern that DEPs using game-like features may blur the lines between solicited and unsolicited transactions or whether such engagements can be classified as recommendations or providing investment advice under Regulation Best Interest (Reg BI). Reg BI is a principles-based rule that imposes a “best interest” standard on BDs when they make a recommendation to a retail investor on a securities transaction or particular investment strategy.
In an October 2021 speech on the use of DEPs, SEC Director of the Office of the Investor Advocate Rick Fleming said “most, if not all, of the online discount brokers are influencing investor behavior with DEPs, which further blurs the line between providing investment advice and traditional brokerage service.”
We believe that as the SEC develops a view on the use of DEPs, it is possible that companies such as Robinhood, which incorporates several DEPs into its retail trading platform, could be forced to either comply with additional obligations under Reg BI or eliminate the use of certain DEP platform features.
The SEC will shift to enforcement of Reg BI, with risks for retail broker-dealers
- Winners: N/A
- Losers: LPL Financial Holdings Inc.(LPLA), Raymond James Financial Inc. (RJF), Ameriprise Financial Inc. (AMP), the wirehouses
In recent months, the SEC has begun laying the groundwork for that enforcement: Staff has been conducting examinations, and Reg BI was put atop the SEC’s 2021 examination priorities. Initial actions may target the lowest hanging fruit, such as cases where broker-dealers lack policies and procedures. Ultimately, we believe, the SEC may use the substantial discretion it is afforded under the regulation to charge broker-dealers with failure to act in customers’ best interest.
A recent hire at the commission has also raised eyebrows: In August, the SEC announced that Gensler was bringing on Barbara Roper to be his senior advisor on retail investor protection issues. Roper spent 35 years at the Consumer Federation of America, a consumer advocacy organization, where she fought for a fiduciary standard (and criticized Reg BI as inadequate). While additional rulemaking does not appear imminent (and tweaks to Reg BI are not included in the SEC’s public-facing regulatory agenda), we believe Roper’s appointment portends intensified scrutiny of conflicts of interest at retail broker-dealers.
The SEC is likely to initiate rulemaking regarding SPACs, posing headwinds for high-growth companies looking to go public
- Winners: N/A
- Losers: Future SPAC IPOs, particularly those of companies with little-to-no current revenue but high-growth projections
These concerns have also attracted scrutiny from key financial regulators. We believe there is a 90% probability that the SEC issues a notice of proposed rulemaking (NPRM) in the first half of 2022, taking effect in early 2024. Gensler has been vocal about his concerns with the current SPAC process. Criticisms of SPACs coalesce around two primary issues, both of which we believe are likely to be addressed in any proposed rule.
The first criticism, levied primarily by investor protection groups, is that the typical compensation structure for SPAC sponsors produces divergent incentives and financial outcomes for different shareholder groups during the de-SPAC process while encouraging sponsors to pursue deals that are not in the best interests of average investors. We expect rulemaking to address both disclosure quality and potential conflicts of interest. At the same time, we do not believe this will significantly impact most transactions, as SPAC compensation models are generally well known.
Second, and more impactfully, we believe there is a 60% probability the SEC’s proposed rule will attempt to eliminate the Private Securities Litigation Reform Act (PSLRA) safe harbor. The safe harbor is key to reducing the litigation risk for companies while allowing sponsors to publicize financial projections during the announced de-SPAC transaction.
We believe the ability to publish financial projections gives small companies that use a SPAC to go public a big advantage compared to companies that use the initial public offering (IPO) process. While the SEC cannot change the statutory language of the PSLRA to muzzle SPACs alongside IPOs, which are prohibited from publishing such projections, we anticipate the agency’s most likely approach will be to take advantage of the lack of a definition of an IPO in the law to redefine the de-SPAC transaction as an “IPO” through rulemaking. If a final rule went into effect with such language (and we anticipate industry participants would sue to block it), we believe it would make it difficult for companies with little-to-no current revenue but high-growth projections to raise capital by going public via a SPAC.
The SEC will propose ESG rulemaking on public companies and ESG funds, raising the compliance burden for covered entities
- Winners: MSCI Inc. (MSCI)
- Losers: N/A
The Biden administration has made climate change a priority for all federal agencies, including the SEC. Given the administration’s emphasis on the issue, we believe it is highly likely the SEC will finalize a rulemaking (80% probability by 2024) standardizing and/or increasing public company disclosure requirements while increasing transparency requirements for investment advisers and funds that are marketed as ESG or sustainable.
While there is no requirement that SEC rules be limited to a “materiality” standard, there are still limitations on the requirements the SEC may promulgate without Congressional action (which we view as unlikely). The SEC’s mandate is to protect markets and investors. As such, it is easier for the SEC to issue rulemaking requiring disclosure of how a company may be affected by climate change, rather than its effect on climate change.
Given substantial opposition from the SEC’s two Republican commissioners, we believe the agency will focus on crafting a rulemaking to withstand legal challenge. Our current view is that the SEC’s strategy will include requiring companies to disclose the legal, regulatory, and legislative risks they face, including the impact of international accords, if policymakers opt to comply with or enforce them.
For asset managers, we believe the SEC is likely to require them to disclose more information about fund strategy and take steps to increase the compliance burden of funds and managers promoting an ESG strategy. The SEC has substantially more authority to craft regulations governing advisers and funds than it does to mandate public company disclosure. Both of these likely policy changes bode well for providers of ESG research and climate index providers such as MSCI Inc.
SEC Agenda Opportunities
The SEC will expand trades included in the NBBO, making exchanges more competitive relative to wholesalers.
We assign a 70% probability that the SEC expands trades included in the National Best Bid and Offer (NBBO) and reduces exchange tick sizes mandated by Regulation NMS Rule 612, which would lead to narrower bid-offer spreads and make exchanges more competitive relative to wholesalers.
Gensler has commented that the NBBO represents an “out-of-date measuring stick” because it excludes a significant amount of trading activity, which limits price improvement for retail investors. A recent study released by NASDAQ indicated that odd lots, which are not included in the NBBO, represent ~70% of trades for high-priced stocks, 47% of trades for mid-priced stocks, and 28% of trades for low-priced stocks. The vast quantity of such trades happening outside of the NBBO, which is the prevailing metric used to measure execution quality, presents a problem.
Additionally, the NBBO currently must be priced in penny increments due to Regulation NMS Rule 612 (the “sub-penny rule”), which restricts quoting for shares of stocks priced over $1.00 to increments of $0.01, and for stocks under $1.00 to $0.0001. A recent analysis conducted by Members Exchange, a US equities exchange, indicated that the market could efficiently execute trades at spreads tighter than the current minimum pricing increment on exchanges and in the NBBO for nearly one thousand different equity securities representing 47% of the trading volume and 25% of the notional value executed in US stock markets. These wider spreads are now mandated by the NBBO.
The SEC’s ESG rulemaking will raise the compliance burden for sustainable funds, benefitting MSCI and other ESG research, compliance, and index providers.
SEC rulemakings to standardize ESG disclosures and impose regulatory requirements on institutional investors (to which we assign an 80% probability by 2024) are likely to increase the already high rate at which investors incorporate ESG data into their investment strategies.
MSCI indices are used to benchmark a disproportionate share of inflows into green or sustainable funds. Using information provided on MSCI’s Q1 2021 earnings call, we estimate that MSCI’s share of ESG inflows is roughly 70% of the total, whereas its share of inflows excluding ESG is roughly 16%. As such, MSCI is well-positioned for ESG tailwinds in a segment with an adjusted EBITDA margin of 76% reported in Q3 2021. Beyond its index segment, the company would also benefit from increasing asset managers’ compliance burden and disclosure requirements for corporates.
SEC Agenda Risks
The SEC will pursue holistic market structure reform that disincentivizes PFOF arrangements creating headwinds for certain BDs and wholesalers.
While we view a full PFOF ban as unlikely in the near term (we assign a 20% probability), we believe the SEC will pursue other key reforms via the rulemaking process in early-to-mid 2022, which will reduce the revenue BDs can generate by selling their customers’ order flow.
Notably, we believe there is a 70% probability that the SEC will increase disclosure requirements for order flow sales by BDs and a 65% probability the SEC will implement more stringent best execution analysis requirements, which together could force BDs to increase price improvement for retail investors and sacrifice some PFOF revenue.
Regulation NMS requires disclosure data on price improvement from wholesalers, though not currently from BDs. However, wholesalers are not required to disclose execution quality metrics for each retail BD that routes orders to them. Mandating disclosure of this information could address regulatory concerns that retail BDs receiving order flow payments are not routing orders based on best execution standards.
Additionally, the SEC could look to require BDs that receive order flow payments to conduct and make publicly available rigorous assessments of alternative order execution outcomes at venues where conflicts of interest do not exist. This was proposed by SEC staff in a 2016 memorandum on equity market structure, and FINRA already requires BDs to conduct a similar assessment periodically, so we believe this reform would be relatively straightforward to implement. We believe this reform is likely to drive greater BD competition based on price improvement and lead to better execution quality for customers, thus reducing BD spread capture. We believe these changes present unique risks to Robinhood, which in Q3 2021 generated 72% of its revenue from PFOF (compared to Charles Schwab, which made 11% of its quarterly revenue from selling order flow). Additionally, based on BD self-reported execution quality data, Robinhood executes fewer orders at or better than the NBBO than peers (95.1% of orders for Robinhood vs. 98.3% for peers).
An SEC rulemaking that limits BDs’ use of DEPs could reduce the attractiveness of Robinhood’s retail trading platform and slow the company’s customer growth
We believe the SEC is likely to issue a rulemaking about the use of DEPs by BDs and investment advisors, affecting the role they play in influencing retail customers’ investment decisions. In our view, a rulemaking would likely clarify whether the use of certain DEPs qualifies as investment advice under Reg BI, which triggers a best interest standard that requires BDs to comply with enhanced obligations related to disclosure, care, conflict of interest, and compliance when making recommendations to retail customers.
In a November speech at the ALI CLE 2021 Conference on Life Insurance, SEC Commissioner Allison Herren Lee said that BDs “should be thinking critically and carefully about the extent to which nascent practices in the industry may, in fact, constitute recommendations [under Reg BI].” She also noted that the use of algorithms, prompts, machine-learning, and other forms of technology do not relieve BDs of responsibilities under Reg BI.
The commission is interested in whether these practices constitute recommendations under the Reg BI definition. We believe reclassification of certain DEPs as investment advice under Reg BI, as well as other restrictions on the use of DEPs, presents significant risks to Robinhood.
Robinhood’s digital engagement strategy is seen as one of the keys to its rapid growth, with a user base that has jumped to 18.9 million monthly active users as of Q3 2021, up 79% over Q3 2020. The SEC’s request for information and comment cited several in-app features classified as DEPs specific to Robinhood, such as digital confetti used to celebrate investor trades, points, badges, and leaderboards. We believe that any rulemaking by the SEC designed to limit or regulate BD use of DEPs on retail trading platforms could limit the attractiveness of Robinhood’s platform to investors and slow the growth of its customer base.
The SEC will eliminate the PSLRA safe harbor for SPACS to make forward-looking projections, creating significant headwinds for all future SPAC IPOs
We assign a 60% probability that an NPRM by the SEC regarding SPACs in 1H2022 will include language defining the de-SPAC transaction as an “IPO” for the purpose of the PSLRA. We believe this restriction would severely limit the ability for companies with little to no current revenue that project rapid growth and high future earnings to go public via SPACs.
According to a public study by FTI Consulting, of 137 de-SPAC transactions from July 2020 through June 2021, 30 (22%) of the operating companies generated no revenue at the time of the announcement, and another 57 (42%) generated no earnings before interest, taxes, depreciation, and amortization (EBITDA).
Financial projections have become a key aspect of SPAC transactions because they allow the sponsors to communicate their expectations for company growth and also disclose material nonpublic information held by private investment in public equity (PIPE) investors. The safe harbor provides legal insulation for forward-looking guidance, significantly reducing the risk of litigation.
Class action lawsuits related to SPACs already doubled in 2021 from the year prior, and we expect an ongoing flow of additional shareholder suits under the regulatory status quo. However, if the safe harbor were removed, litigation and associated costs would rise sharply for companies that choose to make forward-looking projections absent the greater legal protections. Ultimately, we believe this would discourage the practice altogether, and would significantly limit both target company valuations and PIPE financing that rely on the projections and are crucial to many SPACs successfully completing the merger process.
The SEC will pursue actions against retail broker-dealers for violating Reg BI, posing risks for wirehouses, independent broker-dealers, and regional firms
We believe there’s an 80% probability the SEC will take enforcement actions for violations of Reg BI in 2022. In the near term, these may be focused on the lowest hanging fruit, which we view as small firms that lack the required policies and procedures. But other actions may target firms for, more fundamentally, failing to design policies that are in the “best interest” of retail customers, an area in which the SEC will have substantial discretion.
We believe the SEC’s looming focus on Reg BI enforcement presents risks for large, publicly traded retail broker-dealers such as LPL Financial Holdings Inc. (LPLA), Raymond James Financial Inc. (RJF), and Ameriprise Financial Inc. (AMP).
While we believe key revenue sources, such as cash sweep revenue, commissions, and revenue sharing, are unlikely to be fundamentally challenged, broker-dealers may face enforcement for insufficient disclosure or inadequate management of the conflicts presented by those or other revenue sources. To the extent enforcement actions begin to pile up, it could lead broker-dealers to reexamine compliance more fundamentally.
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