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ETF issuers warn stock market experiment could end with 'winners and losers'

A group of Wall Street's biggest companies is worried that the SEC's latest stock market experiment will cut demand for their products while giving other companies a competitive advantage.

On Dec. 19, 2018, the SEC finalized the Transaction Fee Pilot, a program that will silo nearly 1,500 stocks, exchange-traded funds and exchange-traded notes into two buckets with different trading structures than the rest of the stock market. The pilot is designed to gather data to let regulators examine the web of fees and rebates that U.S. stock exchanges use to drive trading onto their venues, a model that many on Wall Street complain creates conflicts of interest for brokers routing orders.

While the test has been lauded as a first step toward potential reforms, the companies behind some of the most popular ETFs in the world — including BlackRock Inc., Invesco Ltd. and State Street Global Advisors Inc. — are concerned that the experiment will lead traders and investors to favor certain products based solely on their location in the pilot.

"To include ETFs could unduly create winners and losers," said Kevin Cronin, Invesco's global head of trading, in an interview. "If one bucket proves to be much more effective than others at facilitating liquidity, you don't want your ETF to be the one that's in the non-liquidity-providing bucket."

Some issuers, market makers and exchanges lobbied the SEC to reconsider the role of ETFs in the pilot after the experiment was proposed in March 2018. But the agency decided to include exchange-traded products, or ETPs, writing in the final rule that excluding ETFs and ETNs would diminish opportunities to gather relevant data.

Under the pilot, one batch of stocks and ETPs will trade with a fee cap of 0.1 cent per trade and carry no rebate restriction. The other group of securities will trade under the current per-trade fee cap of 0.3 cent, but the exchanges will no longer be able to provide rebates when those assets swap hands.

Rebates often serve as incentives used by exchanges to attract market makers and other large-scale traders. But with those payouts limited or stripped away, issuers worry that ETFs included in the test groups could be at a competitive disadvantage to similarly structured products operating in the control group.

In a May 2018 comment letter, BlackRock described placing look-alike ETPs into separate test groups as a "fundamental concern" that could put securities included in those buckets at a "significant competitive disadvantage."

Not all ETF issuers were concerned about the potential dislocation of similar ETPs across the pilot, though.

Pennsylvania-based Vanguard Group Inc. wrote in a comment letter that it believes spreading similarly structured products across the test groups "will not have a significant impact on investor behavior."

The SEC ultimately opted to vary the locations of such ETPs, saying it would allow the agency to compare one group more accurately with another. The regulator added in the final rule that grouping similar ETPs together could "negatively impact the representativeness of the different treatment groups," especially if the products share similar trading characteristics.

But rebate limitations may also force securities included in the test groups to face wider spreads, and as a result, higher trading prices, said Reggie Browne, senior managing director for Cantor Fitzgerald LP's ETF group.

"Markets function when you have a call for capital to come into the marketplace," Browne said in an interview. "When you take away incentives to bring liquidity into the marketplace and you try to find that natural equilibrium point, spreads will widen just because the incentives have been lowered."

Wider spreads could also exacerbate the competitive disadvantage that ETFs included in the pilot would face, according to Jim Toes, president and CEO of the industry trade group Security Traders Association. The higher cost to trade a security could lead investors to look elsewhere for a similar product, a relatively easy task given how closely ETFs tracking the same index can resemble each other.

"Anything that has a potential impact on the spread, even if it appears to be a small change, could have a meaningful impact," Toes said in an interview.

The debate around the role of ETPs in the pilot underscores a rising concern on Wall Street that regulators ought to be thinking of such products in a different light than most other equities.

"They have very similar trading characteristics, which is great and beneficial for investors and one of the virtuous things about them," Invesco's Cronin said. "[But] we have to be really careful in understanding that there are some very important nuances and differences that could impact their efficiency."