Self-Regulatory Organizations; MEMX LLC; Order Disapproving a Proposed Rule Change, as Modified by Amendment No. 1, To Establish a Retail Midpoint Liquidity Program

I. Introduction

On August 18, 2021, MEMX LLC (“MEMX” or “Exchange”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act” or “Exchange Act”) and Rule 19b-4 thereunder, a proposed rule change to establish a Retail Midpoint Liquidity Program (“Program”). The proposed rule change was published for comment in the Federal Register on September 8, 2021. On October 19, 2021, the Commission designated a longer period within which to approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether to disapprove the proposed rule change. On December 7, 2021, the Commission instituted proceedings under Section 19(b)(2)(B) of the Act to determine whether to approve or disapprove the proposed rule change. On January 27, 2022, the Exchange filed Amendment No. 1 to the proposed rule change, which supersedes the original filing in its entirety, and on February 14, 2022, the Commission published for comment Amendment No. 1 and designated a longer period for Commission action on the proposed rule change. The Commission received comments on the proposed rule change, and the Exchange submitted a response to comments at the time it filed Amendment No. 1.

This order disapproves the proposed rule change, as modified by Amendment No. 1, because, as discussed below, the Exchange has not met its burden under the Act and the Commission's Rules of Practice to demonstrate that its proposal is consistent with the requirements of the Act, including, in particular, the requirements in Section 6(b)(5) of the Act that the rules of a national securities exchange be designed to promote just and equitable principles of trade and to protect investors and the public interest, and not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers and the objectives in Section 11A of the Exchange Act, including the maintenance of fair and orderly markets.

II. Description of the Proposal

The Exchange proposes to establish a Retail Midpoint Liquidity Program to provide retail investors with price improvement opportunities at or better than the midpoint of the national best bid and offer (“Midpoint Price”). Specifically, the Exchange proposes to allow Retail Member Organizations (“RMOs”) to submit a new type of order on behalf of retail investors that is designed to execute at the Midpoint Price or better (a “Retail Midpoint Order”). Contra-side liquidity would be provided by (i) a new non-displayed Midpoint Peg order that would be restricted to interacting only with incoming Retail Midpoint Orders through the proposed Program (“Retail Midpoint Liquidity Order” or “RML Order”) as well as (ii) resting liquidity on the Exchange's order book that would offer greater price improvement than the Midpoint Price, and (iii) regular non-restricted Midpoint Peg orders that users designate as also eligible to interact with Retail Midpoint Orders (“Eligible Midpoint Peg Orders”).

MEMX would disseminate a Retail Liquidity Identifier through its proprietary market data feeds, MEMOIR Depth and MEMOIR Top, and the appropriate securities information processor (“SIP”) when RML Order interest aggregates to form at least one round lot for a particular security, provided that such interest is resting at the Midpoint Price and is priced at least $0.001 better than the national best bid (“NBB”) or national best offer (“NBO”). The Retail Liquidity Identifier would reflect the symbol and the side (buy and/or sell) of the RML Order interest but would not include the price or size of that interest.

Priority and Order Execution

Proposed MEMX Rule 11.22(c) sets forth the execution priority rules for the Program. First, an incoming Retail Midpoint Order would execute against resting liquidity priced more aggressively than the Midpoint Price. Specifically, proposed MEMX Rule 11.22(c)(2) provides that if there is: (1) A Limit Order of Odd Lot size that is displayed by the MEMX system (“Displayed Odd Lot Order”) and that is priced more aggressively than the Midpoint Price and/or (2) an order that is not displayed by the MEMX system (“Non-Displayed Order”) and that is priced more aggressively than the Midpoint Price, resting on the MEMX Book, an incoming Retail Midpoint Order would first execute against any such orders pursuant to the Exchange's standard price/time priority in accordance with MEMX Rules 11.9 and 11.10 before executing against resting RML Orders.

Second, after executing against resting liquidity priced more aggressively than the Midpoint Price, proposed MEMX Rule 11.22(c)(3) states that any unfilled portion of a Retail Midpoint Order would next execute against RML Orders at the Midpoint Price in time priority.

Third, proposed MEMX Rule 11.22(c)(4) states that after executing against all liquidity that is priced more aggressively than the Midpoint Price and all RML Orders, Retail Midpoint Orders would execute against Eligible Midpoint Peg Orders at the Midpoint Price in time priority.

III. Discussion and Commission Findings

Under Section 19(b)(2)(C) of the Act, the Commission shall approve a proposed rule change of a self-regulatory organization (“SRO”) if it finds that such proposed rule change is consistent with the requirements of the Act and the rules and regulations thereunder that are applicable to such organization. The Commission shall disapprove a proposed rule change if it does not make such a finding. The Commission's Rules of Practice, under Rule 700(b)(3), state that the “burden to demonstrate that a proposed rule change is consistent with the [Exchange] Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change” and that a “mere assertion that the proposed rule change is consistent with those requirements . . . is not sufficient.”

The description of a proposed rule change, its purpose and operation, its effect, and a legal analysis of its consistency with applicable requirements must all be sufficiently detailed and specific to support an affirmative Commission finding, and any failure of an SRO to provide this information may result in the Commission not having a sufficient basis to make an affirmative finding that a proposed rule change is consistent with the Act and the applicable rules and regulations. Moreover, “unquestioning reliance” on an SRO's representations in a proposed rule change is not sufficient to justify Commission approval of a proposed rule change.

For the reasons discussed below, the Commission is disapproving the proposed rule change, as modified by Amendment No. 1, because the information before the Commission is insufficient to support a finding that the proposed rule change, as modified by Amendment No. 1, is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange.

In summary, MEMX has an existing Midpoint Peg order type and is proposing a new Midpoint Peg order type ( i.e., RML Orders) as part of the proposed Program. From the perspective of an incoming Retail Midpoint Order, the current and proposed Midpoint-priced order types are indistinguishable because, under the proposed Program, both would result in a midpoint execution for the Retail Midpoint Order. From the perspective of market participants posting each order type, however, MEMX proposes to treat them differently by providing RML Orders with execution priority over Eligible Midpoint Peg Orders. This proposed disparate treatment raises concerns about whether the proposed Program is consistent with the Act.

As part of its filing, MEMX bears the burden to provide a sufficient legal analysis to demonstrate how its proposed rules are consistent with the Act, which requires, among other things, that MEMX's rules be designed to promote just and equitable principles of trade and to protect investors and the public interest, and not permit unfair discrimination between customers, issuers, brokers, or dealers.

To demonstrate how providing RML Orders with execution priority over Eligible Midpoint Peg Orders is consistent with the Act, MEMX asserts the following: (1) Because RML Orders will contribute to the Retail Liquidity Identifier, which is designed to attract retail orders to the Exchange, RML Orders deserve the same priority advantage that MEMX provides to displayed orders to reward displayed orders for contributing to price discovery; (2) because the Retail Liquidity Identifier would signal the presence of a buyer or seller at the Midpoint Price, awarding higher priority to RML Orders would balance the risks and incentives associated with entering RML Orders; and (3) market participants that post Midpoint Peg orders can avoid losing priority to RML Orders when trading with Retail Midpoint Orders by switching to RML Orders.

The Commission is disapproving this proposed rule change, as modified by Amendment No. 1, because, as discussed in detail below, MEMX has not met its burden under the Act and the Commission's Rules of Practice to demonstrate how its proposal to provide RML Orders with execution priority over Eligible Midpoint Peg Orders is consistent with the requirements of the Act, including, in particular, the requirements in Section 6(b)(5) of the Act that a national securities exchange's rules be designed to promote just and equitable principles of trade and to protect investors and the public interest, and not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers, and the objectives in Section 11A of the Exchange Act, including the maintenance of fair and orderly markets.

1. Price-Time Priority

The rules of a national securities exchange specify the priority of orders for execution in its matching engine. When exchange rules award higher execution priority to one type of order over another, they must do so in a manner that is consistent with the Act. One reason to provide execution priority to one liquidity-providing order type over another may be that the favored order is more aggressive and takes more risk in a way that provides benefits to the market and liquidity seekers. An exchange may seek to attract those types of orders because they directly improve the exchange's market quality and increase trading volume. Offering a priority advantage to the more aggressive order is an incentive to attract those types of orders to the exchange and may be justified as promoting just and equitable principles of trade, avoiding unfair discrimination between broker-dealers and between their customers, and contributing to the maintenance of fair and orderly markets to the extent the priority advantage rewards those liquidity providers for the risks they take and benefits they provide to the market when they are the first to provide the most aggressive widely-available best prices to the broadest population of liquidity seekers.

MEMX Rule 11.9 establishes the priority of orders and describes how MEMX uses “price-time” priority to rank orders for execution priority. Under its price-time priority rule, MEMX affords priority to the highest-priced order to buy (or lowest-priced order to sell) over orders with less aggressive prices. For equally priced orders, MEMX's rules specify that it will rank them in time priority ( i.e., with the first order entered into the MEMX system having priority over later-arriving orders) and it also generally awards priority to displayed orders over non-displayed orders.

However, for its proposed Program, MEMX would deviate from its price-time priority rule by always awarding priority to the RML Orders ( i.e., Midpoint Peg orders that can only trade against Retail Midpoint Orders) over Eligible Midpoint Peg Orders ( i.e., Midpoint Peg orders that will trade with any counterparty, including Retail Midpoint Orders), even though both orders are equally priced at the Midpoint Price and would otherwise execute in time priority outside the proposed Program. For the reasons further explained below, the Commission finds that MEMX has not met its burden to support a finding that providing RML Orders with execution priority over Eligible Midpoint Peg Orders under the circumstances MEMX proposes is consistent with the Act.

a. Analogizing Non-Displayed Orders to Displayed Orders

MEMX analogizes RML Orders to fully displayed orders ( e.g., a limit order whose price and size is published by the Exchange) because they would contribute to the Retail Liquidity Identifier. Specifically, MEMX states that “it is appropriate to execute RML Orders, which contribute to the dissemination of the Retail Liquidity Identifier, ahead of Eligible Midpoint Peg Orders, which do not contribute to the dissemination of the Retail Liquidity Identifier and are not displayed on the MEMX Book.” MEMX asserts that such treatment is “consistent with general principles of order priority on the Exchange . . . [where] orders that contribute to price discovery receive priority ahead of non-displayed orders that do not contribute to market transparency.” “As such,” the Exchange continues, it “does not believe that the proposed order priority under the RML Program raises any novel issues for the Commission to consider.”

MEMX's proposal does present a novel issue because MEMX seeks to award execution priority to a new type of Midpoint Peg order ( i.e., RML Orders) over an existing type of Midpoint Peg order ( i.e., Eligible Midpoint Peg Orders). First, both Eligible Midpoint Peg Orders and RML Orders would be classified as pegged orders under MEMX rules and MEMX's rules specifically provide that pegged orders cannot be displayed. Second, RML Orders would not contribute to market transparency or price discovery in the same way that displayed orders do because RML Orders are pegged to the Midpoint Price that solely is derived from displayed quotes and does not impact or contribute to those displayed quotes. The information conveyed by the Retail Liquidity Identifier ( i.e., the existence of one round lot of RML Order interest at the Midpoint Price) is different than the information on price and size that displayed orders provide to inform price discovery. Displayed orders help establish the best available prices in the market, which broadly benefits investors, serves the public interest, and facilitates fair and orderly markets by informing not only trading decisions but also security and portfolio valuation, prices of derivative securities like listed options, and the calculation of market indices. MEMX's comparison of the broad benefits that displayed orders contribute to the market to the narrow benefit that the Retail Liquidity Identifier would provide to RMOs to justify endowing RML Orders with the same exception to its price-time execution priority rule that MEMX provides to displayed orders, without more, does not sufficiently address how the proposal would promote just and equitable principles of trade, be consistent with the maintenance of fair and orderly markets, and not permit unfair discrimination between customers, issuers, brokers, or dealers.

Third, Midpoint Peg orders are not eligible to be displayed for a number of reasons, including, among others, prohibitions on the display of quotes in subpenny increments, requirements to avoid locking the market, and the impact that a displayed Midpoint Peg order would have on the Midpoint Price. Thus, MEMX proposes to reward RML Orders for doing something ( i.e., contributing to the Retail Liquidity Identifier) that Eligible Midpoint Peg Orders simply are not permitted to do. Without more, MEMX has not sufficiently explained how providing a priority advantage to one type of Midpoint Peg order (RML Orders) over another (Eligible Midpoint Peg Orders), based on something that Eligible Midpoint Peg Orders are not permitted to do, promotes just and equitable principles of trade, is consistent with the maintenance of fair and orderly markets, and does not permit unfair discrimination between customers, issuers, brokers, or dealers.

b. Balancing the Risks and Incentives Associated With Entering RML Orders

MEMX also states that “entering RML Orders involves some additional risk for those market participants as the Retail Liquidity Identifier will signal that there is a buyer or seller that is willing to trade with retail investors at the Midpoint Price.” “Thus,” the Exchange states, “the RML Program seeks to balance the risks and incentives associated with entering RML Orders. . . .” Consequently, MEMX proposes to reward RML Orders with execution priority over Eligible Midpoint Peg Orders to the same extent that it rewards displayed orders with priority over non-displayed orders.

In general, some market participants may be hesitant to display regular limit orders on an exchange's order book because of the potential for adverse selection when trading against counterparties more associated with price movements and the inability to avoid interacting with those counterparties. To encourage display of trading interest on its order book in light of those risks, an exchange might offer displayed orders enhanced execution priority over non-displayed orders. Rewarding displayed orders with priority over non-displayed orders compensates them for the risks they take in displaying prices that are available for any liquidity taker and for the chance of adverse selection when trading with certain counterparties.

However, market participants posting RML Orders would face little risk (if any) from the Retail Liquidity Identifier because RML Orders are uniquely counterparty-restricted whereas displayed orders are not so restricted. In other words, RML Orders would experience significantly different risk compared to displayed orders on MEMX's order book because MEMX would restrict the counterparties with which an RML Order could trade to only permit executions against retail orders to the exclusion of all other types of orders and counterparties. Market participants placing RML Orders would be specifically seeking to interact exclusively with retail customers because they likely regard retail customers to be attractive counterparties that submit smaller-sized orders that typically are less predictive of very short-term price movements.

Despite this significant difference, MEMX proposes to confer the same execution priority benefit to restricted RML Orders that it grants to unrestricted displayed limit orders. However, MEMX's proposal is designed to effectively eliminate the risk of adverse selection when trading with non-retail counterparties more associated with price movements and RML Orders would not be exposed to a level of execution risk in the Program that is comparable to what displayed orders face on MEMX's order book. The Retail Liquidity Identifier and counter-party restriction would be a benefit to RMOs that permit an otherwise non-displayed order to advertise its presence to the very counterparty with which the poster seeks to trade (and is only permitted to trade with by the terms of the RML Order). Compounding advantages does not appear to balance the risks and incentives of entering RML Orders that MEMX said it seeks to balance.

Accordingly, the Exchange's assertion that the Program “seeks to balance the risks and incentives” is misplaced because the Retail Liquidity Identifier should not generate additional risks to RMOs commensurate with the risks experienced by market participants posting regular displayed orders on MEMX's order book. Moreover, as stated above, market participants placing RML Orders would instead benefit from the Retail Liquidity Identifier because it is intended to attract the desirable retail counterparties with whom they specifically seek to trade and with whom, aside from the proposed Program, they may have fewer opportunities to interact.

Consequently, MEMX is proposing to reward counterparty-restricted RML Orders for contributing to a Retail Liquidity Identifier that benefits them and MEMX has not sufficiently explained why those compounded benefits are consistent with the Act. Further, MEMX has not sufficiently explained why that different treatment proposed between brokers, dealers, or customers when such brokers, dealers, or customers post each different order type is not unfairly discriminatory. Without more, MEMX has not carried its burden to sufficiently analyze how its proposed disparate treatment in execution priority between two types of Midpoint Peg orders promotes just and equitable principles of trade, protects investors and the public interest, contributes to the maintenance of fair and orderly markets, and is not designed to permit unfair discrimination.

2. Choosing Between Two Types of Midpoint Pegs

MEMX states that its users are free to select which Midpoint Peg order type they wish to submit if they want to interact with Retail Midpoint Orders, and would do so knowing their advantages and disadvantages, thus making its proposal to award RML Orders with execution priority over Eligible Midpoint Peg Orders not unfairly discriminatory. As discussed above, MEMX is proposing disparate treatment between two Midpoint Peg order types by proposing to reward RML Orders with execution priority over Eligible Midpoint Peg Orders when interacting with Retail Midpoint Orders. MEMX cannot resolve potential unfair discrimination in favor of RML Orders over Eligible Midpoint Peg Orders by relying on the fact that users can instead use RML Orders; doing so does not convert unfair discrimination into fair discrimination. When MEMX chooses to offer two Midpoint Peg order types but treats them differently, each order type must independently be consistent with the Act and any discriminatory treatment must also be consistent with the Act. The consistency of one order type with the requirements of the Act is independent of, and cannot be contingent on, the existence of a substitute.

3. MEMX Has Failed To Meet Its Burden

When assessing this proposed rule change, as modified by Amendment No. 1, the Commission must consider its consistency with the Act and the applicable rules and regulations issued thereunder. As stated above, under the Commission's Rules of Practice, the “burden to demonstrate that a proposed rule change is consistent with the Exchange Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change.” For the foregoing reasons, the Exchange has not met its burden to demonstrate that it would be consistent with the Act for the Exchange to provide a priority advantage to one type of midpoint peg (RML Orders) over another type of midpoint peg (Eligible Midpoint Peg Orders). As a result, the Commission does not have sufficient information to find that the Exchange's proposal would promote just and equitable principles of trade and protect investors and the public interest, not permit unfair discrimination between customers, issuers, brokers, or dealers, and promote the maintenance of fair and orderly markets. Accordingly, the Commission must disapprove the proposal because the Exchange has not met its burden to demonstrate that the proposal is consistent with the Act, including Section 6(b)(5) and Section 11A of the Act.

IV. Conclusion

For the reasons set forth above, the Commission does not find, pursuant to Section 19(b)(2) of the Act, that the proposed rule change, as modified by Amendment No. 1, is consistent with the requirements of the Act and the rules and regulations thereunder applicable to a national securities exchange, and in particular, with Section 6(b)(5) of the Act.

It is therefore ordered, pursuant to Section 19(b)(2) of the Act, that the proposed rule change (SR-MEMX-2021-10), as modified by Amendment No. 1, is disapproved.