The Securities and Exchange Commission's recently proposed rules could be the most significant market overhaul in more than a decade. The commission's focus is on the hotly debated practice of payment for order flow, where brokers like Robinhood sell their customer orders to market makers, who then execute those orders.

New rules could stifle business for market-making firms like Virtu Financial and Citadel securities. On the flip side, three trading exchanges that could benefit from these new proposed rules are Intercontinental Exchange (ICE 0.39%), Nasdaq (NDAQ 0.05%), and Cboe Global Markets (CBOE 1.59%). What are the proposed rules, and how can exchanges benefit? Read on to find out.

The SEC believes some brokers have a conflict of interest

The SEC occasionally modifies its rules to protect investors and maintain fair, orderly, and efficient markets. One practice the commission has set its sights on is payment for order flow (PFOF). PFOF has been around for decades, but it wasn't until the last few years that it's come under intense scrutiny from regulators and market participants.

The practice of PFOF is where retail brokers, such as Robinhood or Charles Schwab, send orders to wholesale brokers, also known as market makers, to execute customer orders. Those retail brokers accept payment for routing this order flow to specific market makers, such as Virtu and Citadel.

The SEC believes that this creates a conflict of interest in which brokers route orders to wholesalers that will maximize their profits at the expense of getting customers so-called best execution, or the most favorable prices. The proposed rules by the SEC have received a lot of pushback from market makers and brokers that rely on orders and revenue as an essential part of their business. Virtu Financial is fighting the commission and is suing the agency under the Freedom of Information Act, saying that the SEC "is more focused on politics and regulation by innuendo and hypothesis than earnestly engaging with an industry that has created the most fair and competitive equity markets for retail investors globally." 

Here's what the SEC is proposing

Although some retail brokers and market makers will see their businesses suffer, trading exchanges will benefit from two rules. The first proposed rule would require brokers to auction orders for best execution before being executed by a market maker. The rules would require broker-dealers to route orders below $200,000 through an exchange auction in public marketplaces, benefiting those like the New York Stock Exchange (owned by Intercontinental Exchange), Nasdaq, or CBOE.

Another rule would reduce the size of stock ticks to a tenth of a penny, allowing stock exchanges to execute trades in sub-penny increments and level the playing field against market makers. The SEC argues that the proposed rules will increase competition and would result in savings of $1.5 billion annually for retail traders. Opponents argue that the new rules could end up costing investors more and that the delay of auction execution could affect execution quality for retail investors. 

These three trading exchanges could see higher volume as a result

The move by the SEC could greatly affect how and who executes customer orders. The rules could push more volume back toward exchanges, which have lost ground to off-exchange market makers and wholesalers as more retail brokers turned to wholesalers to execute orders. Those brokers argue that this is why they have been able to offer commission-free trading for their customers.

From 2011 to 2021, the off-exchange volume has grown from 30% to 44%, according to data from the Securities Industry and Financial Markets Association (Sifma) and Fitch Ratings. Through the first nine months of 2022, $224 billion in volume was off-exchange, or 38.3% of total volume. In comparison, Intercontinental Exchange, Nasdaq, and CBOE captured $122 billion, $120 billion, and $78 billion of the total on-exchange dollar volume. 

Although not all off-exchange volume is retail traders, Sifma estimates that retail is about 20% to 30% of all equity trading volumes, with the number of trades steered toward wholesalers being as much as 10% of stock activity. By shifting to an auction model, tens of billions in trading volume is potentially up for grabs by these trading exchanges.

Should you buy these stock exchanges?

The proposed SEC rules are going through their public comment period, which will remain open until about March 31. The commission will face a fight from market makers and brokers who have adamantly opposed any new regulations on PFOF, and there will undoubtedly be litigation that will need to work through the legal system. If adopted, trading exchanges will benefit, and market makers like Virtu Financial and retail brokers relying on PFOF like Robinhood will undoubtedly take a hit.

The new rules will benefit public exchanges, which could see volume routed to these auctions jump. While these proposed rules aren't enough reason to invest in those exchanges specifically, investors need to understand the ramifications of these potential rules changes. With that said, any proposed changes will likely take years to be phased in.