Plans for Equity Market Structure Revamp Stimulate Debate

SEC Chairman Gary Gensler’s plan to revamp the rules for U.S. stock trading is stirring debate among market participants, arguing whether the sweeping overhaul is necessary, while others favor a holistic review.

On June 8, the SEC Chair gave a speech outlining a set of far-reaching proposals around retail order handling and execution which could upend the way current equity market structure operates. While these are preliminary ideas, the SEC could look to curtail the ability of retail brokers to receive payments for routing customer orders to wholesale market makers’ execution platforms. To address this issue, Gensler is considering transparent auctions and allowing sub-penny executions on exchanges to increase competition with market makers

The proposals come after the rise of off-exchange trading, in which most retail orders go to wholesalers and not to public exchanges, which Gensler called “an uneven playing field.” Retail investor participation became a force in the markets over the past two years, especially during the meme-stock trading events.

“We’ve needed to address market structure ideas that we haven’t addressed for years,” said Joe Saluzzi, managing partner at Themis Trading LLC, an institutional broker-dealer, who said this is not a solution in search of a problem.

But the plans have already met resistance from brokerage executives who say the markets are functioning well for retail investors. There is also worry that the proposals are too retail-oriented and may not address the needs of institutional investors who struggle to trade in large sizes. On the other hand, there are institutional brokers who maintain that a holistic review is necessary.

“This feels very much like Reg NMS 2.0,” said Joe Wald, managing director at BMO Capital Markets, an institutional brokerage firm, referring to the last major overhaul of equity market structure which began in 2005 with committees and arguments from wholesalers, specialists, ECNs, and other market constituents whose business models were at stake. Wald said the Reg NMS-like review is necessary to address issues of concern to both retail and institutional investors.

One of the biggest possible reforms would be a requirement for retail brokers to route individual orders to buy or sell stocks into a transparent “auction process” for matching customer orders, rather than sending them to wholesale market makers for execution on off-exchange platforms.

Currently, more than 90% of retail marketable orders are routed to a small, concentrated group of wholesalers that pay for that retail order flow, said Gensler, who noted that institutions and pension funds do not get to interact with retail flow.

Introducing “Order-by-Order” Competition

Emphasizing the need for “order-by-order competition,” in the speech before the Piper Sandler Global Exchange Conference, Gensler questioned the market segmentation of retail orders and concentration of wholesalers and whether the market structure “is as fair and competitive” as it could be.

“Having more competition is critical,” said Wald of BMO Capital, “There is midpoint liquidity on exchanges and ATSs, but because of today’s market structure the retail liquidity is not there to interact with directly.”

“What institutional investors don’t have access to today is retail flow on an order-by-order basis because it is being disintermediated by a wholesaler,” he explained. “If there was order-by-order competition, then retail order flow could go to the market on any order-by-order basis and let the market participants compete naturally for that flow,” said Wald.

At an industry conference, sell-side market participants voiced concerns that the plans are heavily retail-oriented and may not serve the needs of buy-side institutions who struggle to find liquidity in larger size. Buy-side firms manage the bulk of assets in the stock market and execute orders on behalf of retail investors through mutual funds and 401-k plans.

“It seems that the SEC is really focused on retail flow, potentially drawing that flow away from internalized and wholesale firms and moving the flow to the exchanges,” said Rich Steiner, Head, Client Advocacy and Market Innovation at RBC Capital Markets, speaking at the San Francisco Securities Traders Association (STA) virtual conference on June 9. “But the question is whether the proposed changes will be good for the entire market,” said Steiner, who moderated a panel on off-exchange trading.

Round Lot Reform & Sub-Penny Executions

As part of the broad package of proposed changes, the SEC Chair also put forth ideas about “harmonizing tick-sizes” to level the playing field between the different market centers. Specifically, Gensler has asked SEC staff to look at redefining a round-lot especially for stocks and changing the minimum price increments to less than a penny for executions to allow exchanges to compete with wholesalers and ATSs.

The SEC’s 2020 market infrastructure rule redefines a round lot from 100-shares down to 40, 20, 10 or even 1-share increments, depending on the price of the stock.

Staff calculations show that odd-lot trades have grown from 15% of trades in 2014 to more than 55% of trades in March 2022.

In addition, Gensler cast doubt on whether the national best bid and offer (NBBO) “is a good measuring rod.” Retail investors receive slightly better prices from wholesalers based on the NBBO. Gensler noted that the NBBO only Includes what’s called round lots – quotes of 100 shares or more-when retail investors are most likely to trade in odd lots.

To close this gap in the NBBO, in June, Gensler said he also wants to accelerate including odd-lot quotes in the core market data that exchanges provide through the SIP (Securities Information Processor).

“In lit markets, investors see prices in one-penny increments. Wholesalers, though, can fill orders at sub-penny prices and without open competition,” said Gensler. “Retail investors who are likely to buy in odd-lots are unable to see the prices, (whereas) sophisticated folks can see the prices of odd lots more readily,” he said.

One sell-side head of market structure, speaking on the SFSTA panel, said that including sub-penny quotes could make it more difficult for buy-side institutions to trade stocks, and it might not lead to the intended outcome of driving more volume back to exchanges. “In a $250 name, somebody could now an institution with 40 or 10 shares, priced at one-tenth of a penny better than the best-bid-or-offer,” said the market structure executive. “That is a horrible outcome for clients. It completely disincentivizes utilizing the exchanges or posting aloud in names that are already having a tough time finding liquidity,” said the sell-side executive, who suggested the policy might result in institutions sending more orders to ATSs.

Saluzzi of Themis Trading agreed that certain ideas, like sub-penny executions, “posed dangers” to institutions. “While Gensler said that exchanges could compete with sub-penny price improvement,” Saluzzi said, “think of the jumping ahead that would occur.”   As an alternative, Saluzzi noted that Nasdaq and coalition of market participants proposed an “intelligent quote,” with a two-to-three-cent spread for small cap stocks.

Saluzzi also said the current SEC plan is “retail Reg NMS.” He added, “If there is market structure reform, let’s not forget the institutions, whether it’s the sub-penny tick and the Trade-At (rule) or the Grand Bargain,” referring to other issues such as tick-size reform and the impact of rebates on displayed liquidity that the industry and SEC has considered in the past. The Trade-At rule was part of the SEC’s Tick-Size Pilot Program, which studied the impact of wider tick sizes on about 1,200 small capitalization stocks. Exchanges pushed for including the Trade-At rule, which required brokers to route orders to public exchanges unless they could meaningfully better the price available in the public markets. The goal was to get more displayed liquidity on exchanges, and fewer orders routed to dark pools and other off-exchange platforms.

According to Wald, it is possible to allow sub-penny executions without sub-penny quoting on exchanges. (Currently, SEC Rule 612, introduced in 2005, prevents sub-penny quoting on exchanges.) “Today sub-penny executions are already occurring on non-displayed venues through wholesaler platforms or dark pools and print to the tape. However, what is unavailable and what we are supportive of, is at order entry, to place orders in sub-penny increments for execution on exchanges and ATSs,” he said.

Other plans outlined in the speech include developing an SEC-defined best execution rule instructing brokers deciding how to handle customer orders. Currently, the rule is from the Financial Industry Regulatory Authority (FINRA). Another SEC proposal is for retail brokers to file monthly transaction reports.

Retail Broker Reactions

Meanwhile, Gensler’s proposals have already received pushback from various sell-side market participants, who emphasized the need for economic cost benefit analysis and questioned whether the overhaul was necessary.

As reported in the Wall Street Journal, Dan Gallagher, chief legal of officer at Robinhood Financial Markets, who spoke at the same conference, insisted that retail investors were enjoying huge benefits, and suggested this was a solution in search of a problem. The Robinhood executive cited the benefit of zero-commission trading and “lightning fast” executions. But the WSJ pointed out that Robinhood relied on payment for order flow from order routing in equities, options, and cryptocurrencies, for about 72% of its revenues in the first quarter of 2021, based on SEC filings.

In the speech, delivered virtually at the Piper Sandler conference, Gensler said the agency staff would examine payment for order flow, which has been banned in the United Kingdom, Canada, and Australia.

PFOF’s Fate: Ban or No Ban?

When asked a question at the Piper Sandler event on whether the new market structure would prohibit payment-for-order flow or internalization, Gensler sidestepped the question. Instead, he said that PFOF poses “an inherent conflict of interest” for brokers, and that he has asked the staff for recommendations on how to mitigate the conflicts, as well rebates paid by exchanges.

Despite the regulator’s comments about PFOF, Saluzzi said the SEC chair “is not going ban payment for order flow because he knows he would be in the courts for years.” Rather than risk a legal challenge, Saluzzi said he thinks the SEC will be creative in recommending solutions. For example, the agency could require a central repository for midpoint prices. The SEC could require brokers “to check a midpoint price before routing to a market maker,” said Saluzzi.

In terms of introducing an auction, the focus of the SEC chair’s remarks was on retail orders interacting with other retail orders, said Saluzzi. As a broker executing institutional order flow, Saluzzi indicated that his firm would be interested in participating in such a pool. “I’d think you would see more people (participating) to tighten up the spreads,” said Saluzzi. “The question is, is there another model,” adding that he doesn’t think everyone will be in the same pool.

Wald said he thinks that zero-commission trading for retail investors is going to stay in this new market structure, and that having an incentive strategy for liquidity providers will happen.” Though it will “not (be) opaque, not overly complicated, and not an end-run around fair access,” he said, referring to PFOF rates and tiered-volume fee arrangements for exchange rebates that are not transparent today.  In terms of the new market structure, Wald said, “There is room for PFOF and exchange rebates in liquidity provisioning, but they should be disclosed on an order-by-order basis.”

Meanwhile, the brokerage industry is exploring alternatives to payment for order flow. On June 10, CNBC reported that Apex Clearing, a clearing firm for online brokers such as Sofi and Webull, is “quietly” building a marketplace for matching customer orders that would let exchanges compete with the two largest market makers.

Rich Repetto, a managing director and senior research analyst with Piper Sandler, who interviewed Gensler at the conference, told CNBC there could be other firms testing out innovations ahead of formal rulemaking that could “reduce the need for any changes.”

On the other hand, market participants expect market makers and retail brokers to fight the overhaul in a lengthy process with industry debate to play out.

In terms of next steps, Gensler said the SEC would publish its own set of rules for best execution and auctions for public notice with its own economic analysis. The SEC also said it would invite the public and market professionals to do the same, encouraging a lively debate.

Saluzzi suggested other ideas like a trade-at rule could resurface in the debate to help institutions drive more displayed liquidity to exchanges, and that data reform is another issue to bring up. “Proprietary data feeds are also huge revenue earner for the exchanges, but they reveal things about the institutions, such as if someone is using a slow algorithm,” he said. Smart subscribers who consume these feeds can take advantage of this data to trade ahead of institutions. For example, he said, IEX gives data feed updates by price level, but not order-by-order.

“The chair laid out his vision for a Reg NMS 2.0,” said Wald. “Ultimately, it is going to be a holistic revamp. The timing is right, the people will be different, and it is going to be better than a piecemeal approach,” he said. “If you push on one thing, something is going to come out the other side.”

Whether it ends up being “auctions, ATSs, or other solutions the industry comes up with, there’s no question that there’s a lot of room to improve our markets,” said Wald.