What are the top market structure issues for sell-side firms in 2023? With the new year off to a fast start, brokerage firms are watching a variety of evolving issues that could affect their trading businesses. On the horizon are SEC proposed regulations to reform U.S. equity trading, increased best execution obligations, artificial intelligence, innovations in ATSs, 24-hour trading, and shortening the settlement cycle to T+1.
At the top of the agenda are the SEC’s proposals for overhauling equity trading rules which contain sweeping reforms that if enacted, will impact retail brokers and electronic market-market makers, and potentially shift certain retail orders to exchanges.
On Dec. 14, the SEC voted to approve four proposals governing U.S. stock trading including an SEC best execution regulatory framework, mandatory open auctions for certain retail orders, amendments to adopt variable tick-size reforms and reduce access fee caps, and increased disclosure requirements for brokers.
“The regulatory environment is probably the hot button topic right now and the biggest concern from a business perspective,” said the CEO of an institutional options trading firm, speaking on a sell-side panel about electronic trading at the Securities Traders Association (STA) annual market structure conference in Washington, DC.
Industry participants on the buy-and-sell sides, as well as retail investors, academics, and the public, are expected to submit comment letters. The rules are open for public comment until March 31, 2023. Final rules are expected in late 2023, but any changes would take many years to implement.
“There is a lot of uncertainty right now from a regulatory perspective,” said the CEO of a proprietary options trading firm, also speaking on an STA panel, who said he is worried about unintended consequences.
Reacting to the proposals, a Fitch Ratings report concluded that if adopted, the proposals would favor exchanges over brokers,” particularly those that engage in wholesaling and off-exchange market making.”
While some market participants are expected to fight the proposals, request more cost/benefit analysis, or even file lawsuits, the spotlight is falling on protecting retail investors whose orders are mainly executed by OTC market makers.
“Data analysis suggests that opening up individual investor orders to order-by-order competition would lead to significantly better prices for those investors,” states the SEC rule. . SEC economists estimate that $1.5 billion in cost savings is being lost due to “competitive shortfall,” states the SEC’s Order Competition Rule
However, some participants want to see the SEC address market structure issues such as tick-size reforms, along with the need to narrow spreads and reduce access fee caps which have been debated since 2015.
To increase transparency into retail order handling and scrutinize execution quality, the SEC proposed its own best-execution framework.
At STA, sell-side firms discussed the SEC’s plan for a best execution framework, questioning how an SEC best execution rule would work with the existing FINRA rule on best execution.
If a more stringent best execution framework is implemented, this could compel brokers to turn to more data-driven analysis to measure execution quality.
“It’s always going to be an arms race. The key is to have a platform where we can measure. The concept of (algo) wheels comes up,” said a bulge bracket trading executive at STA.
2023 is shaping up to be a year of increased competition for order flow and using advanced technologies such as algo wheels to select broker algos and measure performance.
“We realize we’re going to be judged on execution quality on every order. The only way to compete is to be able to do experiments,” said the sell-side trading executive citing the ability to run A/B testing – randomly assigning similar orders to different broker algorithms and then measuring them. “Whether it’s a new order type, or a new venue, you need to be able to measure each part of the value chain.”
On the institutional side, brokerage firms are keeping an eye on the changing liquidity landscape for institutional clients, and how new venues are innovating with technology.
Since the pandemic, liquidity has decreased at the top-of-book and depth-of-book on exchanges, said a sell-side trading executive at STA. While trading costs have come down consistently since 2005, that has changed in the last three years. “For the passive traders, it’s probably become a much better environment in equities, but for the liquidity seeking folks, it’s become more challenging, so they are using innovative order types,” said the sell-side trading executive.
“A lot of the innovation in the US execution space has been protective. You’ve got places like IntellgentCross ATS, Trajectory Crossing with PureStream ATS, and IEX (which offers its D-Limit order type), so innovation has grown around protection,” said the sell-side trading executive at STA.
In a crowded field of alternative trading systems and exchanges, ATS operators at STA said they continue to innovate and explain their value proposition to the brokers.
Starting in 2018, IntelligentCross has climbed to No.3 among ATSs tracked by the Financial Industry Regulatory Authority (FINRA). The firm uses AI to optimize price discovery and price stability after trades occur, notes its web site.
A key innovation is that IntelligentCross offers a choice to brokers of either posting non-displayed or displayed quotes like an exchange. It started a midpoint cross to address market impact associated with larger orders, which delivers 80% lower market impact than exchange midpoint averages, notes its web site. The firm’s near-continuous limit order book allows broker algos to display bids and offers, resulting in 1.5 basis points (bps)lower adverse selection than maker-taker exchanges, states the web site.
“Not surprisingly, orders that display experience 2-3 times the hit rate because they are attracting order flow coming in rather than the dark orders,” said Roman Ginis, CEO of Imperative Execution, which operates the AI-driven equity venues, who spoke on the panel.
In 2021, PureStream Trading Technologies launched a U.S. equity trading venue that algorithmically matches orders against streaming block liquidity. “There is more liquidity over an interval of volume. Every venue that exists now is a point in time-based market structure,” said Armando Diaz, CEO of PureStream on the ATS panel.
In a market where liquidity has become fragmented, PureStream is a tool that brokers deploy in their algo suites to match buy-side orders over an interval of volume. Rather than referencing the NBBO, the ATS references every trade that hits the tape. Another distinguishing feature is that PureStream matches orders based on a percentage rate, which lets the broker algo scale up its volume. “The need to trade point in time is not going away. But the advantages of being able to stream over an interval of volume is valuable,” said Diaz.
Meanwhile, new venues and order types keep entering the ATS ecosystem.
Venues like CBOE Global Markets began offering a periodic auctions order type in the U.S. last April, and OneChronos Markets LLC launched a new ATS in June, letting institutional investors bid for stocks through automated auctions in what’s known as “expressive bidding,” reported Bloomberg News.
AI & Machine Learning
2023 will be a year in which artificial intelligence is playing a role on sell-side trading desks to increase efficiency or performance. While AI has been a buzzword in the industry, many people define it differently. Panelists at STA said it could apply to the entire market infrastructure, but not to get hung up on definitions.
Firms are working with more precise terms such as machine learning and neural networks, though even that can be complicated. Several panelists at STA said they are working with machine learning to improve the performance of benchmark-style algorithms.
A fintech provider of algorithmic trading systems said the firm invested in a two-year R&D project using deep reinforcement learning to improve the performance of its VWAP and POV schedule-style algorithms. The results were robust, and it improved performance in the range of 33-50%.
One industry participant suggested the sell-side ought to leverage AI in smaller ways, whether for benchmark algos, or to define logic around order handling for open and closed auctions and participation rates there. “It doesn’t have to be a new algorithm or new product.”
Sell-side firms advised others to focus on what they can measure in the context of efficiency and performance. An institutional broker had success focusing on using AI for sourcing dark liquidity in other regions “We’ve had a neural network the initial results are quite promising. We are redeploying models used elsewhere in the US market and we’ll see how it ends up,” said the trading executive for a bulge bracket firm.
With 24-hour trading offered as a feature of cryptocurrency markets, retail brokerage firms said they expect round the clock trading to materialize in U.S. stocks within the next five years.
“The idea that the market is closed at a specific time is foreign to a lot of our new investors. They see crypto as the ideal sort of exchange, and the ideal sort of setup, with instantaneous settlement,” said Anthony Denier, CEO of Webull on a panel at STA.
Another factor to watch is the growing gig economy, where people work at night and want to trade at their convenience. Of Robinhood’s 23 million customers, 70% of people do their research or education in off hours, said Steve Quirk, chief brokerage officer on a panel STA. “There’s a lot of people who work odd hours in the gig economy. The notion that they need to figure out a time to trade or invest, is odd to them,” he said.
CBOE Global Markets has seen demand for 24-hour trading increase. “Our first foray is extending the trading hours in our proprietary index complex – options on the S&P 500 index and the VIX,” said Ed Tilly, CEO of CBOE on a panel. “I don’t even think it will be five years that customers will be able to represent their opinions around the clock,” said Tilly.
In October 2021, Blue Ocean Technologies launched an ATS for overnight trading, matching trades when U.S. stock exchanges close from 8 pm to 4 am ET. Partnering with retail and institutional broker-dealers, Blue Ocean gives Asian retail investors access to U.S. stocks during their day-time hours. In 2023, the ATS plans to extend its hours of operation into the U.S. pre-market and after-hours trading sessions, reported Traders Magazine.
However, panelists questioned whether there is enough demand for 24-hour trading from institutional customers in options and if market makers could support liquidity in 1.5 million options instruments. Firms will need to deal with the operational demands of longer hours, staffing desks, risk management, clearing, and strains on systems.
“It is a challenge. You must build the right infrastructure to follow the sun and have people in local markets to answer time-zone specific questions,” said a market making executive that runs a 24-hour business in FX and futures.
Dmitri Galinov, founder and CEO of 24Exchange, pointed out that FX trades around the clock five days a week, starting on Sunday night and ending on Friday evening. “It’s not a big deal,” said Galinov, speaking on the digital assets panel. Currently, the multi-asset platform trades FX, cryptocurrencies, and cryptocurrency derivatives, and has filed with the SEC to register as a U.S. stock exchange.
Webull’s Denier said his firm’s customers will demand 24/7 for all assets across the board. “When it will happen will depend on when the infrastructure, support personnel, and settlement are ready,” said Webull’s Denier. “We are working with the Blue Oceans of this world and 24Exchanges of this world to make sure that our customers can access that sort of experience of trading all day, all night whenever they like,” said Denier.
Moving Forward with T+1
Another regulatory change on the agenda for broker-dealers in 2023 is shortening the settlement cycle to T+1.
Last February, the SEC voted to propose rule changes to shorten the clearance and settlement process for U.S. equities from T+2, two days after the trade date, to T+1, one day after the trade date. Market participants including institutional asset manager and asset owners such as pension funds support the change which will reduce credit, market, and liquidity risks for U.S. market participants and investors.
According to the SEC’s proposal, the change would be implemented by March 31, 2024. (Some industry groups have requested a delay until Sept. 3, 2024, after the Labor Day weekend because Canada’s markets are migrating to T+1 around the same time.) But industry stakeholders are awaiting the SEC’s final rule to know when the exact transition date for T+1 will be, reported Pensions & Investments. “It’s hard to set a testing schedule when you don’t know the implementation date,” an Investment Company Institute executive told P&I.
In August, DTCC and other industry bodies published an industry implementation playbook outlining what a one-day settlement period would look like for the brokerage industry, proposing a two-year plan to move settlement to T+1, one day after the trade is executed.
But the shift to T+1 is not as simple as “changing the drop-down menu,” said a third-party vendor at STA. Shortening the settlement cycle “could lead to a drive for more automation between the middle office and front office, where there is less time to resolve exceptions,” said the third-party vendor.
According to the SEC, the change will require broker dealers to process trade affirmations and confirmations as soon as technologically practicable on T+0.
As broker-dealers plan for 2023, there are many issues to watch, ranging from the SEC’s market structure rule proposals, to thinking about how to position their firms for 24-hour trading, or how to take advantage of the latest innovations from ATSs. It’s too early to predict what will happen, but time will tell how these market trends evolve.