The meme-stock frenzy of 2021 focused the public’s attention on market structure with unprecedented intensity.
Flush with COVID stimulus funds and hemmed indoors by pandemic restrictions, Americans took advantage of no-commission trading services like Robinhood HOOD, +2.67% to gobble up high-flying stocks made famous on social media.
It was a wild ride, until the intensity of the frenzy became its undoing. The unprecedented volume of buy orders for shares of GameStop GME, +1.50% and other meme shares forced brokers to cut off customers, leading to widespread outrage and intense scrutiny of the plumbing of U.S. financial markets.
U.S. Securities and Exchange Commission Chairman Gary Gensler has used the meme-stock saga to illustrate some of the challenges retail traders face in today’s market, which he said in a December statement are not “as fair and competitive as possible for…everyday retail investors” because of a lack of a level playing field between market makers, stock exchanges and other trading venues.
“Right now, a concentrated group of wholesalers earns significant revenues from this market,” Gensler added. “They’re willing to pay for this order flow, but… investors may not be getting the benefit of full competition in this market.”
His solution is to force stock brokers to submit individual orders to an auction, where market participants would compete to fill a trader’s order at the best possible price, but some investor-protection advocates are wary that Gensler’s solution could end up hurting retail traders in the end.
Payment for order flow
“Retail trading has never been cheaper than it is today, by far,” Christopher Schwarz, professor of finance at the Paul Merage School of Business, told MarketWatch. “There’s a lot of downside risks here and unknowns” to embarking on the sort of fundamental reforms that Gensler and the SEC are envisioning, he added.
Schwarz has particular expertise in what is known as payment-for-order flow (PFOF), a practice whereby market wholesalers like Citadel Securities and Virtu Financial Inc. VIRT, +0.16% pay stock brokers for the privilege of executing market orders. These firms earn money on the spread between the price at which they will buy and sell a particular security.
PFOF is eyed suspiciously by some in the financial world in an era of zero-commission trading, and Gensler himself has complained that it creates a conflict of interest between a broker, who is ostensibly serving his client but sometimes earning a large share of its revenue from market-maker payments.
Schwarz’s research into PFOF, however, revealed some counterintuitive results. He compared the execution quality of six different brokerage accounts through 85,000 market orders. He says he was surprised to find that the brokerage that gave the best prices, TD Ameritrade, took payment for order flow, while Fidelity FNF, -0.06%, which offered the worst prices, did not.
“Picking your broker actually matters, but we can say certainly say it doesn’t seem to matter whether they accept PFOF,” Schwarz said.
New auctions
Tyler Gellasch, president and CEO of Healthy Markets Association, has long been an advocate for the sort of market reforms that the SEC proposed in December, but he declined to support the retail order auction proposal in a comment letter submitted to the SEC last week.
He instead argues that the SEC should focus on adopting rules that simply require brokers to get the best prices possible for their customers, without taking into account fees or rebates paid to them by market makers or exchanges.
If the SEC can strengthen these so-called “best execution” rules, Gellasch wrote, “this new, exceedingly complex apparatus…should be unnecessary.”
The North American Securities Administrators Association, which represents state securities regulators and advocates for investor protection, took a similarly skeptical stance in its comment letter submitted Friday.
Andrew Hartnett, NASAA president, wrote that while he supports cultivation of more competition for retail orders, the SEC should consider whether these auctions could create opportunities for market manipulation or fail during times of market stress.
“Liquidity can vanish unexpectedly in times of extraordinary market stress and market participants can withdraw from the market in the face of uncertain trading conditions,” he wrote, adding that order-by-order auctions in times of stress could lead to retail traders getting worse prices.
The Winner’s Curse
There are also concerns that the design of the auctions, as proposed by the SEC, could lead to worse prices for retail investors.
Thomas Ernst, who teaches finance at the Robert H. Smith school of business authored a paper published last month with former SEC Chief Economist Chester Spatt arguing that such auctions could lead to a “winner’s curse” that could lead to worse prices for retail investors.
Currently, brokers route orders to market makers based in part on how cheaply they have filled orders in the past, Ernst said, while the SEC proposal would require brokers to submit each individual order to a competitive market process.
“These auctions are actually less competitive than the current system,” Ernst said. because market makers and exchanges would worry that they have less information about the order than their competitor, and therefore bid more conservatively.
“The winner’s curse is if you win the auction, it means that everyone else thought that you bid too aggressively,” he said.
The path forward
Despite these concerns, many investor protection advocates support the auction proposal, and the SEC has received thousands of letters in support of it and other proposed reforms from individual investors.
“The SEC is attempting to solve basic problems that have hurt retail traders significantly over time,” Stephen Hall, of the financial-reform group Better Markets told MarketWatch. “The bottom line is they’re not getting the best prices. It stands to benefit everybody except the wholesalers who have been taking advantage of the status quo.”
Whether or not the SEC moves forward with the order-by-order auction proposal as currently constructed, a study of comments submitted to the agency reveal deep anger at the current system and specifically at market makers who have reaped record profits in recent years.
We The Investors (WTI), a retail investor advocacy group, organized more than 2,600 submissions of a letter in support of Gensler’s broader attempts to overhaul financial market structure.
WTI advocates for a system modeled on Canada’s that would force the vast majority of trades on stock exchanges rather than market makers, but would prefer the SEC proposal to the status quo.
The SEC has a tall task ahead of it studying the thousands of comment letters on proposed changes that would mark the most significant overhaul to the U.S. financial system in nearly twenty years.
The SEC will take time to thoroughly examine these comments, according to Better Market’s Hall. Rule changes of this magnitude can take years, the SEC may decide to significantly revise the rule proposal before voting to adopt it, and there is no set timetable for when any of these steps will occur.
“They are clearly going to need a significant amount of time, because they have a lot of comments to digest and they are under an obligation to consider them as they refine the proposal and come to a final rule,” Hall said.