Not only does he want to “freshen up” Rule 10b5-1 (see this PubCo post), SEC Chair Gary Gensler has the same prescription for the rules governing the equity markets. In remarks yesterday at the Global Exchange and FinTech Conference, Gensler observed that “technology has changed how market makers interact, how trading platforms compete, how investors access those markets, and the economic incentives amongst these various market participants.” For example, a few years ago, retail investors weren’t even trading on commission-free brokerage apps. But the rules governing markets were “mostly adopted 16 years ago” and “do not fully reflect today’s technology.” Gensler believes that “it’s appropriate to look at ways to freshen up the SEC’s rules to ensure that our equity markets reflect our mission: to maintain fair, orderly, and efficient markets, while ensuring we protect investors and facilitate capital formation.” Gensler focused his remarks on segmentation and concentration in the equity markets, as well as two fairly recent developments: the rise of payment for order flow (and the related issue of best execution) and gamification. This is clearly an area in Gensler’s sweet spot—having conducted research and taught classes on the intersection of finance and technology—and his remarks were of interest even for those of us who do not typically focus on market structure issues.
Segmentation and concentration. Gensler began by identifying the three segments of our equity markets: “lit markets,” such as Nasdaq and the NYSE, are the markets that the public generally considers to be “the market,” but, for example, in January, the lit markets really accounted for only about 53% percent of trading volume. The other 47% of trading volume (in January) was executed on other markets—about 9% on alternative trading systems, also known as dark pools, and 38% mostly by about seven off-exchange wholesalers. When an ordinary retail investor places a small market order to buy shares on a brokerage platform, Gensler said, “more likely than not, it won’t be routed to Nasdaq or the New York Stock Exchange. A lot of people are surprised to learn that the vast majority of such orders go to these wholesalers.” While Exchange market makers compete against each other on each order to offer the best price, wholesalers have pricing advantages because they can price their order flow by reference to a “much less competitive benchmark,” the national best bid and offer (NBBO). He also noted that there is substantial concentration among off-exchange market makers, with one firm having stated that it executes nearly half of all retail volume. Gensler believes that market concentration can deter healthy competition, limit innovation and increase the possibility of system-wide risks.
Payment for order flow. Gensler identified two types of payments for order flow, both of which “raise questions about whether investors are getting best execution.” Payment for order flow for retail trades has received most of the attention, but there are also “rebates,” payments for order flow from exchanges to market makers and to brokers. Of course, brokers with these arrangements receive more payments for higher trading volume. What’s relatively new are zero-commission brokerages, which Gensler suggested, may not be as free as they appear to investors. According to Gensler, “payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict?” For example, he suggested, is there a tradeoff between payment for order flow and price improvement for customers, with the result that customers bear the costs of “inferior executions?” It’s “best execution,” he observed, “not just better execution.” In addition, he asked whether broker-dealers may be “incentivized to encourage customers to trade more frequently than is in those customers’ best interest?” Some countries, he noted, prohibit broker-dealers from sending retail orders to wholesalers in exchange for payments. He also questioned whether NBBO was an appropriate benchmark for best execution, given that almost half of the trading volume is executed in dark pools or by wholesalers, neither of which are reflected in the NBBO. He’s asked the staff to make recommendations on all these issues.
Gamification. Gamification and other “behavioral prompts” may be encouraging “investors to trade more, leading to more payment for order flow for the brokers. Some academic studies suggest, however, that more active trading or even day trading results in lower returns for the average trader.” Accordingly, Gensler has asked the staff to prepare a request for public comment on these issues.
Settlement cycles. Gensler believes that, by reducing the standard settlement cycle from T+2, we can lower costs and risks. “The good news is,” he said, “though it will take a lot of work, we now have the technology to further shorten the settlement cycles, not only to T+1, but even to same-day settlement—T+0 or “T+evening.”