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Introduction
There are concrete explicit ways the private sector could improve the structure of securities markets. More SEC rulemaking is not the answer. The SEC’s approach to a fix – banning this and that – will only lead to another goat rodeo like the existing National Market System (NMS).
Moreover, private sector changes bring a built-in guarantee that the consequences of the change will better traders’ lot. If a private-sector change is not constructive, lack of profitability marginalizes it. Public sector changes, on the other hand, are not inhibited by the possibility of loss. The current collection of fifteen securities exchanges stands in mute testimony to the excessive cost of well-meaning regulatory mistakes.
The financial futures market structure is a better way to organize transactions in use right now. No innovations are needed. Modification of financial futures’ market structure to conform to spot market needs would improve the spot securities market structure. And a futures-like system for spot securities trading is both initiative-taking and not coercive.
The SEC agenda
The SEC has axing Payment for Order Flow (PFOF) at the top of its to-do list. Gary Gensler, chair of the Securities and Exchange Commission, said on Wednesday, June 5th that he had asked the agency’s staff to make recommendations to amend a host of market structure rules. Read about the Gensler speech here.
PFOF is wholesale broker-dealers’ payment to retail brokers in return for wholesaler access to retail orders. PFOF has enabled retail brokers to profitably eliminate commissions charged to retail customers. Zero commissions attract retail investors since without them trading appears to be free. But PFOF disguises a higher cost of retail trading. Commissions would better serve retail than does PFOF.
The flow of retail transactions is valuable to wholesalers because they profit by executing retail trades at an off-market price. Wholesalers then capture arbitrage profit by accessing a better price in the wholesale market.
In other words, the profitability of PFOF is proof that retail traders lose more paying an above-market price for their investments than they save from free commissions.
Can retail investors get fair treatment from Wall Street on market structure issues?
The SEC’s ongoing investigation of securities market structure is an excellent opportunity for those who seek to further the interests of retail investors to provide the outline of a new market structure that would better reflect retail investors’ needs.
But nobody is presently representing retail investors’ interest while the new structure of payments to execute retail transactions is determined.
Retail brokers no longer represent retail investors. One logical source of retail investor advocacy is retail brokers like Robinhood. Robinhood (HOOD), a brokerage firm once beholden to retail investors for its profits, is now beholden to a few wholesalers (Citadel, Virtu, others) for PFOF that replaced commissions in Robinhood’s bottom line.
Robinhood tells us a fundamental truth “…our values [Robinhood’s] are in service of our customers.”
Left unsaid is a more fundamental truth. Robinhood’s customers are no longer retail investors. Now their customers are a few large wholesalers that make much of their income from arbitrage of retail orders against the orders of other wholesale market participants. Retail investor orders are Robinhood’s product, not their customer.
Any profit-making firm will inevitably represent profit-making stakeholders, so Robinhood is not to be blamed for leaving retail in the lurch.
What is wrong with the current securities market structure?
Market structure has changed dramatically since the SEC introduced the NMS in 2005. The SEC’s objective with the NMS rules was to assure that investors receive the best price execution for their orders by encouraging competition in the marketplace. But the SEC’s NMS rules have had serious adverse unintended consequences. Thus, the current SEC search for market structure improvements.
The key market failures of NMS in 2021
The SEC staff study “Staff Report on Equity and Options Market Structure Conditions in Early 2021,” details the weaknesses of the NMS, as revealed during the 2021 meme stock fiasco.
Retail order exploitation. Brokers route 90-plus percent of retail marketable orders to a small, concentrated group of wholesalers that pay for this retail market order flow. The execution of retail orders by off-exchange market makers is compelling evidence that individual investors are subject to hidden costs and conflicts of interest.
Margin calls in volatile markets. On January 27, 2021, in response to market activity during the trading session, National Securities Clearing Corporation (NSCC) made intraday margin calls from 36 clearing members totaling $6.9 billion. Some broker-dealers restricted activities in a limited number of individual stocks in reaction to margin calls and capital charges imposed by NSCC. This was a decision made by the broker-dealers and not directed by NSCC.
Payment for order flow. The ability of a small number of off-exchange market makers to trade profitably with retail order flow has led these market makers to negotiate agreements with retail broker-dealers to secure rights to this order flow. The execution of retail orders by off-exchange market makers raises further questions about whether individual investors may still be subject to other less conspicuous costs and conflicts of interest.
Short squeezes. The potential of “buy-to–cover” volume to increase share prices, thus leading to further buys to cover is often referred to as a “short squeeze.” A short squeeze might occur when an event triggers short-sellers en masse to purchase shares to cover their short positions. For example, if there is a sudden increase in the price of the stock being shorted, short sellers would face margin calls requiring them either to post additional collateral or to exit their position. Short sellers that cover their positions by buying the underlying stock would cause additional upward price pressure on the stock, which could force other short sellers to exit their positions, adding further upward price pressure. The result might be dangerous market instability.
How futures markets prevent each kind of NMS failure
Retail order exploitation. The exchange clearinghouse controls financial futures volume. Any wholesale trader competes for retail orders on the same level playing field as the rest of the market. A similar SEC plan to somehow require wholesalers to compete for each retail order in securities trading would be stupefyingly complicated in the securities markets with fifteen separate exchanges.
Margin calls in volatile markets. Unlike spot securities markets, the clearinghouse easily adjusts futures margins when clearinghouse officials perceive an increase in market volatility.
Payment for order flow. Wholesaler payment to the clearinghouse for retail order flow is not possible since a futures contract does not exist until a futures transaction creates it.
Short squeezes. Seller open interest in a futures market is always equal to the number of buyers, limiting short interest. The potential for a short squeeze exists only in futures delivery where the settlement instrument is issued by a not-for-profit such as the US Treasury. Otherwise, the profit motive assures sufficient issuance of a deliverable security.
How to incorporate futures technology into securities trading
Adaptation of futures market structure to spot securities trading assures elimination of the market structure problems bared by the GameStop fiasco. But innovators could build a much better market structure by adding these innovations to a new exchange.
Originate spot instruments. The listing and trading of different versions of securities traded in the NMS are how the futures markets gain superior control of trading and market access. This system eliminates:
- High-frequency trading.
- Intermarket direct arbitrage.
- Payments for order flow.
Use a futures-style clearinghouse. The powerful advantage of futures trading in market risk management is the result of the futures market-clearing method. From the use of a futures clearing method, the new kind of marketplace would gain:
- Instantaneous zero-cost clearing.
- Margins that adjust with changes in anticipated price volatility.
- Exchange custody of customer and house margins.
An exchange portfolio manager. The point of this innovation is to further assure market safety and to enable the exchange to modify traded instruments to better meet the needs of its retail investor constituency.
A captive exchange broker-dealer. This addition achieves two improvements.
- Assurance that the transactions on the new exchange are inside the National Best Bid and Offer (NBBO).
- Exchange capacity to make PFOF in competition with wholesalers.
Conclusion
The first requirement of any change to the NMS is to do no harm. This means that instead of new rules to adjust the NMS, any change should be a private-sector system that competes with the NMS. There is already a private-sector structure that competes with the NMS – the financial futures markets.
Notably, financial futures exhibit none of the problems observed following the Meme stock fiasco. In addition, the proposals above would adapt futures trading technologies to the needs of securities markets.
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