(Bloomberg) -- The Securities and Exchange Commission is weighing changes to rules that, if adopted, could upend the structure of stock trading that’s been in place for years.
Most Read from Bloomberg
The possible changes, previewed by SEC Chair Gary Gensler in an attempt to increase competition, could directly impact how firms including Citadel Securities, Virtu Financial Inc. and Robinhood Markets Inc. process retail-trade orders. However, industry executives argue the existing market structure already benefits individual investors, citing the ability for brokerages to offer zero-commission trading.
We caught up with Larry Tabb, head of market structure research for Bloomberg Intelligence, for his take on the proposals. The following has been edited for length and clarity.
Q: SEC Chair Gensler has proposed a number of rule changes. What’s the big one?
A: The big one is order-by-order competition, and while he keeps things pretty nebulous in terms of what he wants to do, he’s really looking to try to have each retail order competed over. And what that means is, right now, self-directed retail orders go to a wholesaler, those wholesalers are allowed to internalize that order -- basically trade it within their order book without sending it to an exchange -- and use the best prices that are provided as a guide to how they get executed. The execution has to be at or better than the best price displayed in the marketplace at that point in time. And what he wants to do is have each and every order basically get auctioned off. It’s not known whether he means it be sent away to a live order book where there are bids and offers, or whether he really means auctions. He has mentioned the price-improvement process that happens for options. And so what that means is when you send your order in for 100 shares of XYZ, there’s an auction process that says, “Hey look, anybody want to buy this or sell into this order for XYZ?” You’ve got a limited amount of time -- whether that’s a millisecond or five milliseconds or a microsecond -- and you can respond and bid for that order.
What that does is, while it sounds perfectly sound and logical, it breaks down this whole idea of how retail brokers send their orders to wholesalers and how they execute those orders. And it really will depend upon how the rules are written to better understand the impact. It could be that retail brokers could still send their orders to wholesalers and wholesalers could then route those orders to the market, or it could go further and force the retail brokers to send these orders directly to exchanges. And we’ll have to wait for the rules to come out on that. But that is very controversial because the retail broker manages its order flow with wholesalers kind of holistically. It looks at all its clients overall. If all of a sudden the orders went to an exchange on a one-by-one basis and got auctioned off, then what would probably happen would be the more liquid and more in-demand securities would have the most competition and they may or may not be priced as well as they currently are. But the ones that are less in demand, the question is what would happen to them? Would they get better pricing than they do today or worse, as well as what are the economics? Right now, the retail brokers get paid for their orders and the question is does the economic model hold? Will the exchanges basically rebate the brokers for these orders, and if they don’t, then that may impact the free commissions or how much money the brokers can make sending all this order flow.
Q: Can you give me a simple analogy of how this new process might work?
Let’s just say there are five convenience stores on the block and you want to go in to buy milk. Currently, you go into one of those stores and that store would have to check the other four stores and make sure it sells you milk at or better than the price that the other four are offering. On the other side, under the new rule, the client would come out and say, “Hey, look, I want to buy a gallon of milk,” and then all five of those stores would have to shout out their best price. Now you also have to think that the person walking up to the store may not necessarily be buying milk, but may be selling milk. So the question would be do the stores actually want to buy that milk instead of sell it? I’m sure all those guys would want to sell it if they can handle the inventory. The question is what are they willing to buy it for? Somebody could walk up with a pint or a quart of milk and force the convenience stores to buy it.
Q: Does this hurt the retail investor?
It may. A lot of it will depend upon what new structures develop. First of all, these were only broad outlines and calls for his staff to investigate, so we don’t know what the final rules will be. Depending upon what the rules are, the impact could be nebulous to pretty significant, so it’s really too soon to ascertain if this is going to be good or bad. There are parts that virtually every group would not be happy about if all these rules were implemented as they were proposed or rumored.
Q: Why do you think they’re doing this?
A: Because the current process, even though it’s actually pretty efficient, retail investors in April captured about 47% of half the spread. You measure spread from the midpoint, so retail investors through the current process captured 47% of that, which is a lot. The question is will they be able to do as well on an order-by-order competition given that competition for orders will be at the most liquid products, and retail investors trade more than just liquid products. Currently, because the wholesaler is trying to provide service to the retail broker, they try to improve the pricing of all the orders they get sent, not just the Teslas and the Twitters and the Apples of the world, but symbol 11,002. In April, retail investors traded 13,000 symbols, and certainly for the top 50, 100 or even 200 there will be adequate institutional and other retail demand for those symbols, so the pricing on those orders may be pretty good. The question is what happens when you get to 5,000, 10,000, 13,000. The symbol is way down the list.
Q: Does this mean brokers have to develop new business models now?
A: It depends on how the rules are written. If payment for order flow (PFOF) goes away, yeah, they’ll have to develop new business models. If payment for order flow migrates from the wholesaler to the exchange, then maybe not. So if the exchanges pay the retail brokers via rebates, then the economics may look pretty similar. Depending upon whether the brokers have to send orders to the exchanges directly, that could very much impact wholesalers’ business model via spread and access fee cuts. And so these rules, if implemented in the most stringent mechanisms, would impact pretty much everybody -- investors, brokers, wholesalers, exchanges, alternative trading systems, all sorts of people.
Q: What would the PFOF rules mean for the stock market?
A: He didn’t really call on banning PFOF. He talked about looking at access fees and issues, which would then impact the economics of PFOF. And depending upon whether brokers route these orders directly to exchanges and what the fee structure with exchanges are, it could have a tremendous impact on PFOF. The access fee at exchanges to take liquidity is 30 cents per 100 share, or 0.3 cents per share. If that goes down to 0.1 or 0.5, yes, that only impacts when you take liquidity -- but most of that fee goes to creating rebates. So if you reduce the 0.3 to, let’s just say, 0.1, there’s less money to provide rebates. That would then basically reduce available money for the exchanges to pay the brokers for the orders. While a number of these structures don’t necessarily say, “Oh, we’re going to ban you from paying PFOF,” what they do do is impact the economics of the execution process, which means there will be more money in investors’ pockets and less money in intermediary’s pockets. Now, some of that money that goes into the intermediary’s pockets winds up as incentives for more aggressive pricing. So all of this stuff is tightly knit together.
Most Read from Bloomberg Businessweek
©2022 Bloomberg L.P.