OVERVIEW
For questions on the note below, please contact Daniel Austin or Edmund Perry at (202) 547-3035.
Today, the Securities and Exchange Commission (SEC or Commission) held a meeting of its Investor Advisory Committee (IAC or Committee). The meeting also included a panel discussion on 10b5-1 plans and presentation of IAC subcommittee reports, but they are not included within the scope of this note.
Key Takeaways
- SEC Chairman Gary Gensler and Commissioner Caroline Crenshaw said that payment for order flow (PFOF) can create conflicts of interest for brokers and noted that multiple jurisdictions around the world have banned the practice. Gensler noted that brokers are obligated to seek the best possible execution, not simply better execution than is available on an exchange. Both Gensler and Crenshaw said that there is a need for additional transparency and improvements to 605 disclosures so that investors have a better understanding whether they are receiving best execution.
- Sal Arnuk, Themis Trading LLC, Former SEC Commissioner Paul Atkins, and Gensler said that the National Best Bid and Offer (NBBO) is not a complete representation of the market because it does not incorporate trading in dark pools or trading internalized by wholesalers. Gensler said that the NBBO is also priced only by penny increments, so it is not narrow.
- Atkins explained that Reg NMS disperses liquidity, drives trading off of exchanges, and only focuses on price when considering best execution, leading brokers to prioritize price over the needs and preferences of customers. He encouraged the SEC to take a comprehensive look at Reg NMS and the overall equity market structure in a rule-making process.
- Stanislav Dolgopolov, Decimus, said Enhanced PFOF disclosures are likely the most promising path to a more equitable market. He added that reforming the tick-size regime could push more trading on-exchange.
- In discussing PFOF, Bloomberg’s Larry Tabb said that if retail brokers did not route to wholesalers, they would need to build out trading desks which would be expensive and create new conflicts. He said the most important regulatory changes would be to increase transparency by altering 605 reports so customers know their execution quality, improve the odd-lot process, tighten spreads, and make best execution more demonstrable.
- Commissioner Hester Peirce and Virtu Financial CEO Doug Cifu said that best execution is a complex issue, and PFOF does offer better prices and enables commission-free trading to investors. Cifu said that, although the NBBO is a limited representation of the market, wholesalers still offer significant price and size improvements over exchanges when other factors (odd lots orders and short sales) are considered.
SUMMARY
Opening Statements
Chairman Gary Gensler
Broker-dealers are obligated to seek the best execution, not better execution. Multiple jurisdictions have banned PFOF because of best execution requirements; price improvement is not necessarily best execution. The NBBO is not a complete enough representation of the market. The SEC tried to address this in the infrastructure rule, but half of trading is in dark pools or internalized by wholesalers, which are not incorporated into the NBBO. Most retail orders are in these dark pools. The NBBO is also priced only by penny increments, so it is not narrow.
Commissioner Hester Peirce
Best execution is a nuanced topic with many complexities. It is not a one-sized-fits-all issue. Retail investors may care only about cost of transactions, but institutional investors have different priorities. Exchange rebates present similar conflicts to PFOF. PFOF does, however, lower broker costs for investors.
Commissioner Caroline Crenshaw
Following the GameStop event, we must investigate our current equity market structure, which is undermined by conflicts of interest and may result in less investor confidence. Customer-facing and wholesale broker-dealers have incentives to route orders in ways that are not consistent with best interest regulations. The public should have all the data necessary to determine that routing is done in their best interest. There should be clear and specific guidance for how brokers pursue best execution.
Investment advisors also have the responsibility of best execution, and we should study if there are changes needed to this rule. Trading has been moving increasingly off-exchange, and nearly all retail order flow is executed by wholesale brokers, which could have negative effects on price discovery.
Panel Discussion Regarding Best Execution and Its Role in Post-NMS Market Structure
Paul Atkins, Former SEC Commissioner
Individual investors today get sophisticated execution quality at low costs that are typically better than listing prices, but improvements are possible. There are still emerging and evolving markets, and the SEC should not be overly quick to create new rules to fix perceived ills. Reg NMS disperses liquidity and drives trading off of exchanges. Reg NMS only focuses on price when considering best execution, leading brokers to prioritize price over the needs and preferences of customers.
The NBBO is a flawed standard and should not be used as the benchmark for market positions and should not be applied to retail orders that do not go to exchanges. The SEC must investigate what concentration is doing to the equity market. The SEC should take a comprehensive look at Reg NMS and the overall equity market structure in a rule-making process.
Sal Arnuk, Partner & Co-Founder, Themis Trading LLC
Best execution is an ever-evolving concept, and it applies differently to retail investors than it does to institutional orders. The NBBO is shallow and does not account for many market prices because so much trading takes place off-exchange. Exchanges make massive amounts of money selling speed and access. The best way to regulate fairness is to eliminate all conflicts of interest where possible, and PFOF should be banned. We should have a natural state of supply and demand in equity markets, not complex and nuanced rule-making.
Tyler Gellasch, Executive Director, Healthy Markets Association
It is easier to trade complex financial instruments than ever before, and there are fewer explict prices than ever. We are seeing extremely volatile price changes disconnected from business values. Order routing incentives pit brokers’ best execution obligations directly against their own profit-making incentives. Investors only defense is best execution, and they deserve disclosures that allow them to see whether or not they receive best execution.
Daniel Gray, Senior Special Counsel for Market Structure, Division of Trading and Markets, SEC
Brokers have increased PFOF rates and customer prices have suffered as a result. Customers sometimes lose more in PFOF tradeoffs than they would have paid in a commission fee. Brokers have very different internal policies regarding PFOF, and many are not influenced by conflicting incentives.
Chester Spatt, PhD, former Chief Economist at the SEC, and Professor of Economics at Carnegie-Mellon
The ambiguity in the regulatory definition of best execution makes it difficult for market participants to internalize their responsibilities. Reg NMS facilitated electronic execution but is now being abused by many exchanges. The trade-through rule could improve routing, but trade-through restrictions could also increase execution costs for larger investors. The SEC should consider banning pricing tiers for rebates and should implement much stronger disclosure requirements.
Open Discussion – Moderator: JW Verret, Associate Professor, Antonin Scalia Law School
Verrett: How should the SEC improve PFOF disclosures? Gellasch: When a broker makes an order routing decision, they do not have certainty on the fee or rebate they receive for that order. If you trade at the start of the month, you may not know until the end of that month what you are being paid, so that information does not come through to customers in a timely way. There should be complete transparency on prices and rebates at the time that trades are made, but this would require revising how fees and rebates go into effect, making them prospective only; Arnuk: When we legislate specifically instead of through principle, we create larger problems. Customers want a cost-agnostic, trustworthy broker. We should alter the system to remove conflicts of interest.
Verrett: Is there a negotiation window for discussions about trade-throughs and the conflicts of interest regarding rebates? Should we adopt the Canadian system for trade-throughs, and should we eliminate PFOF and rebates? Gellasch: It makes no sense that we have a duty of best execution; exchanges are sometimes required to route orders to competitors. When we talk about eliminating the Order Protection Rule, the duty falls on investors to understand how to protect themselves. This disadvantages retail investors; Arnuk: Some markets without PFOF are functioning better than ours; Atkins: Best execution should be principles-based. Banning PFOF could just lead to some other concept more damaging.
Jennifer Marietta-Westberg, Cornerstone Research: If the Commission needs to acquire more information, do they have access to it? Spatt: The SEC can do a better job at facilitating access to market data for the academic community. The tiering of rebates exacerbates all of these issues and academics have no access to the relevant data; Gellasch: Customized pricing tiers seems inconsistent with the Exchange Act. The SEC should increase transparency on this issue.
Ted Daniels, Society for Financial Education and Professor Development: What do brokers think about conflicts of interest and best execution? Gellasch: It depends on which brokers you ask, but it is clear that brokers are making decisions on whether to pass money to clients or keep it for themselves; Arnuk: When we legislate specifically, investment managers hear that they just need to check a box, which is often not the same thing as best execution.
Brian Hellmer, State of Wisconsin Investment Board: Is it a productive to try to revise the definition of best execution, or would it be better to eliminate conflicts of interest and improve transparency? Spatt: Conflicts of interest are very important, but best execution needs an adequate definition. This discussion is framed in a world without latency, but there needs to be a review of the definition for best execution, because it is not defined in a world with latency; Arnuk: The SEC will not be able to understand latency while the definition of best execution is so complex and ambiguous. A rule regulating best execution and speed will be too specific to improve the system; Gellasche: The overall objective of trading is trying to get the best prices you can, and best execution is a fiduciary responsibility. The current system to bring best execution cases is made extremely challenging due to the ambiguity of the definition.
Paul Mahoney, University of Virginia School of Law: Is the market too fragmented, and if so, what can the SEC do about it? Arnuk: The markets are too fragmented, and dark pools have made markets too complex, leading to segmentation of order flow; Gellasch: If exchange practices are remarkably similar, it would make sense to have these exchanges consolidate, but we have not seen that. This is because the true value is in market data; Atkins: Reg NMS encourages atomization because the biggest incentive is information. There is a regulatory incentive to operate more exchanges.
Mina Nguyen, Jane Street Capital: Is PFOF interconnected with the difficulties in moving retail orders onto exchanges? What are the tradeoffs between democratizing trading and price volatility? Arnuk: There is regulatory disparity between on- and off-exchange trading. Banning PFOF in dark pools and not doing it for institutional routers will lead to unintended, negative consequences. The SEC should be concerned that less than half of trading is on lit exchanges and should try to incentivize retail investors to move to these exchanges; Gellasch: We have made trading look free and easy, but in doing so, we have made trading riskier, particularly options trading. PFOF pricing does not correctly align with prior Commission fees. Brokers are incentivized to encourage smaller, more frequent trading and trading on stocks with larger spreads, contributing to price volatility.
Panel Discussion Regarding Best Execution Issues Unique to Wholesale Broker
Doug Cifu, CEO, Virtu Financial
The current U.S. equities market structure provides meaningful and measurable benefits to retail investors. We offer significant price and size improvement, and wholesalers commit capital to execute marketable retail orders. There is robust broker competition due to the wholesale services model that lowers barriers to entry for new retail brokers. There is currently a competitive and resilient execution ecosystem. Benefits to retail investors in the current model are significantly understated. Including odd-lot orders, short-sell orders, and odd-lot quotes in calculating price improvement would not significantly lessen the benefits to retail investors.
If trading took place on lit exchanges, spreads would not be improved, and retail investors would pay more explicit and implicit prices to trade. We advocate for changes that enhance execution quality metrics and 605 disclosures to provide more granular information to retail investors and encourage vigorous competition. Retail brokers would not obtain better execution by routing to exchanges. It is not true that there is a lack of competition for order flow; at least eight wholesalers compete for order flow, and barriers to entry into the market are low.
Stanislav Dolgopolov, Chief Regulatory Officer, Decimus
The wholesaling business model in equity markets is based on some combination of custom order flow, aggregation and segmentation of order flow, PFOF, automated execution, and provision of dark liquidity based on matching the NBBO with potential improvement. FINRA says that the obligation of best execution can fall on different actors in a market, but that obligation is not necessarily the same for everyone.
Rerouting practices, dark pools, and fee-rebate structures run contrary to best execution in wholesaling. Banning PFOF would require the SEC to reassess every incentive in the system to ensure they do not create unintended problems. Enhanced PFOF disclosures seems like the most promising path to a more equitable market. Reforming the tick-size regime could help bring retail investors back onto exchanges.
Hitesh Mittal, Founder and CEO, BestEx Research
Odd-lot liquidity at exchanges is not visible, so retail investors may be getting the spreads they offer anyway. Retail investors receive better execution than institutional investors, but the fundamental issue is that the spread on retail order flow should not be compared to the spread on exchanges because the cost of providing liquidity on an exchange is different than the cost of providing it to retail investors.
The most important issue is the lack of competition in the wholesale markets. New market makers cannot compete with established players due to the information edge they have, meaning they can price orders more efficiently than anyone else in the equity market. The more information asymmetry, the higher the spread will be. The SEC should consider whether investors could receive better execution under a better market structure, not if they are getting the best execution in the current system. Banning PFOF or increasing transparency would not sufficiently reshape the equity market structure.
Larry Tabb, Director, Market Structure Research, Bloomberg, LLP
A vast majority of retail flow is executed by six wholesalers, most of which is executed by Citadel Securities and Virtu Financial. The compensation model for retail brokers is from PFOF and one quarter of PFOF can be as much as $481 million. Investors are not left out, however; investors received roughly $1.2 billion in price improvement last year. Investors currently receive 36.61 percent of each half-cent spread; the rest is sent to market makers, but most is spent on PFOF.
While this does serve retail, this is not the best market structure because of fragmentation, complexities, segmentation, and the fact that the majority of trades are executed OTC. PFOF creates perceived and possibly real conflicts of interest, but we should not ban it because of the benefits it offers investors. If retail brokers did not route to wholesalers, they would need to build out trading desks which would be expensive and create new conflicts. The most important changes in regulation would be to increase transparency by altering 605 reports so customers know what they are getting, improve the odd-lot process, tighten spreads, and make best execution more demonstrable.
Open Discussion – Moderator: JW Verret, Associate Professor, Antonin Scalia Law School
Marietta-Westberg: What is your recommendation on disclosures? Tabb: Brokers should display their price improvement practices.
Jamila Abston, Ernst & Young: How do you feel about the information asymmetry in the market? Tabb: Theoretically all orders competing against each other is the way to get the best execution, but the market has become so segmented that you would have to shut down many wholesalers to make a sizable difference in information asymmetry; Cifu: Retail brokers do a great job at managing the privacy of their clients. We have no client information. The information is already out there; whether or not we internalize and process the available data has no effect on customers. We compete vigorously to provide the most price improvement possible. This is a fluid and fiercely competitive market for wholesalers; Mittal: The issue is not shutting down wholesalers; the issue is that there should be more. Currently, two wholesalers dominate the entire market. All information is available, but if you have constant order flow, you can use that information to predict future market changes; Dolgopolov: Theoretically, there is a possibility of competition on an order-by-order basis, but it is not functional in practice.
Verrett: Does PFOF create a major conflict of interest? Cifu: There are conflicts in every business and throughout this market. We do not handle them by outright banning them; they are addressed with disclosures and oversight.
Brian Hellmer, State of Wisconsin Investment Board: Price improvement is calculated against the NBBO price. Is the price improvement calculation flawed in a way that, if fixed, it would hurt retail investor price improvement or in a way that would benefit retail investor price improvement? Cifu: We recalculated our data from last year including odd-lot prices, and it slightly hurt price improvement, but when including all other data, such as short selling information, it actually benefits our price improvement even more. The reason Virtu is so successful is because of segmentation; Mittal: There is price improvement due to wholesalers versus the NBBO spread, but there would be better execution in a system with less information concentration and segmentation. Wholesalers are providing better bid-offer spreads and are receiving rebates for creating markets.
Nguyen: How did you integrate institutional flow with retail flow in your analysis, and what did your analysis show? Mittal: We looked at all on-exchange trades. If you increase the minimum tick size, it will have a massive impact on the spread. It is not fair to compare an exchange with retail flow. Wholesalers do provide price improvement, but they get almost all retail order flow. ATSs are great tools for retail investors and take no transaction cost.
Alice Stinebaugh, Parkland School District and University of Scranton: What are the other distortionary influences that could arise if PFOF was banned? Dolgopolov: If you banned PFOF without changing incentives, new problems will arise in its place. A more granular tick size would benefit the market.