Speaking at the Piper Sandler Global Exchange Conference, Gary Gensler, chair of the US Securities and Exchange Commission (SEC), addressed a number of deficiencies that have been identified in the US trading system – providing suggestions on how these issues could be resolved.
Gensler started off his address by acknowledging that technology has transformed and continues to transform US equity markets, however, noted that this technological transformation has also led to challenges including market segmentation, concentration and potential inefficiencies.
“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges. Further, the markets have become increasingly hidden from view. In 2009, off-exchange trading accounted for a quarter of US equity volume. Last year, during the meme stock events, that share swelled to a peak of 47 percent. What’s more, 90-plus percent of retail marketable orders are routed to a small, concentrated group of wholesalers that pay for this retail market order flow,” said Gensler.
“It’s not clear, with such market segmentation and concentration, and with an uneven playing field, that our current national market system is as fair and competitive as possible for investors.”
Following previous proposals from the Commission related to shortening the settlement cycle and enhancing short sale disclosure, Gensler’s most recent address focused on trading in dark pools and through wholesalers.
“We haven’t updated key aspects of our national market system rules, particularly related to order handling and execution, since 2005. Thus, last year I asked staff to take a holistic, cross-market view of how we could update our rules and drive greater efficiencies in our equity markets,” Gensler added.
Tick sizes
Gensler’s first area of focus was the minimum increments at which securities are priced – referred to as the tick size. He noted that a level playing field does not currently exist among different trading venues and among the several disparities that exist, tick size is one worth highlighting.
In lit markets, investors see prices in one-penny increments, however, wholesalers are able to fill orders at sub-penny prices and without open competition.
“More than half of the share volume in the first five months of this year was in stocks constrained by tick size. In contrast, sub-penny trading, including at a tenth of a penny, accounts for 37 percent of share volume executed off-exchange,” said Gensler.
“Given this activity, I wonder why lit markets should have that one-penny constraint. It raises real questions about whether this structure is fair and best promotes competition. Why not allow all venues to have an equal opportunity to execute at sub-penny increments?”
To combat this issue, Gensler has asked staff to make recommendations for the Commission’s consideration to level the playing field with respect to two elements of tick size. Firstly, harmonising the tick size across different market centres, to allow all trading to occur in the minimum increment. Secondly, shrinking the minimum tick size to better align with off-exchange activity.
National Best Bid and Offer
The National Best Bid and Offer (NBBO) is a quote designed to aggregate information across different exchanges, providing investors with important pre-trade transparency. The NBBO currently includes round lots, which are quotes for 100 shares or more. Gensler noted that retail investors, who are more likely to buy or sell at odd lot prices, are unable to see these prices.
Gensler has proposed the acceleration of the Market Infrastructure Rule. The rule, which was adopted in 2020, created a new round lot definition, which, depending upon share price, can be anywhere between 1 and 100 shares. It also added odd-lot information to core market data, noted Gensler. In addition, the Infrastructure Rule enhanced transparency for quotation information with the remaining odd lots.
“I asked staff to consider whether to accelerate implementation of this piece of the Infrastructure Rule as well. Together, I believe accelerating these timelines would allow retail investors to see better prices sooner. I also have asked staff to consider whether there should be an odd-lot best bid and offer so that investors would know the best price available in the market regardless of share quantity,” said Gensler.
Disclosure of order execution quality
Gensler also discussed ways in which retail investors’ ability to compare execution quality by their brokers could be enhanced.
“Today, retail investors cannot compare execution across brokers, such as how much price improvement they provide to their clients. That’s because only “market centres,” such as dark pools, wholesalers, and exchanges, are required to provide these disclosures on monthly Rule 605 reports. Moreover, this rule hasn’t been substantively updated since 2000,” said Gensler.
To combat this issue, Gensler has suggested making recommendations to the Commission around how Rule 605 could be updated to give investors more useful disclosure about order execution quality.
“This could include mandating that broker-dealers, along with market centres, file monthly Rule 605 reports,” added Gensler.“Further, I’ve asked staff to make recommendations considering whether to require that all reporters provide summary statistics of execution quality, such as the price improvement as a percentage of the spread.”
Best execution
Gensler highlighted that as of now, even though the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) have rules on best execution, the SEC does not.
Gensler noted that these rules require broker-dealers to exercise reasonable diligence to execute customer orders in the best market so that their customers receive the most favourable prices under prevailing market conditions.
“I think investors might benefit if the SEC considered proposing its own best execution rule. In addition, broker-dealers and investors might benefit from more detail around the procedural standards brokers must meet when handling and executing customer orders,” said Gensler.
Order-by-order competition
Gensler also discussed ways in which to promote as much competition as possible for retail investors on an order-by-order basis. He highlighted that competition promotes efficiencies where economic rents, or excess profits above market competition, might otherwise accrue.
“As I mentioned, the vast majority of retail marketable orders are flowing to wholesalers that pay for this order flow. What’s more, this segmentation means that institutional investors, such as pension funds, don’t get to interact directly with that order flow. This segmentation—which isolates retail orders—may not benefit the retail public as much as orders being exposed to order-by-order competition,” said Gensler.
“Some suggest that this segmentation, with such isolation, allows retail investors to receive slightly better prices compared to the NBBO. Price improvement without competition, though, isn’t necessarily the best price improvement. Wholesalers may be saving more than they’re passing along to investors in terms of price improvement.”
Gensler has called for recommendations to enhance order-by-order competition, which may be through open and transparent auctions or other means, unless investors get midpoint or better prices.
Payment for order flow, exchange rebates, and related access fees
Gensler noted that payment for order flow can raise issues around conflicts of interest as well as distort routing decisions. In addition, Gensler highlighted that payment for order flow may incentivise broker-dealers to use digital engagement practices, such as gamification, to increase customer trading. In a similar breath, Gensler said that exchange rebates may also present conflicts.
“Exchanges give rebates to traders. High-volume traders benefit more from these arrangements, and retail investors don’t directly benefit from those rebates,” highlighted Gensler.
“Just as payment for order flow presents a conflict of interest in the routing of marketable retail orders, exchange rebates may present a similar conflict in the routing of customer limit orders.”
Gensler has called for recommendation on how the SEC can mitigate conflicts with respect to payment for order flow and rebates.
“One thing I’ve asked them to consider is whether exchange fees — what somebody pays to access a quotation on an exchange — and rebates should be more transparent, so that investors can understand these amounts at the time of trade execution,” said Gensler.
Finally, in response to related access fees, Gensler has asked staff to consider how the access fees might change in light of a potentially lower minimum tick size.
“Currently, access fees for protected quotes that are priced at $1 or more are capped at three-tenths of a penny per share. If we reduce the minimum pricing increment, it may also be appropriate to reduce these access fee caps proportionately,” added Gensler.
Gensler concluded his address by emphasising the need for the SEC to ‘freshen up’ its rules – once again highlighting that there is still room to make its current national market system as fair and competitive as possible for investors.