Billions of dollars are at stake for some equity market players as the chair of the US SEC says stock markets are not as efficient as they could be. By Justin Pugsley. 

What is happening?

US equities markets face one of their biggest shake-ups in decades. If the suggested reforms go ahead, they will substantially alter the way business is done in US equities and potentially sweep away some business models.

Reg rage anxiety

Gary Gensler, chair of the US Securities and Exchange Commission (SEC), has ordered his staff to investigate six areas and to come up with proposals. These are the minimum pricing increment or tick sizes; the national best bid and offer; disclosure of order execution quality; best execution; order-by-order competition; and payment for order flow (PFOF), exchange rebates and access fees. 

Upon investigation, the SEC could simply dismiss these issues and simply leave the market as it is. But that is highly unlikely. Mr Gensler has spoken on several occasions about these points and appears determined to do something about them. 

When regulators publicly make proposals or state that they believe something to be wrong, they nearly always follow through with action. 

Why is it happening? 

In a speech on June 8, Mr Gensler crystalised his views on the functioning of US equities markets. In short, he feels they are not working as efficiently as they should and are being fragmented by technological developments, such as dark pools. Worst of all, retail investors may not be getting the very best deals on their trades. That last point is contentious as it dovetails with the practice of PFOF.

PFOF is where market-makers buy the order flow from retail stockbrokers. The most famous example is Citadel Securities buying order flow from Robinhood Markets on an exclusive basis, enabling the latter to offer its clients commission-free trading. 

The suspicion is that investors whose orders are being sold to market-makers in this way are not getting the very best deals — i.e. the tightest bid and offer spreads. Unless there is some fat in the spread, why would a market-maker pay for it in that way? 

However, it is not that simple. Brokers still have an obligation to get the best deals for their customers. Also, many of the trades via brokers, such as Robinhood, are only in the hundreds of dollars. So even if the spread is slightly wider than it otherwise would be, it is still a lot less than paying commission on trades. Incidentally, PFOF is banned in the UK and Canada. Ending the practice in the US would badly damage Robinhood’s business and would remove a nice earner for market-makers. 

Also, Mr Gensler said he is contemplating opening up competition for retail investor orders to improve the prices they get. That would mean institutional investors, such as pension funds, interacting with it. 

Other controversial topics include sub-penny pricing (tick sizes) for shares. Exchanges are not allowed to do it, but it is permissible off-exchange — i.e. via dark venues and internalisers. Mr Gensler would like to level that playing field. 

What do the bankers say? 

The public exchanges are certainly happier about Mr Gensler’s ideas than bankers. More transparency, less dark trading and more open competition for orders bodes well for exchanges, and they are certainly supportive. 

However, most of the changes Mr Gensler is proposing have been in place for years in other countries where banks manage to carve out a living from those markets. So, while it would undoubtedly introduce more competition, it would not be a disaster for most banks. 

Will it provide the incentives?  

Mr Gensler’s proposals would certainly drive more competition, particularly in the short-to-medium term. But such is the complexity of market dynamics that substantial changes could unleash all sorts of unintended consequences. It is possible that if it drives industry consolidation, some of those benefits might be lost.

Meanwhile, there is a huge question mark over whether Mr Gensler will get his way. At best, his proposals will take years to implement. But more likely, the SEC will face a barrage of lawsuits, which will take years to work through, where the legal outcome is uncertain.    

However, Mr Gensler should not be underestimated. He is one of the toughest regulators out there and certainly not afraid of a ‘bare-knuckle fist fight’ with the industry. 

Veterans of the post 2007-09 global financial crisis reforms remember him well when he headed the Commodity Futures Trading Commission. He took on industry interests with vigour and determination. 

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