P&I: Enhanced competition for retail orders promotes transparency, better prices

This piece originally appeared as a byline in Pensions & Investments’ Industry Voices column. Click here to view the original article.

In mid-December, the SEC released four separate proposals that collectively represent the most significant U.S. equity market reform initiative since Regulation NMS in 2005.

So far, industry reaction has been overwhelmingly negative and, in certain cases, unambiguously critical of SEC Chairman Gary Gensler and his staff. But one must consider the lens through which the most vocal opponents view the SEC proposals before blindly accepting industry criticism as the universal consensus.

America's public equity ecosystem encompasses a diverse group of entities with varying interests, resources and perspectives. For instance, the orders and trading strategies of an institutional investor seeking to establish buy-and-hold positions differ from those employed by, say, an automated market maker trading in and out of small positions throughout the day. Thus, a change to the market's infrastructure that negatively affects one market participant may very well serve to benefit another.

Contrary to the criticism we have heard to date — mainly from a minority of firms whose entrenched interests would be adversely affected by the proposed rule changes — it is our contention that institutional investors (and investors in general) would realize a net benefit should certain aspects of the SEC proposals ultimately gain approval.

In this piece, we focus on what is arguably the most controversial of the SEC's four proposals — the proposed rule to enhance competition for stock orders entered by retail investors — and its potential implications for investors more broadly.

The wholesaler model

The SEC's enhanced order competition proposal directly targets the current over-the-counter retail trading model — an exclusive bilateral trading construct that includes only retail brokers and a short list of proprietary market-making firms known as retail wholesalers. Two firms in particular — Citadel Securities and Virtu Financial Inc. — account for the lion's share of wholesaler volume.

Under the wholesaler model, retail brokers bypass exchanges and other trading venues and route orders directly to a retail wholesaler. In exchange for this "flow," retail brokers receive direct monetary payments from the wholesaler and — for their retail investor clients — a guaranteed fill price no worse than the prevailing national best bid (in the case of retail "sells") or offer (in the case of retail "buys"), collectively referred to as the NBBO.

Here, retail broker compensation is referred to as "payment-for-order-flow" or, more colloquially, PFOF. In addition to PFOF and a guaranteed execution, retail wholesalers may slightly "improve" execution prices (vs. the NBBO) for retail investors. For instance, if a wholesaler receives a marketable retail "buy" order when the NBBO is $10.00 (bid) / $10.02 (offer), the wholesaler may fill the order at $10.019, providing $0.001 of "price improvement."

The economic benefits of the wholesaler model to retail brokers and retail investors are straightforward. But how is this arrangement advantageous for the wholesaler? Are wholesalers equity market altruists — paying retail brokers for their clients' orders and providing retail investors with better prices than the market has to offer? Not quite.

Retail orders tend to be smaller in size and less "informed" than orders routed by institutions and/or proprietary trading firms. Thus, relative to the latter, retail orders exhibit less adverse selection. Said differently, retail orders are less likely to impact a stock's price in a manner that is unfavorable to the liquidity-providing market participant. As a result, retail orders are more profitable for wholesalers to trade against — even after accounting for any PFOF and price improvement.

NBBO misses the mark(et)

While the wholesaling model may seem like a mutually beneficial arrangement for all parties involved, it is the SEC's contention — and we agree — that retail investors may not be receiving such a good deal after all.

In today's equity market, the NBBO is not truly representative of all available bids and offers. In fact, there are often better prices available within the NBBO spread that many investors never see. This is, in part, due to the way the NBBO is defined.

The NBBO includes only "round lots," or quotes for whole multiples of 100 shares, posted on one of 16 registered U.S. stock exchanges. "Odd lot" orders, or sub-100 share quotes, posted on the same exchanges do not contribute to the NBBO. Consider the following:

In keeping with our $10.00 (bid) / $10.02 (offer) NBBO scenario, an offer to sell 99 shares could have existed on an exchange order book (e.g., New York Stock Exchange) at a price of $10.01 when the wholesaler received the market buy order from the retail broker. However, because wholesalers are only required to fill orders at prices no worse than the NBBO, they can legally fill the retail buy order at $10.019 — or 9 basis points worse than the best available price ($10.01) at the time of execution. When you consider that nearly 60% of market-wide trades occur in odd lot sizes today, the round lot NBBO feels an outdated benchmark for measuring retail execution quality and, in many cases, leads to inferior prices for retail investors.

Enhanced competition facilitates accessibility, cost savings

Despite an extremely limited number of firms operating in the retail wholesaler space, retail trading now accounts for 20% of total equity trading volume in the U.S., and virtually all of it flows through the wholesaling construct. That means it is routed directly to a wholesaler and not exposed to the broader marketplace where other market participants could step in and offer more competitive prices.

In other words, in the current market structure, retail orders are unable to interact with institutional market participants like us even though these interactions would be to the advantage of both parties.

Simply put, siphoning off retail order flow deprives the broader market of significant liquidity. The current system, while certainly beneficial to the wholesaler firms, has the implicit effect of driving up trading costs for retail and institutional investors alike.

The SEC believes that the retail trading model for U.S. stocks is long overdue for an overhaul. We agree.
As part of the enhanced order competition proposal, marketable retail orders routed to wholesalers would be required to be exposed to a blind public auction facility whereby all market participants, including institutional investors, can compete (on price) to interact with retail orders directly.

Such a construct should produce better prices for both retail and institutional investors and improve market quality for a broader group of participants than the select few entrenched firms benefiting from the current system.