Tagged: memx

Gensler’s Gambit

Suddenly it’s September.  Statistically, the worst month for stocks.

Illustration 172906555 © Corneliakarl | Dreamstime.com

It’s then no surprise that SEC Chair Gary Gensler would start hucking Molotovs at market structure.  If you’re gonna do it, why not when stocks might be rocky? Gives you air cover.

For those who missed it, Gensler told Barron’s the SEC could consider banning what’s called Payment for Order Flow (PFOF).  I’ll explain.

You might also have seen that new stock exchange MEMX (Members Exchange) has asked the SEC to let stocks quoting with a one-cent spread to trade in half-cents.

What do these things mean to you, traders and investors and public companies? 

I’m glad you asked!

First, let’s understand the current rules. PFOF exists because of rules. Ironic, right? SEC rules require all stocks to trade at a single best price marketwide.  What’s more, brokers who execute the trades are required to meet “Best Execution” standards that, simplified, are a percentage of time at the best prices to buy or sell.

Well. Retail trades are small. Prices constantly change. It’s a pain trying to comply with SEC rules when handling gobs of tiny trades.

So firms like Robinhood sell their orders to others with sophisticated systems for complying with the rules. Regulators keep making exceptions to accommodate the vital role these so-called “market-making” firms play in the SEC’s grand scheme for a continuous auction where everything exists in 100-share increments.

We’ll get to what it all means.  Now, half-pennies?  Not what meets the eye.  Regulation National Market System prohibits QUOTES in sub-penny increments for stocks with prices above $1. That’s the Sub-Penny Rule.

But stocks TRADE all the time in sub-pennies.  Of my last ten trades using decision-support from our sister company (vote for us in the Benzinga Fintech Awards!) Market Structure EDGE, five were in tenths of pennies.

Examples of that, I bought 75 shares and then 25 shares of AAPL (there aren’t 100 shares at a single venue at the market’s best price – yup, truth), both at half-penny spreads.  I sold FB for a two-tenths spread.  But brokers, not exchanges, matched these.

The doozy is this: I bought NVDA at a six-tenths penny spread through the Nasdaq’s “Retail Liquidity Program” where a high-speed trader like Virtu sold it to my broker, Interactive Brokers, at a price a scooch (say three-tenths) better than the best offer and was also paid about three-tenths of a penny by the Nasdaq for doing it.

All this fits together. Don’t worry if you’re feeling confused. I’ll sort it out for you.

MEMX wants a piece of the half-penny business brokers are getting. It could double MEMX’s market-share. It’s not virtuous.

Now let’s understand PFOF. The SEC wanted a perfect Shangri-La for the little guy. Where anybody can buy or sell 100 shares of everything.

Except that’s impossible.

Brokers said, “We can’t do it. You’ll have to permit us to create shares for instances when there are no real sellers for buyers, and vice versa.”

The SEC agreed. Thus, market-makers like Citadel Securities are exempt from Reg SHO Rule 203b(2) mandating that stocks must be located before they can be shorted.

That’s another story.

Since there was no incentive for market-makers to buy and sell, the SEC gave them a guaranteed spread, permitting broker-operated Alternative Trading Systems called dark pools (where my trades matched) to execute trades BETWEEN the best bid and offer.

Volume shifted off exchanges to dark pools. Conceding, the SEC approved Retail Liquidity Programs letting exchanges pay for trades that originate with retail investors.

And they allowed exchanges to pay traders incentives called “rebates” to set the best bid to buy and offer to sell. I’m hitting only high points.  Now 85% of trades are midpoints at exchanges too.

But this gave rise to PFOF. Enterprising firms realized that if exchanges would pay them for trades, they could buy trades too. And execute them at fractions of pennies of profits both directions.

And brokers like Schwab, E*Trade, Ameritrade, Fidelity, Robinhood, realized they had this…thing.  Retail flow. By selling it, they offloaded compliance. And they could now give trades away to boot to foster more of them.

Gary Gensler is threatening to chop the legs off this stool the SEC created.

Look. I don’t like this market because it’s not free. But the problem isn’t PFOF by itself. It’s a contrived, rules-driven market that promotes arbitraging time and price as an end unto itself.  And now $50 trillion of market cap dances, pirouettes, on tiny split-penny trades.

Kick a leg out and it’ll be a disaster.  Re-think Reg NMS, and disconnect markets, and stop paying traders to change prices, and we could bring back lumpier and committed investment. Right now, we have exactly what the rules encourage.

I have low expectations.  And this is why you need Market Structure Analytics, traders and public companies. We understand it all. 

Exchanging Data

Do we need another stock exchange?

I’ve been asked this question repeatedly since Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial agreed Jan 7 to collaborate on seeking approval for a 14th official US stock market.

The answer? It depends on who “we” is, or are.

Adam Sussman of block-trading firm Liquidnet wrote that it’s an effort to lower trading costs which, thanks to high prices from exchanges for data feeds, have gone the opposite direction of trading commissions.

As to further fragmentation – more venues, less aggregation of buyers and sellers – Sussman says amusingly (the whole piece is funny) that “fragmentation is like having kids – after you have three of them, you just go numb to the pain.”

Michael Friedman, formerly of proprietary trading shop and technology vendor Trillium Management, said at TABB Forum (registration required) that these trading firms representing perhaps more than half of all volume resent how the exchanges keep raising prices for market data that brokers themselves create.

Before the exchanges IPO’d – all but IEX are now owned by public shareholders – they were member-owned, and members didn’t pay for data. Coincidentally the new market is called MEMX, or Members Exchange, anachronistically hailing a different era.

Friedman artfully unfolds market structure, explaining how a bid to buy shares at $9.08 at the NYSE cannot execute if the Nasdaq has a bid to buy at $9.10 because buyers willing to pay more are given legal priority and the trade must route out to the Nasdaq.

What if these firms were to route all the best trades – ones wanting to be the highest bid to buy or offer to sell – to themselves?  They could conceivably ravage market-share among big exchange groups until costs fell to a new equilibrium.

I think there are two other big reasons for this new cooperative.

One is easy to understand. Brokers are required to prove to customers that they provide “best execution,” or trading services that are at least as good as the average.  Paradoxically, that standard is predicated on averages for customer trades in the market – which concentrate heavily into the largest firms, including several MEMX backers.

If the order flow is consistently better than the average, it’s conceivable these firms could use their own data for free to meet best-execution requirements, a tectonic fist-bump amidst market rules.

So how would they boost odds that their data are better?  Look at who’s involved. They are mostly retail brokerage firms, or firms buying retail flow.

At Fidelity, about 97% of the firm’s retail orders are “nondirected,” lacking instructions about where the trades should occur. And well over 50% of those orders are sent to Virtu and Citadel.

Schwab says 99.6% of its trades are nondirected and 70% of them go to Virtu, Citadel and UBS.

And guess what?  Retail orders are permitted under rules to, in the jargon of market structure, “price-improve” trades.  The NYSE says its Retail Liquidity Program “can be used by retail firms directly as well as by the brokers who service retail order flow providers.”

Interactive Brokers, a firm for sophisticated retail traders and hedge funds, says retail orders with a limit, or set price, can be hidden from display at exchanges in increments of a thousandth of a dollar better than the displayed one, and the orders will float with a changing bid to buy or offer to sell.

That is, if the best bid to buy everyone sees is $9.08, a hidden limit order can be set at $9.081 and bounce like a bobber, staying always a fraction of a penny better than visible prices.

Under market rules, stocks cannot quote in increments below a penny. But they sure can trade in smaller increments, and they do all the time.

By aggregating retail order flow that market rules give a special dispensation to be better than other orders the members of MEMX believe they can not only match more orders but create the best market data.

How is it possible? Regulators wanted to be sure the little guy wouldn’t get screwed, so they give retail trades preference. They never dreamed innovative high-speed traders would buy it, or take advantage of rules permitting these trades to have narrower spreads.

It may work.

The problem is that the advantage MEMX hopes to leverage is a regulatory one that gives special access to one kind of activity.  (Editorial note: As we’ve written repeatedly, it’s just as Exchange Traded Funds have proliferated not by being better but through unique regulatory advantages giving them a private, wholesale block market with no transparency).

What’s it mean to investors and public companies? Investors, you could be picked off because MEMX could have compounded capacity to price-improve non-displayed orders. Public companies, something other than capital-formation is driving markets, which is not in your best interest.

We’d prefer a fair, level playing field serving investors and issuers, not rules permitting exceptions traders can game.