September 1, 2021

Gensler’s Gambit

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

Illustration 172906555 © Corneliakarl |

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. 

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