After a decadelong struggle for trading volume, stock exchanges have mostly lost the trades of individual investors to a half-dozen off-exchange market makers like Citadel Securities and
These wholesale market makers now process a quarter of all stock trades, which they get from retail brokers like Charles Schwab and
Now, new rules proposed by the Securities and Exchange Commission at the end of December would shift those trades back to the exchanges.
The most controversial of the new proposals would revamp how stocks trade, with the SEC projecting that changes could save small investors over $1 billion in annual costs. Close examination of the agency’s math by Barron’s and others, however, suggests that those savings are overstated and highly uncertain.
The proposals face a stiff fight from Virtu (ticker: VIRT), retail brokers like Schwab (SCHW) and Robinhood (HOOD), and even from institutional investors like
T. Rowe Price Group
(TROW). They say they’ll file critiques of the SEC’s proposals before the March 31 deadline. And if the final versions of the rules aren’t significantly different when they appear toward year end, there will be lawsuits.
Some of the agency’s new proposals have wide support. Most participants say they welcome rules to improve reporting of stock trades by brokers, ease the trading of small odd-lot orders, and allow prices of the most popular stocks to move by fractions of a penny. But apart from exchanges and individuals who write letters to the SEC, Wall Street is generally unhappy with many of the trading proposals.
The sharpest criticism greets two initiatives championed by SEC Chair Gary Gensler, which he says will yield better stock-trading prices for individual and institutional investors. The first would take individual trading orders away from wholesalers like Virtu and send them to a computerized stock- exchange auction, where the SEC expects institutional traders will compete to trade with small investors’ orders. SEC economists project that these so-called order-by-order auctions would gain investors between $1.1 billion to $2.3 billion a year in savings, by providing better prices than they get today from wholesalers.
The second set of initiatives would make it much harder for retail brokers like Robinhood to receive payments for sending customers’ orders to a wholesale market maker like Citadel Securities. Gensler believes these so-called payments- for-order flow create conflicts that deter brokers from seeking the best trades for customers.
Finance researchers such as University of Notre Dame professor Robert Battalio have looked for evidence that individual investors suffer when their brokers get paid to send orders to market makers. What the evidence shows, however, is that wholesale market makers provide consistently better prices than exchanges.
University of California-Irvine professor Christopher Schwarz and his colleagues have found that order flow payments weren’t related to the pricing that brokers got for their customers. The SEC’s recent proposals feature statistics that the agency says prove that order payments are linked to poor pricing—but Schwarz notes that the SEC’s own analysis shows any economic impact of the payments on pricing is incredibly small.
Meanwhile, Robinhood and other retail brokers note that order flow payments largely subsidized the industry’s elimination of trading commissions for individual investors. In its proposals, the SEC finds it unlikely that reducing order flow payments will bring back commissions. But after trading volumes dropped in stocks and cryptocurrencies, stand-alone retail brokers like Robinhood scrambled for other revenue sources. They warn that without order flow payments they may have to resume charging commissions.
Schwarz is puzzled that the SEC believes market intermediaries will process trades at little or no profit, without commissions. “Somehow the brokers have got to be paid, the market centers have got to be paid,” says Schwarz. “Ultimately, the retail investors have to pay something.”
To get retail order flow, under current rules, market-makers must commit to executing trades at prices better than those quoted on stock exchanges. The savings on a single trade from these price-improvements may be less than a dollar, but Virtu Chief Executive Doug Cifu told a conference last year that in the aggregate they total $12 billion a year for small investors.
Retail brokers require wholesalers to fill trades across every public stock and improve price, on average, says Notre Dame’s Battalio. The trading in big stocks may subsidize smaller ones that might otherwise not find a market.
With its new Order Competition Rule, the SEC thinks it can extract additional price improvement for retail traders by routing buy or sell orders to the exchanges’ computerized auctions. The system would be complex. Retail brokers would send each customer order directly to the auctions, or have the order forwarded there by a wholesale market maker. There would be a fractional-second auction for each order millions of times a day, with brokers and institutional investors invited to bid. Wholesalers could only make off-exchange trades at no profit, or if an auction failed to find a counterparty. The agency says this arrangement could improve trading prices for individuals by $1 billion to $2 billion a year—which the agency believes are the profits that wholesalers realize by carving off the industry’s retail orders.
The market-makers’ lost business would be the exchanges’ gain. Order-by-order auctions would also generate huge volumes of trading data, boosting the exchanges’ data sales.
At least one stock exchange thinks the auctions could succeed. Executives there said they have heard from smaller market makers who would eagerly compete for retail trades in such auctions—but the exchange asked to go unnamed because of Wall Street’s ambivalence toward the idea.
Other institutions are also less-than enthusiastic.
The SEC’s auction proposal requires participants to disclose too much information with each order, says Mehmet Kinak, the head of systematic trading at mutual fund manager T. Rowe Price. Institutional investors fear prices will slip away as information leaks out about big trades, especially in smaller, less-liquid stocks favored by T. Rowe’s funds and many retail traders, he says.
“The large-cap stocks would probably be OK,” Kinak says of this information leakage. “But the small-caps won’t have as good an outcome.”
The SEC acknowledges “considerable uncertainty” in predicting the benefits and costs of its untested auction idea. Digging into the agency’s own numbers, the headlined $1.5 billion in benefits shrinks.
The gains from introducing auctions would range from 15 cents to 47 cents for a 100 share order—says the SEC—or an average of 31 cents. While the agency doesn’t expect that information leakage from auctions will cause stock prices to slip away from traders, it says the cost from slippage could be five cents. It thinks a revival of trading commissions is unlikely, but says the industry’s loss of order flow payments could cost another 15 cents.
By the SEC’s own accounting, therefore, the 31 cent-per-order gain from auctions could end up being 11 cents. And that doesn’t include the loss of billions in price-improvement now provided by wholesalers.
“They say that the amount that they are going to unlock through this auction process is additive,” says Citadel Securities’ trading executive Joe Mecane. “In other words, today’s $12 billion in price improvement will become $12 billion-plus.”
There’s a flaw in that reasoning, says Mecane. “The $12 billion isn’t going to be $12 billion any more.”
Write to Bill Alpert at firstname.lastname@example.org