Gensler’s gambit

The Securities and Exchange Commission yesterday unveiled a far-reaching plan to “do better” for retail investors. Collectively, it looks like a pretty radical plan that is going to piss off a lot of people.

Setting aside the fact that things have arguably never been better for US retail investors — with free trading and near-free index funds — it’s long been clear that the SEC at least has to do something, even if it is just to counter the widespread view that “markets are rigged”.

And honestly, the proposals chair Gary Gensler unveiled yesterday at a Piper Sandler conference (and trailed in the WSJ a few days earlier) seem at first glance to be pretty sensible?

Goldman Sachs’ Alex Blostein has a good report out on handful of main areas of focus for the SEC and what the implications are. Below in block quotes are his thoughts.

The first Gensler proposal is to standardise tick-sizes across trading venues, which will hopefully lead to more volumes returning to “lit” public markets:

US stocks trade at one-penny increments on lit-markets (Exchanges) vs sub-penny pricing off-exchange. The SEC is considering looking to standardize tick-sizes across venues in order to improve competition between lit and non-lit venues (dark pools, wholesale market makers, internalizers). This would be achieved harmonizing tick sizes and shrinking minimum tick sizes.

Implications: We believe that normalizing tick sizes between Market Makers and Exchanges could improve the Exchanges competitiveness and potentially lead to more lit-volumes, and therefore potentially more revenues for the Exchanges, while potentially weighing on market markers’ spreads.

The second is to improve the prices that investors get, the national best bid/offer, in the industry’s argot.

The Chair believes that the NBBO could be improved to better reflect the actual market price for stocks. Currently, NNBO is based only on round lot trades (100 shares), with odd lots not reflected in the NBBO. With NBBO used to as benchmark to measure price improvement, the Chair sees this as the wrong measuring rod and including odd lot trades would enhance it. This is similar to the proposal introduced a few years back as part of the SEC’s market data reform and the Chair is looking to accelerate implementation process here.

Implications: Potential to decrease the spread that Market Makers are able to earn economics in.

The third is Gensler’s desire to improve transparency around orders executed on behalf of investors by trading firms, and perhaps articulating the SEC’s version of a “best execution rule”.

The Chair is considering if disclosure around execution quality should be extended to Broker Dealers along with “Market Centers”.

Implications: Increased disclosure efforts from Broker Dealers could marginally increase G&A expenses and increase regulatory risks.

The Chair is considering their own version of a Best Execution rule, which we believe would increase oversight around execution quality.

Implications: Potentially increase of regulatory risks for Broker Dealers.

The next two are the biggest and most controversial proposals. Gensler wants to make market-makers compete order-by-order for retail flow, rather than the current bundled approach, and revisit the payment-for-order-flow system.

Here’s Blostein again on order-by-order competition:

The chair is considering a way to improve competition for retail trading on an order-by-order basis, as opposed to the more bundled approach that Market Makers interact with Retail Brokers. With only a handful of market makers handling most of the retail order flow, the Chair believes that introducing more competition in a more transparent/auction process would enhance execution quality for retail investors. Here, the SEC would look to US Listed Options markets as an example of what Cash Equities could potentially look like — though we note that Options Markets also have several large players dominating the space.

Implications: Market Makers have suggested that in the bundled approach to purchasing Retail order-flow, there is a combination of purchased profitable orders and unprofitable orders for the Market Maker, but that they guarantee best execution on all orders. They have suggested that in an auction process, this could result in unprofitable orders not seeing interest from Market Makers and those trades ultimately being executed less favorably for Retail clients. We would also note that existing market makers operate with significant scale which enables them to deliver competitive pricing to the market and it is less clear how sub-scale players in the US equity space would significantly alter this competitive landscape. We note that this could also impact brokers that internalize retail order flow.

And on PFOF, everyone’s favourite market structure culture war.

While it is not clear if the SEC would aim for PFOF to be eliminated, the Chair reiterated the view that PFOF has inherent conflicts of interest and could, at least, have an influence on where Retail order flow is routed and its impact should be further studied. Interestingly, given that the Chair is suggesting the Options markets are an example upon which Cash Equities can draw, and that PFOF is an important part of the Options markets, it could suggest that PFOF may not be directly eliminated in Cash Equities. Here the chair argued that some Retail Broker Dealers do not accept PFOF and are still able to offer commission free trading to retail investors.

Implications: A reduction in PFOF could be a marginal negative to some of the Retail Brokers.

Gensler is known to be pretty unsympathetic to finance industry complaints, and he already seems to be girding for a fight.

As our FT colleagues report, the SEC chair stressed that while the proposals were at a preliminary stage, “we’re representing 330mn Americans [and] you’re representing . . . frankly, your revenues. We might have a different perspective”.

So what do you all think? What should the final list of proposals look like?