SEC’s Stock Proposals Fix What Ain’t Really Broken

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COMMENTARY

The holiday trading lull overshadowed the stock market’s good fortune: Just 10 days before Christmas, the Securities and Exchange Commission dropped a slew of proposed new rules on them. At 1,656 pages, the draft left market participants with a lot to absorb.

For wholesalers like Virtu Financial Inc. and Citadel Securities, would not have brought much joy to read as one major theme emerged: minimizing their role in the stock trading value chain.

Gary Gensler, the SEC chairman, made his motivation clear. “Today’s markets are not as fair and competitive as they could be for individual investors,” he said. “There is not a level playing field between the different parts of the market: wholesalers, dark pools, and bright exchanges.”

Wholesale stocks are a relatively new niche, sandwiched between retail brokers and the market. It evolved after an earlier wave of rulemaking in the late 1990s and early 2000s that essentially gave birth to the sector. The implementation of Reg NMS in 2007 and Reg ATS before that led to the fragmentation of the market previously dominated by exchanges. Liquidity is now distributed across 16 national exchanges and more than 40 alternative trading systems (or “dark pools”); navigating the maze requires expertise and tools that retail agents don’t have. As a result, they now route over 90% of their order flow through wholesalers. One of the largest, Charles Schwab Corp., explains the system as a “form of strategic contracting that uses the concept of comparative advantage.”

But Gensler thinks wholesalers hinder the transparency of markets and is wary of the power they have amassed. His proposed new rules threaten them in two ways. First, a reduction in the minimum tick size attacks a major source of profit. Because they are not subject to the same minimum tick sizes as exchanges, wholesalers can profit from artificially wide bid-ask spreads. Smaller price increases will collapse spreads, transferring value from wholesalers and other intermediaries to end investors. Perhaps they shouldn’t complain: any business model born of regulatory arbitrage risks being squeezed out when the arbitrage disappears.

However, if that’s not enough, Gensler also proposes that wholesalers bid on retail order flow on a more transactional, per-order basis, rather than through the wholesale contracts they typically have with brokers. The SEC estimates that this could free up $1.5 billion in value for end investors. While wholesalers are free to bid, the two largest exchanges — the New York Stock Exchange and the Nasdaq — are well placed to compete. Doug Cifu, Virtu’s chief executive, is not impressed. “30 years of competition and Gary, with zero stock market experience, decrees let’s have a duopoly,” he tweeted. “I know well over 200 brokers who have been on the road for 20+ years. Zero data. Gary is a politician playing regulator.”

Wholesalers and the retail brokers they work for alike have long argued that they offer better prices to retail investors. In addition to their ability to offer tighter spreads, they correct retail order flow together, shielding it from institutional activity that is likely to trade against it on an exchange. According to Charles Schwab, “the fact that the structure of the US stock market has enabled such segmentation of retail order flow is the fundamental driver of value in which retail investors have increasingly been able to participate.” The broker estimates that in 2021, its clients received $3.4 billion in price improvement for equity orders using wholesalers versus what they could have achieved on an exchange (albeit in a possible third strike to overturned them, the SEC argues that these figures may be overstated and plans to review the standard against which they are calibrated).

Even the SEC concludes that wholesalers do a good job. “Traded orders sent to wholesalers appear to have higher fill rates, lower effective spreads and lower E/Q ratios” — a measure of trade quality — his analysis said. According to SEC data, 83% of stocks traded through wholesalers in the first quarter of 2022 benefited from a price improvement, compared to 9% on the exchange.

The battle to remake the system will take time. The SEC will hold a comment period until the end of March; the sites are already filling up and the wholesalers themselves have yet to post an official response. The SEC may discourage them, but the wholesalers won’t go down without a fight. Meanwhile, they provide a valuable service for retail brokers and good prices for retail investors. Perhaps the market structure does not need reforming after all.

More from Bloomberg Opinion:

• The SEC wants to improve the stock market. Should?: Editorial

• Gensler’s SEC is learning to pick its battles: Editorial

• SEC’s views on competition would stifle innovation: Aaron Brown

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly finance newsletter Net Interest.

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