Gary Gensler is trying to remake the SEC regs as it relates to stock trading. I am not hopeful but it’s not because I don’t think the plumbing of the stock market should be refined and made more competitive, it’s that I don’t trust Gensler.
When he was chair of the CFTC he was absolutely terrible for the futures industry.
Since I started in the trading business back in 1986, I have seen SEC regulated stock exchanges become commoditized and far less important. At the same time, I have seen CFTC regulated exchanges become far more important than they used to.
In each segment of the trading industry, volume has concentrated and big huge players have arisen where it used to be a highly fragmented industry. For example, Jump Trading does the lion’s share of market making in the US Treasury complex at CME. They couldn’t do this without co-location.
The plumbing of markets is extremely complex. It’s not just about the matching of bids and offers. It’s also about how data is disseminated. It’s about who gets information when, and what kind and what it is formulated like. It’s about clearing and settlement.
Plumbing is a big deal, because when you change the plumbing you can artificially create winners and losers.
Gensler’s idea now is to try and make stock trading more competitive by restricting the actions of “wholesalers”. Wholesalers are institutions like Citadel or Virtu. They pay for order flow from big brokers and trade against it. If they can’t make money on the stuff they buy, they toss it into the general market so the peons can bid/ask on it.
One thing to remember. Retail orders are now commission-free. Companies like Robinhood sell their order flow to wholesalers. But, you pay a “commission” upon execution because your order isn’t executed at the exact best price. How much slippage is there? It’s debatable. Electronic markets trade faster than the blink of an eye so it is really hard to measure.
Here is some history on stock trading plumbing. Back in the dinosaur days when the trading floor mattered, “specialists” would hold the book of orders on stocks. Specialists could trade against those orders, but they were required to make a “liquid market”. At CME we always thought this was a license to steal. How could you lose? Even if you had a few trades go against you, the bulk of trades would go your way. The specialist business was lucrative!
After the crash of 1987, reforms were instituted by the specialist system remained. Over at the NASDAQ, the rise of SOES bandits happened. These were traders that manipulated the order system of the NASDAQ and day traded.
The innovative SOES bandits created their own dark pools where they paid for order flow and traded against it. Dark pools are trading systems OFF exchange-and prices are simply reported. If your order goes to a dark pool, it’s likely that the owner of the dark pool is making a penny per share off your order. It doesn’t sound like a lot but if you can do it thousands, millions, or billions of times a day, it adds up.
This led to the rise of Citadel, and companies like Virtu. The more trading became electronic, the more powerful they became and the less important specialists became. Today, specialists basically aren’t really an entity anyone pays attention to.
Pay for order flow (PFOF) directs almost all the stock trading off exchange to dark pools. Themis Trading has some nice blogs about it. Should institutions be allowed to pay for orders and make money off of them? Or, should all those orders go into a central limit order book and be competitively bid/offered by the entire market?
I have seen data supporting both positions.
I will tell you that in my gut, I don’t think PFOF should be allowed to happen. I prefer competition. Let everyone get into the scrum and see who wins. Stock exchanges should see more volume if PFOF is ended.
However, at the same time, the SEC and exchanges tangled in a lawsuit over data. The exchanges lost. It’s unclear how this will all sort out.
My personal opinion is this:
When I envisioned computerized trading as a member of the CME Board, I didn’t think we’d have what we have today. As we remade the exchange, I knew full well that the chain of distribution would be changed. Desk brokers would lose jobs and so would pit brokers as customers internalized those roles inside their organizations.
If I thought about stocks, I never envisioned PFOF and thought they would transition to a more CFTC model-except because clearing is commoditized and not regulated as a strategic asset on the SEC side, so it’s impossible for exchanges to be very competitive. Clearing on the SEC side is “fungible”. You can buy a stock on one exchange, and sell on another and the transaction clears and cancels. You can’t do that in CFTC-regulated commodities which is why CME is so valuable.
In my vision, I never envisioned co-location either. I figured everyone would get data at the same time and act on it. Today, unless you spend millions on technology, you do not have a chance. This has caused bid/ask spread size and the amount of volume in the book to drop.
I think both the CFTC and SEC need to pay attention to the principle of competition. Make markets hyper-competitive. Pay very close attention to concentration. If one player is the dominant market maker, they can cause harmful effects to happen to a market if they pull away during volatile times. One nice thing about the old specialist system is they couldn’t pull away. They had to make a market.
I am a big fan of lots of buyers and sellers in a marketplace competing. I thought electronic trading would do that and in some ways, it has. But, in other ways, the “producer surplus” (for lack of a better description) that used to be distributed over many many entities is swallowed up by a few. I don’t think that is good long-term for markets.
I don’t have confidence that Gensler and his crew will get it right. I hope they do, I won’t be surprised if they don’t.
On a personal note, I am on the road again. My dog Archie and I are driving across the country to go to a wedding and then up to Minnesota for the summer. My wife will join us but will use modern air transport.
Pfof is fraud
Think about it I’m Schwab I have a order from a client I sell it to virtu virtu gives payment for flow which puts the broker on the other side of his order
The payment should be against the best interest of the client period
No pfof