Fixing the national market system: more regulation is not the solution

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There are concrete and explicit ways for the private sector to improve the structure of securities markets. More SEC regulation is not the answer. The SEC’s approach to a fix – ban this and that – will only lead to another goat rodeo like the current National Market System (NMS).

Moreover, changes in the private sector provide a built-in guarantee that the consequences of change will improve the lot of traders. If a change in the private sector is not constructive, the lack of profitability marginalizes it. Changes in the public sector, on the other hand, are not inhibited by the possibility of loss. The current collection of fifteen stock exchanges is mute testimony to the excessive cost of well-intentioned regulatory errors.

The financial futures market structure is a better way to organize transactions in use right now. No innovation is necessary. Changing the structure of the financial futures market to conform to the needs of the cash market would improve the structure of the cash securities market. And a futures-like system for trading cash securities is both proactive and non-coercive.

The SEC Agenda

The SEC has suspended payment for order flow (PFOF) at the top of its to-do list. Gary Gensler, Chairman of the Securities and Exchange Commission, said on Wednesday, June 5e that he asked agency staff to make recommendations for changing a host of market structure rules. Read Gensler’s speech here.

The PFOF is the payment from wholesale brokers to retail brokers in exchange for the wholesaler’s access to retail orders. PFOF has enabled retail brokers to cost-effectively eliminate commissions charged to retail clients. Zero commissions attract retail investors because without them, trading seems to be free. But the PFOF masks a higher retail cost. Commissions would serve retail better than PFOF.

Retail trade flow is valuable to wholesalers because they profit from executing retail trades at an off-market price. Wholesalers then capture the arbitrage profit by accessing a better price in the wholesale market.

In other words, the profitability of the PFOF is proof that retail traders lose more by paying an above-market price for their investments than they save on free commissions.

Can retail investors get fair treatment from Wall Street on market structure issues?

The SEC’s ongoing investigation into the structure of the securities market is an excellent opportunity for those seeking to advance the interests of retail investors to provide an outline of a new market structure that would better reflect the needs of retail investors.

But no one is currently representing the interests of retail investors as the new payment structure for executing retail transactions is determined.

Retail brokers no longer represent retail investors. Retail brokers like Robinhood are a logical source of advocacy for retail investors. Robinhood (HOOD), a brokerage once beholden to retail investors for its profits, is now beholden to a few wholesalers (Citadel, Virtu, others) for PFOF which replaced commissions in Robinhood’s bottom line.

Robinhood tells us a fundamental truth “…our values [Robinhood’s] are at the service of our customers.

The unsaid is a more fundamental truth. Robinhood customers are no longer retail investors. Today, their customers are a few large wholesalers who derive much of their revenue from arbitrage of retail orders against orders from other wholesale market participants. Retail investor orders are the product of Robinhood, not their client.

Any for-profit business will inevitably represent for-profit stakeholders, so Robinhood shouldn’t be blamed for leaving retail behind.

What is wrong with the current structure of the securities market?

The structure of the market has changed dramatically since the SEC introduced the NMS in 2005. The SEC’s goal with the NMS rules was to ensure that investors received the best execution price for their orders by encouraging competition in the market. But the SEC’s NMS rules had serious unintended negative consequences. Thus, the SEC’s current search for improvements in market structure.

The main failures of the NMS market in 2021

The SEC Staff Study “Staff Report on Equity and Options Market Structure Conditions in Early 2021” details the weaknesses of the NMS, exposed during the meme stock fiasco of 2021.

Operation of retail orders. Brokers route over 90% of marketable retail orders to a small, concentrated group of wholesalers who pay for this order flow in the retail market. The execution of retail orders by off-exchange market makers is compelling evidence that individual investors are subject to hidden costs and conflicts of interest.

Margin calls in volatile markets. On January 27, 2021, in response to market activity during the trading session, the National Securities Clearing Corporation (NSCC) made intraday margin calls to 36 clearing members for a total of $6.9 billion. dollars. Some brokers have restricted their activities on a limited number of individual stocks in reaction to margin calls and capital charges imposed by the NSCC. This was a decision made by the brokers and not directed by the NSCC.

Order flow payment. The ability of a small number of off-exchange market makers to trade profitably with retail order flow has led these market makers to negotiate agreements with retail brokers to obtain rights to this flow of orders. orders. The execution of retail orders by off-exchange market makers raises further questions as to whether retail investors may still be subject to other less visible costs and conflicts of interest.

Short presses. The potential for “buy-to-hedge” volume to drive up stock prices, thereby driving further buying-to-hedge, is often referred to as a “short squeeze”. A short squeeze can occur when an event causes short sellers to en masse buy stocks to cover their short positions. For example, if there is a sudden increase in the price of the stock being sold short, short sellers would face margin calls forcing them to either post additional collateral or exit their position. Short sellers who cover their positions by buying the underlying stock would cause additional upward pressure on the stock’s price, which could force other short sellers to exit their positions, thus adding further pressure. on the rise in prices. The result could be dangerous market instability.

How futures markets prevent each type of NMS failure

Operation of retail orders. The exchange clearing house controls the volume of financial futures contracts. Any wholesale trader competes for retail orders on an equal footing with the rest of the market. A similar plan by the SEC to somehow force wholesalers to compete for every retail order in securities trading would be staggeringly complex in securities markets with fifteen stock exchanges. distinct.

Margin calls in volatile markets. Unlike spot stock markets, the clearinghouse easily adjusts forward margins when clearinghouse officials perceive an increase in market volatility.

Order flow payment. Payment from the wholesaler to the clearing house for the retail order flow is not possible because a futures contract does not exist until a futures transaction creates it.

Short presses. The seller’s open interest in a futures market is always equal to the number of buyers, which limits short interest. The potential for a short squeeze only exists in the delivery of futures contracts where the settlement instrument is issued by a non-profit organization such as the US Treasury. Otherwise, the pursuit of profit ensures sufficient issuance of a deliverable security.

How to Integrate Futures Technology into Securities Trading

Adapting the futures market structure to cash securities trading ensures the elimination of the market structure issues exposed by the GameStop fiasco. But innovators could build a much better market structure by adding these innovations to a new exchange.

Origin of point instruments. Listing and trading different versions of securities traded in the NMS allows futures exchanges to gain superior control over trading and market access. This system eliminates:

  • High frequency trading.
  • Direct intermarket arbitrage.
  • Payments for order flow.

Use a futures type clearing house. The powerful advantage of futures trading in managing market risk is a result of the futures market’s compensation method. From using a forward clearing method, the new type of market would gain:

  • Instant compensation at no cost.
  • Margins that adjust to changes in anticipated price volatility.
  • Exchange custody of the house and client margins.

An exchange portfolio manager. The purpose of this innovation is to further provide market certainty and allow the exchange to modify the instruments traded to better suit the needs of its retail investors.

A captive exchange broker. This addition brings two improvements.

  • Assurance that trades on the new exchange are within the National Best Offer and Offer (NBBO).
  • Trading capacity to manufacture PFOF in competition with wholesalers.


The first requirement of any NMS modification is to do no harm. This means that instead of new rules to adjust the NMS, any change should be a private sector system that competes with the NMS. There is already a private sector structure that competes with the NMS: financial futures markets.

Notably, financial futures do not exhibit any of the problems seen following the Meme stock fiasco. In addition, the above proposals would adapt futures trading technologies to the needs of securities markets.

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