On May 6, 2021, new SEC Chair Gary Gensler made his debut, giving testimony to the House Financial Services Committee. Although Mr. Gensler is not new to regulatory leadership – he was head of the Commodity Futures Trading Commission (CFTC) – and as such, his style is certainly not new to capital markets participants, the testimony was nonetheless very enlightening of the mindset of the new SEC regime. The purpose of the testimony was particularly related to the market volatility in January, including GameStop and AMC, and reactions to that trading frenzy including Robinhood’s temporary trading restrictions, but over four hours, touched on much more.
From thirty thousand feet, Gensler attributes the January volatility to an intersection of finance and technology. On a more granular level, he highlights: (i) gamification and user experience; (ii) payment for order flow; (iii) equity market structure; (iv) short selling and market transparency; (v) social media; (vi) market plumbing – i.e., clearance and settlement; and (vii) system-wide risks, giving us a first look at potential areas of regulatory change and focus in the coming year.
This is a first look into Gensler’s points of interest and regulatory focus. Interestingly, Gensler’s SEC will obviously be much different than the agency under Clayton. Jay Clayton’s first speech focused on the SEC’s mission to protect Main Street Investors (see HERE), a mantra he continued throughout his regime. Although, I was (and am) a fan of Jay Clayton, I also believe that his policies had the unintended consequences of suppressing the under $300 million market cap class (see for example HERE and HERE regulator, his deep understanding of technology and focus on the bigger system could be a benefit to small and middle market enterprises.
Gamification and User Experience
As with all industries, mobile apps have expanded access to capital markets, making it easy and cost-effective to open accounts, trade, get wealth management advice and learn about investing. Gensler considers gamification as the use of game-like features, such as points, rewards, leaderboards and competitions, to increase customer engagement. Similarly, many apps enhance user experience with push notifications and social media features. Technology allows the designers and engineers to collect data that is used for predictive analytics and which then makes suggestions to users.
Although that technology exists across many platforms from shopping to fitness to entertainment suggestions, in the world of capital markets, the consequences can be more severe. As Gensler puts it, “[A] big loss could have immediate implications for the app user’s ability to afford their rent or pay other important bills. A small loss now could compound into a significant loss at retirement.” Moreover, the apps encourage users to trade more, which in and of itself increases risks and could lower long-term gains.
The SEC staff is in the process of preparing a request for public comment on the issues and the interface with current SEC regulations, including Regulation Best Interest. Moreover, the SEC will be considering new or updated rules that take into account recent technologies and communication practices.
As an aside, Mr. Gensler is not incapable of constructing and implementing an entire new rule set where one did not exist previously. While running the CFTC, Gensler directed the agency to create and then implement regulations for swaps. His tough stance earned him a divisive following with both strong opponents and proponents. I’m an advocate for clear rules and guidance as opposed to regulation through enforcement but as the saying goes, be careful what you wish for. As much as I like guidance, I would hate to see rules that squelched liquidity and opportunity for any investor class, especially the younger, technologically-savvy generation.
Payment for Order Flow
In the past few years, most broker-dealers have stopped charging fees for processing trades. To make up for this lost income, they make money by charging market makers for funneling order flow through them. The process is called payment for order flow. Robinhood reported $331 million of revenue for Q1 this year in payment for order flow – it is a big business.
Gensler breaks down payment for order flow into two categories: payment from wholesalers to brokers, and payment from exchanges to market makers and brokers. In a payment from wholesalers to brokers process, retail broker-dealers enter into agreements with wholesalers to purchase their order flow. Unlike public exchanges that must offer fair access to their publicly displayed quotes, these wholesalers can decide whether to execute these orders directly or to pass them along to be executed by the exchanges or other trading venues. Putting aside other aspects of this process, the data alone that the wholesaler garners is extremely valuable and provides a market advantage.
Gensler raises several other concerns, including a conflict of interest by brokers and an incentive to churn accounts or encourage more frequent trading. He points out that other countries, such as the UK and Canada, prohibit brokers from routing order to off-exchange market makers in return for payment. However, I do not believe that payment for order flow would create any additional conflict, and probably less so, than when a brokerage firm charges a straight-up commission on each trade. Rather, the issue becomes disclosure and ensuring best execution.
Case in point, in the recent settled SEC enforcement action against Robinhood, certain principal trading firms seeking to attract Robinhood’s order flow told them that there was a tradeoff between payment for order flow and price improvement for customers. Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself.
Although Gensler points to this flaw in the system, I believe that requiring a firm to choose best execution over higher payments for order flow can at least partially resolve the issue. In my mind, the issue becomes, if a brokerage firm cannot charge for trades because of competition and cannot charge for order flow, they will be forced to find other income sources (such as selling data, advertising, increased proprietary trading, higher fees on managed accounts, etc.). Hopefully, the SEC will have a clear picture of what those other sources may be, and the potential negative consequences, when considering future policies and rulemaking.
Equity Market Structure
Gensler breaks the equity markets down to three segments: the national exchanges; alternative trading systems (ATSs), also called dark pools); and off-exchange wholesalers. In January, the national exchanges accounted for 53% of volume; ATS trading was 9% and wholesalers accounted for 38%. Of that 38%, only seven wholesalers accounted for the vast majority of volume. Citadel Securities alone represented 47% of all retail volume.
Gensler raises several concerns including potential fragility, lack of healthy competition, and limits on innovation. He has asked the SEC staff to look closely at the matter to make policy recommendations.
Gensler is not the first SEC Chair to be concerned with the state of the equity market structure. In March 2019, then Chair Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform (see HERE). As noted in the speech, in 2018, the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.
Clayton and Redfearn also talked about a need for an overhaul of Regulation NMS. Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
In December 2020, the SEC adopted some amendments to Regulation NMS, including the Market Data Rules (subject of a future blog). Also, related to equity market structure, in September 2020 the SEC adopted new rules completely overhauling Rule 15c2-11 and its related processes (see HERE. Those rules have a September 28, 2021 compliance date which is keeping firms like mine, and audit firms extremely busy in between the regular 10-Q and 10-K seasons.
Short Selling and Market Transparency
Although the Dodd-Frank Act directed the SEC to publish rules on monthly aggregate short sale disclosures and to increase transparency in the stock loan market, those rules are two of the 11 remaining rules required by Dodd-Frank that have not yet been completed. Gensler has directed the SEC staff to prepare recommendations for these rules.
In addition, turning to a topic he knows well, Gensler has asked the SEC staff to consider recommendations about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so, how. He believes that the March 2021 failure of giant family office Archegos Capital Management was fueled, at least in part, by the use of total return swaps based on underlying stocks and the significant exposure that the prime brokers had to the family office as a result. Archegos Capital Management imploded, losing its entire $20 billion in just 10 days.
As we all know, social media has officially intersected with the capital markets. On Reddit, individuals gather in online communities to discuss a variety of topics anonymously, including investing; the subreddit r/wallstreetbets has about 10 million members. Outside of Reddit, social media aspects of trading apps, and all social media sites, now have various capital market centered communities.
Of course, the obvious concern is the use of social media to engage in pump-and-dump activities and other market manipulation schemes. Allaying “big brother” feedback, Gensler specifically states, “[T]o be clear, I’m not concerned about regular investors exercising their free speech online. I am more concerned about bad actors potentially taking advantage of influential platforms.”
He also points out that institutional investors and their algorithms also follow these online conversations. Developments in machine learning, data analytics, and natural language processing have allowed sophisticated investors to monitor various forms of public communication to see relationships between words and prices – known as sentiment analysis. At this point, the SEC is monitoring and learning more about these practices.
Market Plumbing – Clearance and Settlement
The clearing process is what makes the markets operate. For more on the U.S. Capital Markets Clearance and Settlement Process, see HERE. Currently the settlement process takes two days – i.e., T+2 – a trade entered on Monday, settles on Wednesday. For more on the settlement cycle and T+2 rule, see HERE.
Clearinghouses have rules to cover the credit, market, and liquidity risk that is present during those two days. All members transacting with the clearinghouses need to post collateral, called margin, to cover potential losses. If the broker went bankrupt before the trade is settled, the clearinghouse would use such margin to back the deliveries and payments with the goal of not disrupting the broader financial system. In January, the rapidly changing prices, high volatility, and significant trading volume of the meme stocks prompted larger-than-usual central clearing margin calls on broker-dealers. Some of those broker-dealers, such as Robinhood, scrambled to secure new funding to post the required margin. A number of brokers, including Robinhood, chose to restrict additional buying activity by their customers in a variety of the meme stocks.
Using this as a backdrop, Gensler questions whether broker-dealers are adequately disclosing their policies and procedures around potential trading restrictions, whether margin and payment requirements are sufficient, and whether the broker can manage its liquidity risk.
Gensler has asked the SEC staff to look into these disclosure requirements and practices. He has also asked for recommendations regarding shortening the settlement cycle further. As an aside, it is thought with current technology the settlement cycle could now be shortened to T+1 and that with further adoption of blockchain-based technologies, settlement could occur simultaneously with the trade. Gensler is a proponent and he understands technology. Time is risk, and he supports a move towards T-0.
System Wide Risks
In general, Gensler points out that the January liquidity explosion highlighted areas of concern. Robinhood, for instance, didn’t have sufficient liquidity to meet margin calls and had to fundraise within hours to meet $1 billion-plus obligations, and several brokers chose to shut down customer access to trading. Several hedge funds also lost significant money during these events. He also points to the Archegos implosion and the losses incurred by its banking partners. Finally, the concentration of trading activity with Citadel and a few other major players increases system-wide risks.