On October 18, 2021, the SEC released a report on the meme stock craze that caused the securities of companies like GameStop Corp. to soar to unprecedented high trading prices and volume. Commissioners Hester Peirce and Elad Roisman criticized the report as being used as an excuse to add or consider adding additional regulations in the areas of conflicts of interest, payment for order flow, off-exchange trading, and wholesale market making when, however, no causal connection between the meme stock trading and these other factors has been established. I found the report interesting for the background and discussion on the U.S. trading markets.
Market Structure
From the perspective of individual investors, the lifecycle of a stock trade starts with an investor placing an order through an account they establish with a broker-dealer. The broker-dealer then routes the order for execution to a trading center, such as a national securities exchange, an alternative trading system (“ATS”), or an off-exchange market maker. Once a trading center executes the order, the customer receives a confirmation, the trade is reported to a securities information processor that collects, consolidates, and publishes the price and volume data to market data vendors and others. The trade details are also sent to the clearing broker, who affirms the trade by verifying the trade details. The clearing broker must “settle” an equity trade within two days of the trade date (called “T+2”) by officially moving the stock from the seller’s brokerage firm’s account to the buyer’s brokerage firm’s account and moving the money from the buyer’s brokerage firm to the seller’s brokerage firm, a process facilitated by clearing agencies. For an in-depth discussion of the U.S. capital markets clearance and settlement process, see HERE as updated HERE.
The market system and individual participants are regulated by the SEC, and under the SEC, various self-regulatory organizations (SROs, including national security exchanges, clearing agencies and FINRA). The Exchange Act includes various rules, requirements, and principles, such as those that prohibit exchanges from engaging in unfair discrimination and require them to promote the protection of investors and the public interest, as well as those that require SROs to file all proposed rule changes with the SEC. Broker-dealers register with the SEC and also become members of FINRA and, as such, are regulated by both.
Broker-dealers are subject to a multitude of rules and regulations related to trading, account opening obligations, custody of funds and securities, net capital requirements, sales practices, regulation best interest and a duty of “best execution.” Best execution requires a broker-dealer to execute customer orders at the most favorable terms reasonably available under the circumstances, generally, the best reasonably available price. In addition, FINRA rules prohibit a broker-dealer from trading ahead of customer orders – i.e., receiving a customer’s order to buy and then buying for its own account first at a price that would satisfy the customer’s order, without providing the customer with that price or better. Various rules also require disclosure of order flow and data on executions.
As mentioned, individual investors access the markets through opening accounts with a broker-dealer. Broker-dealer customers can open “cash” accounts or “margin” accounts. With a cash account, the customer must pay the full amount for securities purchased. With a margin account, the broker-dealer loans the investor money with the securities in the investor’s account serving as collateral. Individual investors in a margin account can use this money to purchase securities, sell securities short, or cover transactions in case their available cash falls below zero (i.e., overdraft). Option trading is even more sophisticated and as such a broker-dealer has increased obligations to ensure the customer is suitable for such trading.
The broker-dealer business has changed over the years with increased technology and competition resulting in very low and no commissions on a trade. To attract clients broker-dealers have become creative offering all kinds of incentives such as free stock for opening an account, no minimum account opening requirement, referral programs, celebrity and influencer marketing, social aspects in trading apps and gamification. The SEC is concerned about how these features affect investor behavior and is considering rulemaking in that regard.
Although no one is completely sure, it is thought the meme stock craze resulted from the perfect storm of (i) a huge increase in accounts opened using trading apps during the Covid lockdown; (ii) large price movements; (iii) large volume changes; (iv) an increasing short squeeze; (v) frequent Reddit mentions, including in WallStreetBets; and (vi) significant coverage in the mainstream media.
Some broker-dealers offer the ability for customers to buy fractional shares. Stocks do not trade in fractions and trades are only reported in multiples of one share. A broker-dealer fractional share program typically involves the dealer maintaining a separate account in which it either aggregates customers together for a full share or uses its own capital to purchase or sell a full share and then gives the customer a fraction of such share. These programs vary by broker-dealer, and voting or proxy rights depend on the broker-dealer’s policies.
Though retail broker-dealers have reduced commissions, some have maintained or increased other sources of revenue, such as: (i) payment for order flow; (ii) advisory services or managed accounts from broker-dealers that are dually registered as investment advisers or from affiliated investment advisers; (iii) interest earned on margin loans and cash deposits; (iv) income generated from securities lending; and (v) fees from additional services.
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. Also, most exchanges offer a form of payment for order flow wherein they compensate firms that provide liquidity with rebates and charge firms that take liquidity
Payment for order flow can be broken down 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. The SEC is concerned that payment for order flow creates a conflict of interest by brokers to create more trading so they can charge a market maker for funneling those trades through them.
Order Execution, Clearance and Settlement
When an order is received, the broker-dealer routes the order for execution to a trading center, such as a national securities exchange, an alternative trading system (“ATS”), or an off-exchange market maker. Even if an order is executed off-exchange, the price is that quoted on the exchange. More than 40% of trades are executed off-exchange. Off-exchange market makers have more flexibility compared to on-exchange participants because they are not subject to the rules of the exchanges on which they quote. For example, exchanges require quotes in penny increments whereas wholesalers can execute in sub-pennies.
In January 2021, when the meme stocks were trading in unprecedented volumes, some retail broker-dealers restricted buying in certain stocks. Clearing agencies act as the central counterparty for almost all equities and options trades in the U.S. markets by functionally serving as the buyer to every seller and the seller to every buyer to lessen the risks associated with one counterparty to the trade failing to perform (i.e., deliver the securities or the money to pay for them). The NSCC, which is part of the DTCC system, maintains a “Clearing Fund” into which its member broker-dealers contribute margin to protect NSCC from potential losses arising from a defaulted member’s portfolio until it is able to close out that member’s positions.
The amount any member has to maintain in the Clearing Fund is based on complicated algorithmic calculations that include trading price, daily activity and risk assessments. On January 27, 2021, in response to market activity during the trading session, NSCC made intraday margin calls from 36 clearing members totaling $6.9 billion, bringing the total required margin across all members to $25.5 billion. In short, the amount that was required to be deposited with the clearing agency, by members as a result of the huge volatility in stocks such as GameStop caused some broker-dealers to restrict buying.
There are no rules that prevent a broker-dealer from restricting trading in any of its customer accounts. The impact on these broker-dealers raises question about the possible effects of acute margin calls on more thinly capitalized broker-dealers and other means of reducing their risks. One method to mitigate the systemic risk posed by such entities to the clearinghouse and other participants is to shorten the settlement cycle