9/5/21, 3:00 PMSEC Chief Gary Gensler Says the Stock Market Needs an Update | Barron's

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SEC’s Gary Gensler Has a Big, New Vision for theStock Market. There Are Too Many ‘InherentConflicts of Interest.’By Avi Salzman Updated Sept. 3, 2021 6:57 pm ET / Original Sept. 3, 2021 9:59 am ET

The plumbing of the U.S. stock market, like actual plumbing, tends to operate quietly in

the background.

In January, as if a wall had been ripped open, the market’s tangled and decades-old

pipes were suddenly exposed to millions of retail investors who had given little thought

to them before. They had piled into stocks like GameStop (ticker: GME).

Then, at the height of the mania, some brokers, including Robinhood Markets (HOOD),

whose explosive growth has been fueled by new investors, restricted trading in those

stocks. The newbies cried foul, and lawmakers called for change.

MARKETS COVER

Securities and Exchange Commission Chairman Gary Gensler.

Melissa Lyttle / Bloomberg

Listen to article14 minutes

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Now, a new Securities and Exchange Commission chairman, Gary Gensler, has made it

clear that he is interested in the mechanics that burst into the open during the meme-

stock turmoil. He seems intent on overhauling market structure in ways that he thinks

will make it fairer for the new retail traders and everyone else.

The infrastructure that allows investors to tap on a phone and instantly buy stocks and

options has been revolutionary for investors and the financial industry. Yet the trading

system is extremely complex underneath, and it could be in for a remake.

Gensler is particularly concerned that the market for executing stock trades has

become segmented, with nearly as much order flow going to “dark pools” and other

less-transparent venues as goes to exchanges.

It’s not clear how much change Gensler and the SEC can push through. Resistance

from the industry and possibly Congress would need to be overcome. Still, his vision

for the stock market could lead to its biggest overhaul in decades.

“We cannot take for granted that the

U.S. equity markets will always be

considered the most efficient, the most

liquid in the world,” Gensler told

Barron’s in an interview this past week.

“We have to be realistic that technology

changes, and we’ve got to update things.”

The current trading regime, he said, has too many “inherent conflicts of interest” that

are putting investors at a disadvantage.

Among the most prominent of those conflicts are the payments that brokers get from

the market makers that process their clients’ trades. So-called payment for order flow

could be banned in the U.S., as it is in the United Kingdom and Canada, and it may not

be the only change coming.

Illustration by Ryan Melgar

We cannot take forgranted that theU.S. equitymarkets willalways beconsidered themost efficient, themost liquid in theworld. ”— SEC Chairman Gary Gensler

“

READ MORE:

Robinhood Says It Likely Would Challengea Cash-for-Order Flow Ban

Why Brokers Care About Payment forOrder Flow

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It’s an important moment to examine how the market works and how trades are

processed, because more people than ever are participating. Since the start of 2020,

more than 20 million people have opened brokerage accounts in the U.S., a record

pace. If the trend continues, it could cause a fundamental shift in the nature of wealth

in the U.S.

The changes are also rippling through the financial industry. Retail trading now makes

up 22% of trading volume, Bloomberg Intelligence estimates, more than double the

share of a decade ago. The influx of all that new money has enriched brokers, market

makers, and other players. Fidelity just announced plans to hire an additional 9,000

people to keep up with the growth.

Proponents of the current system say that the increased participation in the markets is

evidence that the markets are becoming fairer. Robinhood, which has signed up the

largest share of the new investors, doesn’t charge commissions or have account-size

minimums. Its business model depends on getting paid on the back end of trades.

When a client makes a trade, Robinhood sends it to one of a handful of market makers,

which match buyers and sellers internally instead of sending them to exchanges.

Those market makers, like Citadel Securities, Virtu Financial (VIRT), and Two Sigma

Securities, profit off the spread between the bid and the ask, and then send a portion of

that profit back to Robinhood.

Trading on the market makers’ platforms happens largely out of the public eye, though

the companies have to publish monthly data about their trade execution. What that

data show is that they are getting better prices for stocks than the exchanges are. The

market makers that execute retail trades, also known as wholesalers, got more than

$3.6 billion in price improvement for retail investors in 2020, according to Virtu.

Most other major brokers do this, too, although it accounts for a much smaller

percentage of their revenue. At Charles Schwab (SCHW), for instance, payment for

order flow accounted for about 5% of revenue in 2020. At Robinhood, it accounts for

75% to 80%.

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Gensler, however, doesn’t think it’s a fair comparison. Because so much trading

happens off exchanges, the “best price” on an exchange may be different from the best

overall market price.

“Nearly half of our market is in dark pools or wholesalers, not lit,” he said. Even the

orders that go to stock exchanges, a “fair amount of that’s not lit, either,” he said. “So

price improvement versus the lit part of the market is not a full measure of the efficiency

of the market. And it is not a full measure of best execution. So much is being left out of

the measuring stick. It’s sort of like if I was going to measure the height of my children,

but I left some of the parts of the ruler out.”

People who want the industry to change say that liquidity on exchanges has suffered

as more trading has moved off exchanges, and that is causing price spreads to widen,

making the overall market less efficient. Segregating retail trading on its own venues

reduces liquidity and transparency in the entire market, says Dennis Kelleher, CEO of

Better Markets, a nonprofit that focuses on financial reform.

Some wholesalers think the critics are mischaracterizing their role and how they help

the market. Virtu said in a presentation to the SEC this year that the benefits that retail

investors get from their operations are probably understated, not overstated. If all of

those benefits were included, the value of Virtu’s price improvement would probably

be three times as much as the company discloses in securities filings, the company has

argued.

Gensler’s concerns are not just about retail brokers and their market makers. He is also

critical of the payments, known as rebates, that exchanges pay for certain kinds of

orders. Gensler wants more transparency in the market and for trades to compete on an

“order by order” basis, as opposed to being segmented based on where the order

originated, or to be routed based on how they are paid for.

Virtu CEO Doug Cifu responded to Gensler’s comments about market structure this

past week by warning that “drastic changes to the market ecosystem are not warranted

and would likely result in worse outcomes for retail investors.”

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When markets are opaque, and customer orders are processed differently, the

investing public could be at risk. He thinks it is affecting prices.

“It provides an opportunity for the market maker to make more, and for ultimately the

investing public to get a little less when they sell, or have to pay more when they buy,”

Gensler said. “I think it also affects companies raising money,” he added, because it

impacts the efficiency and fairness of those markets.

Does that mean that Gensler wants all trading to happen on exchanges? He wouldn’t

say in the interview with Barron’s, speaking more about the principles the agency plans

to follow, but not the specific route of each trade. “If, when I place a buy or sell order, I

know that it’s going to be in a competitive pool among other investors that are seeking

to buy and sell and there’s that broader competition—that’s the tenet of a competitive,

efficient market,” he said.

Experts in the field aren’t so sure where Gensler is heading.

“That’s the $64,000 question,” Kelleher says. “Or, I actually think it’s the $40 billion

question.”

Kelleher expects that the SEC will float several options and “put them all out there to

get a maximum amount of information and make a decision.” He favors a system that

requires brokers to get the best price for their client at any given moment, instead of

directing trades to a few companies.

“Whether you’re in the dark market or lit market, it doesn’t matter,” he says. “What

matters is the best available price at the time. It’s forum-agnostic, but the duty is

uniform. And then you require disclosure so that people can see that, in fact, they’re

getting the best available price at the time.”

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Others want to make sure any rules allow for flexibility. SEC Commissioner Hester

Peirce said at a hearing earlier this year that “best execution is not a one-size-fits-all

concept.”

“For most retail investors, price might matter most, but institutional investors often have

a larger set of considerations,” she added.

Changes to payment for order flow in particular would be controversial. The payments

are legal and have been used for decades. The SEC has been expressing concern

about them since at least 1984. But Robinhood’s rise has shined a new spotlight on

how they work.

There is no evidence that the payments had anything to do with Robinhood’s decision

to temporarily ban purchases of GameStop in January. The company has said it was

forced to halt purchases because of capital demands from its clearinghouse. And other

brokers also limited trading in some stocks or options, though not to the same extent as

Robinhood.

Nonetheless, the episode infuriated some retail traders, and led to congressional

hearings where the payments became an issue. At a February hearing, Rep. Brad

Sherman (D., Calif.) likened it to Facebook’s business model. “When you’re not paying

for it, it’s not free,” he said. “You’re the product; someone else is the customer.”

Others have also criticized the practice because they say it gives brokers an incentive

to encourage more trading even if that is not the best investment strategy.

Last year, Robinhood settled administrative charges about payment for order flow with

the SEC. The regulator found that the company had misrepresented its business model

to customers and routed orders from 2015 to 2018 in a way that hurt them—in some

cases it cost them more than an up-front commission would have. Robinhood paid $65

million and neither admitted nor denied the findings. It says it has changed its practices

since.

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Robinhood has vigorously defended payment for order flow as beneficial to customers.

“We think payment for order flow is a better deal for our customers versus the old

commission structure,” its chief financial officer, Jason Warnick, said during a virtual

road show the company held before its initial public offering. “It allows investors to

invest smaller amounts without having to worry about the cost of commissions.”

Robinhood has said that it doesn’t push investors to trade or offer advice—it simply

gives them access to markets that had previously been closed off to them.

“The idea that the revenue we do receive from payment for order flow is somehow the

result of some unmitigated conflict or not earned money is inappropriate,” he said.

He called the idea of banning it “pretty draconian,” and expects that it would result in

up-front commissions coming back, at least for some brokers. That’s one reason that

Gallagher doubts it will happen. “They are going to realize that payment for order flow

is an amazingly good thing for investors,” he said. If it did get banned, “we’d have to

seriously consider” legal action. “We’d have to get in line for that, though. There would

be a long line of folks who would sue.”

Some competitors that focus on retail trading have managed to get by without

accepting payment for order flow. Fidelity, for instance, doesn’t take the payments for

stocks, though it does for options. And a start-up called Public decided earlier this year

to do away with it, too.

Dan Gallagher, Robinhood’s chief legal officer, said in an interview with Barron’s that

Gensler’s statement about conflicts of interest is nothing new. Gallagher, himself a

former SEC commissioner, said that the SEC has accepted that conflict, and has been

comfortable with it as long as it is disclosed to customers. But he thinks the rhetoric

around it is overblown.

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Public’s chief operating officer, Stephen Sikes, says the company now directs orders

through a “smart order router” to several venues. And the company now gets better

prices than when it was routing only to wholesalers. “What we’ve found is that a

meaningful portion of the orders find better prices than what they would have gotten in

the old way,” he said.

There is, of course, a downside to brokers of not accepting the payments. Public has

more than one million customers but is still figuring out how to make money.

One way it replaced payment for order flow is “tipping,” which allows users to decide

how much to pay for the service. It also makes money from securities lending and

interest on uninvested cash.

A similar change could be coming for the broader stock market.

In 1975, Congress authorized a national market system that the SEC has put into effect

in sections over the subsequent decades, establishing how stocks are routed and

traded. One former SEC chief says the work is unfinished, opening a door for Gensler.

Harvey Pitt, who was SEC chairman from 2001 to 2003, says that “even today, we really

don’t have” a national market system.

“Going back to 2002 and 2003, we held public forums where we asked people what

the structure of the markets ought to look like, what would you like to see the

marketplace look like,” Pitt says. “We just weren’t able to—too many other things took

over our attention span. I would say it’s very possible for Gary Gensler to mobilize the

commission to do that. It’s not easy. And along the way, he’s going to be met with a lot

of opposition. No one who’s part of the status quo wants to change the status quo until

they figure out how they’re going to profit from the status quo.”

Banning payment for order flow is “on the table,” Gensler said in the interview this past

week. But his vision clearly encompasses more than that. When Gensler was chairman

of the Commodity Futures Trading Commission from 2009 to 2014, he moved the

trading of a derivative product called swaps—which he said contributed to the

financial crisis—onto more highly regulated and transparent venues.

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Carleton English, Evie Liu, and Bill Alpert contributed to this article.

Write to Avi Salzman at avi.salzman@barrons.com