Here’s an unexpected pair: Jon Stewart interviewing SEC Chairman Gary Gensler on his podcast, The problem with Jon Stewart. In many ways, the interview was remarkably financially sophisticated, with acronyms like “PFOF” thrown around casually, not to mention “bare shorts”, “best execution”, “dark pools” and “enlightened markets”. Someone has definitely done their homework.
Of course, Stewart definitely has a point of view, and to some extent the interview was a way to express it. Its main theme was the lack of a level playing field in the stock market – not everyone plays by the same rules; some big players have advantages. (Of course, Gensler already accepted this concept on some level, observing that one issue that deserved attention was the difference between the prices available to institutional investors and those available to retail traders. See this post PubCo.) Why wasn’t the SEC doing more? There was general frustration with what the SEC was not Do. Gensler replied that in fact, the SEC had published many proposals on its agenda and even adopted some of them. Why does it take so long to get the rules through, asked Stewart? Does the process take just long enough for a new administration to come to power and then you don’t have to deal with it? Gensler wished to have a larger staff and later explained that the Administrative Procedure Act prescribes the lengthy rule-making process; when it’s not followed — and sometimes even when it is — opponents of rulemaking take the SEC to court, often dragging the process out even further. It happens with some frequency.
Stewart relayed a question from the audience about dark pools, lit markets and PFOF. Gensler explained that most retail market orders end up, not on enlightened markets like the Nasdaq, but rather on black market wholesalers, where there was little transparency and less competitive pricing for investors. detail. Additionally, due to ‘PFOF’ or ‘order flow payment’, retail investors may not benefit from ‘best execution’. Doesn’t that create conflicts of interest, asked Stewart? Gensler agreed. Why is there no rule to prevent this? Gensler replied that there is a best execution rule, but it is a FINRA rule. So, Stewart asked, why isn’t the SEC adopting a rule?
In Remarks in June 2021, Gensler asserted that “it is appropriate to consider ways to refresh SEC rules to ensure our stock markets reflect our mission: to maintain fair, orderly, and efficient markets, while ensuring that we protect investors and to facilitate capital formation. Gensler began by identifying the three segments of our stock markets: “lit markets,” like the Nasdaq and NYSE, are the markets that the public generally thinks of as “the market,” but, for example, in January 2021, Markets lit markets actually accounted for only about 53% of trading volume. The remaining 47% of trading volume was executed on other markets, including around 9% on alternative trading systems, also known as dark pools, and 38%, mostly by around seven OTC wholesalers. When an ordinary retail investor places a small market order to buy stock on a brokerage platform, Gensler said, “more likely than not, it won’t get routed to the Nasdaq or the New York Stock Exchange. Many people are surprised to learn that the vast majority of these orders go to these wholesalers.While Exchange market makers compete on every order to offer the best price, wholesalers have price advantages because they can price their order flow against a “much less competitive benchmark”, the National Best Offer and Offer (NBBO).He also noted that there is substantial concentration among off-exchange market makers, a firm having stated that it carries nearly half of all retail volume Gensler believes market concentration can discourage healthy competition, limit innovation and increase l a possibility of system-wide risks.
Additionally, Gensler identified two types of payouts for order flow, both of which “raise questions about whether investors are getting best execution.” Order flow payment for retail trading has received the most attention, but there are also “discounts”, payments for order flow from exchanges to market makers and brokers. Of course, brokers with these arrangements receive more payouts for higher trading volume. What’s relatively new are commission-free brokerages, which Gensler says may not be as free as they seem to investors. According to Gensler, “payment for order flow raises a number of important questions. Do brokers have inherent conflicts of interest? If so, are clients getting best execution in the context of this conflict? For example, he suggested, is there a trade-off between paying for order flow and improving prices for customers, with the result that customers bear the costs of “lower executions?” It’s “best execution”, he observed, “not just best execution”. Further, he asked if brokers can be “incentivized to encourage clients to trade more frequently than is in the best interests of those clients?” Some countries, he noted, prohibit brokers from sending retail orders to wholesalers in exchange for payments. He also questioned whether the NBBO was an appropriate benchmark for best execution, given that nearly half of trading volume is executed in dark pools or by wholesalers, none of which is reflected in the NBBO. He asked the staff to make recommendations on all these issues. (See this post PubCo and this post PubCo.)
Stewart also raised the issue of insider trading, particularly by members of Congress, and gave examples of profitable misconduct by powerful entities that end up paying relatively small fines. Where was the responsibility? Gensler did his best to explain the role of enforcement, restitution and penalties, but Stewart’s concerns didn’t seem to be allayed. While the SEC talks about building the resilience of the system, he said, it appears Main Street is paying the price for that resilience: the system privatizes the gain and socializes the loss. Do we need a new system?
There was a lot more to the interview, which lasted 54 minutes. A boon of acronyms you might not want to miss.