In one of those "we'll believe it when we see it" updates, moments ago the WSJ reported that the SEC – having been lambasted for years for doing nothing to contain the rigged, criminal casino known as the stock "market" – is preparing to propose unprecedented changes to market structure as soon as this fall which would make it virtually impossible to frontrun retail orders.
According to the WSJ, SEC Chair Gary Gensler directed staff last year to explore ways to make the stock market "more efficient for small investors and public companies." And while aspects of the effort are in varying stages of development, one idea that has gained traction is to require brokerages to send most individual investors’ orders to be routed into auctions where trading firms compete to execute them, effectively making frontrunning impossible and obsoleting the entire microwave/laser trading industry which is meant to do just one thing: trade ahead of slower (retail) orderflow.
Digging into the details, we find that the most consequential change being discussed would impact the way trades are handled after an investor places a so-called market order (i.e., adding liquidity) with a broker to buy or sell a stock. Market orders, which account for the majority of individual investors’ trades, don’t specify a minimum or maximum price the investor is willing to pay, and are ripe for frontrunning by countless subpennying algos which move the entire market away from the order and force it to chase the market higher or lower, creating massive "slippage" in the process, or profits for HFTs and internalizers, such as Citadel, which can then turn around and immediately take the other side of the trade locking in risk-free profits.
Gensler has said he wants to ensure that brokers execute orders at the best possible price for investors—the highest price for when an investor is selling, or the lowest price if they are buying.
Under current rules, brokers have to perform “reasonable diligence” to determine the likely best market for executing a trade. Many brokers route orders to big electronic trading firms called wholesalers, including Citadel Securities or Virtu Financial, which of course have been accused for over a decade that their entire business model is frontrunning retail orders, rather than to exchanges such as IEX and the Nasdaq, arguing that the wholesalers provide the best prices (spoiler alert: they don't, but that's the lie they spread for popular consumption, and instead by collecting tens of millions of risk free pennies every day, the profits such "internalization" creates allows Ken Griffin to buy a new massive mansion every quarter).
Of course, as regular readers know well, some brokers, such as Robinhood Markets, have converted their entire business model to essentially be middlemen for the Virtus and Citadels of the world, and while offering "zero cost" trades, they accept compensation from wholesalers for routing trades to their venues. And since said orderflow allows the internalizers to trade ahead of billions in dollars, effectively guaranteeing risk-free trades, the internalizers end up making orders of magnitude more than they pay to say Robinhood for the exclusive right to see all orderflow first.
Gensler has said this practice, known as payment for order flow, creates a conflict of interest and limits competition for individual orders.
Under the auctions being considered by the SEC, different firms would compete with each other to fill an individual investor’s trade.
Such a mechanism would fundamentally alter the business model of wholesalers, which can make more money by trading against small investors than they do on public exchanges, where they may find themselves trading with other sophisticated trading firms or institutional investors.
Translation: if PFOF is banned and if retail market orders enter an auction system, Robinhood is worth exactly $0, while those "feeder" firms which rely on Robinhood access to retail order flow will be far, far less profitable.
That's why a number of Wall Street firms pushed back forcefully last year when it became apparent that Gensler was targeting their business models. Wholesalers and brokers ramped up their lobbying and campaign spending in Washington and published their own plans for improving the stock market. Virtu and Citadel Securities – which have been the names most often cited as frontrunners of retail orderflow, and in the case of Citadel, FINRA actually founds that's precisely what Citadel does – have argued against the sort of changes the SEC is considering. In response, they revert to the oldest excuse in the playbook, that payment for order flow has underpinned a broad reduction to trading costs that has made the stock market more accessible.
Here's the reality: PFOF is frontrunning of orderflow pure and simple, and while it may make trading slightly cheaper for retail investors, it also makes the entire market far more unstable as the core pillar of risk assets are HFTs which disappear at the first sign of trouble. In short: the liquidity provided by PFOF firms and their HFT algos is fake.
That doesn't mean that the HFTs won't fight tooth and nail to prevent the SEC from destroying them: billionaire Doug Cifu, CEO of Virtu, said the order-by-order competition sought by Gensler could allow trading firms more discretion in choosing which trades they fill. This could end up being more profitable in the short term for wholesalers, he said, but wouldn’t necessarily help investors.
“The SEC should engage all market participants before proposing significant untested changes that would harm retail investors’ execution quality and reduce retail investors’ access to our capital markets,” Mr. Cifu said in an emailed statement, reeking of desperation to preserve the status quo. As for Citadel, the Chicago-based HFT powerhour with an adjunct hedge fund did not even bother providing a comment to the WSJ.
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And while we said that we'll only believe it when we see it – because it is very bizarre to see the SEC actually pursue policies that truly protect markets and retail investors – the Journal reports that after a year of internal deliberations, the agency has homed in on a narrowing set of proposals. If the SEC votes to release them for public comment later this year, they would have a path to implementation, as Democrats hold a majority of seats on the commission.
The agency is also considering creating a more-stringent version of the so-called best-execution rule that directs brokers to find the most favorable terms for their customers, two of the people said. The rule that brokers currently follow was written by the Financial Industry Regulatory Authority, an industry body overseen by the SEC.
On the other side of the spectrum, the SEC is also weighing a proposal to allow stock exchanges to "subpenny," i.e., quote shares in increments of less than 1 cent, a development that would enable venues like Nasdaq or the NYSE to better compete directly with HFT wholesalers, which can beat the prices publicly displayed on exchanges by adding or subtracting hundredths of a penny to the price of a stock. In other words, it would make the already crowded HFT playing field, so crowded it would be almost impossible to make a profit. Two people familiar with the matter said the agency is also considering an idea to harmonize the price increments, known as tick sizes, that are available on exchanges versus other venues.
In addition, SEC officials are aiming to reduce the maximum fee that exchanges can charge brokers to access their quotes, two of the people said. Like some of the other changes under consideration, such a move could encourage more orders to be sent to exchanges rather than to other venues.
The bottom line: don't hold your breath, but it appears that some 13 years after this website first brought attention to the widespread scam that is HFT, the "high freaks" may be on their way out.
Not surprisingly VIRT stock slumped on the news, as did Robinhood, which is worth exactly $0.00 if it can't sell retail orderflow to HFT internalizers.
And while Citadel is private, if it was public, its stock would share a similar pattern.