PFOF regulation and market data: What does the future hold?

It might have made more headlines had the US Supreme Court not overturned Roe v Wade on June 24. But that was also the day the House Financial Services Committee published its findings on the “meme stock market event” of January 2021.

The 140-page report details how introducing brokers—it focuses particularly on how events unfolded at Robinhood—failed to respond adequately to unexpected market volatility driven by meme stock trading, to the point that they had to impose trading restrictions on customers.

In 2021, amateur investors, many of them first-timers, co-ordinating online in forums such as Reddit’s r/wallstreetbets, drove up the prices of stocks like GME and AMC, against which several hedge funds held short positions. Online, the event took on the color of class war: the “apes”, as they dubbed themselves, cast themselves as scrappy underdogs staking their modest all to go up against a greedy, corrupt establishment—which meant everyone from Melvin Capital to Citadel to the Depository Trust & Clearing Corporation.

The report—and let me digress here to say what a thoroughly entertaining read it is, featuring as it does a play-by-play account of how Robinhood battled operational and liquidity concerns at the peak of the volatility on January 27 and 28, even as senior management thought its wildest dreams were coming true—is a cracking story, complete with chat logs, memes, and a cameo appearance from Elon Musk. Anyway, this report detailed how Robinhood was especially disposed to consider this volatility as a huge opportunity: the more volatility, the more order volume, the more orders it could ship to market-makers like Citadel, Virtu, and Two Sigma for execution. The more flow Robinhood could send to these wholesalers, the more returns it would receive in rebates. But the report details how Robinhood and other broker-dealers with similar business models did not have the risk management measures in place to withstand these events.

Some of these trading platforms had to restrict trading on meme stocks as an emergency risk management tactic. Others suffered outages in their systems due to the unexpected order volume. Both the restrictions and the outages limited market access for investors, increased risk as downward pressure was exerted on the stocks, and undermined confidence in market integrity, the report says.

But the meme stock market event also had wider, systemic implications, the report finds. While these businesses had certainly not been adhering to best practices, they were within the bounds of the regulations. The issue is as much outdated regulation that cannot respond to a world in which retail order flow makes up so much of the market.

Because at the center of the issues that the meme stock market event uncovered is how quickly and sharply retail participation in equities trading has increased. Much of this increase is due to Robinhood and its ilk: platforms that offered fractional trading and lenient extension of margin trading coupled with an investing experience that trading into a “high-stakes multiplayer game”, as the House committee report puts it, with social media integration and features like animation. The demographic of the traders these apps brought to the market began to skew younger, with millennials and Gen Z trading in smaller amounts.

BNY Mellon research says Covid-19 lockdowns perhaps helped exacerbate this shift, as many young people were furloughed, stuck at home unable to go to sports events or concerts, and sitting on extra cash from stimulus checks. Whatever the reasons, retail’s share of total equities trading volume was 15% of the market before the pandemic; it now makes up 25%, according to BNY’s figures. And this is among the more conservative estimates out there. Analysis from trading tech company BestEx Research performed in 2021 shows retail volume now represents just under half of the total trading volume in the displayed limit order books of 16 exchanges in the US equity market. These figures may have declined somewhat since then, says the company’s CEO, Hitesh Mittal, but not by much.

The surge in retail volume has brought increased scrutiny to the practice of payment for order flow (PFOF). Robinhood and its ilk did not charge commissions, and relied on PFOF for revenue, agreeing to route their trades to the wholesalers in exchange for rebates. The question then becomes that as retail represents more and more of the total market, what does it mean that this flow is not visible to those operating on the public exchanges?

This was at least a question that piqued the interest of BextEx and inspired its 2021 analysis, Mittal says.

“What is the effect of that? That 45% of the order flow does not ever make its way to the exchanges? What effect does that have on the national best bid and offer (NBBO)? That was a subject of our research,” he adds.

Retail’s rough deal

What BestEx Research found was that PFOF, while seeming to give investors the kind of discounts you’d expect from any wholesale supply business model, only offers about a 15% price improvement. But retail traders are in fact getting a raw deal: if trading moved from market-makers to public exchanges, the NBBO would decline, pushing a much more dramatic price improvement. Moving retail to public exchanges would narrow spreads by 25%, the analysis says.

“That’s obviously quite disturbing,” Mittal tells WatersTechnology. “The markets are bifurcated—retail market orders go to a few wholesalers and even those wholesalers are not competing on an order-by-order basis.”

A bifurcated or segmented market means that market-makers, institutional investors, and high-frequency traders that trade in public exchanges never get to interact with this retail flow. “Retail is not getting competition for their order flow, and hence not getting the best prices that they could. And because there is less liquidity on the exchanges, the bid/offer spreads on exchanges are very high. So it hurts institutional investors like the pension funds,” Mittal says.

“The only firms that are benefiting from this bifurcated market structure are the Citadels of the world.”

These opinions are apparently shared by Securities and Exchange Commission chair Gary Gensler. After the meme stock debacle, about which the commission put out its own (much dryer) report, SEC staff have been focused on addressing some of the issues raised by the event—PFOF, trading on dark pools and through wholesalers, and short-selling.

In early June, the Gensler said that ordinary investors are getting a raw deal because investors such as pension funds can’t interact directly with order flow. “This segmentation, which isolates retail orders, may not benefit the retail public as much as orders being exposed to order-by-order competition,” he said, adding that he had asked staff to make recommendations for how the commission could enhance such competition, perhaps through the use of transparent auctions where trading firms compete for execution. 

Many, including Mittal, expect the SEC to come out with proposals tackling these issues as soon as this fall. Mittal says the commission is taking an approach modeled on options markets. The SEC says that options market structure is very similar to equities, but with some key differences: there are a lot more instruments and they are traded exclusively on national securities exchanges.

“In options markets, you can run an auction for retail market orders. You can’t give your order to a wholesaler directly in an options market, but you can run an auction on the exchanges, where people can compete to basically provide liquidity to that retail order. And they get the best price possible on exchanges,” Mittal says.

“Auctions are not attracting liquidity from one or two wholesalers—everybody can provide liquidity.”

This accomplishes two things, Mittal says. Firstly, it creates hundreds of market participants who will determine the best price they can offer to retail investors on an order-by-order basis.” And institutional investors have access to more liquidity and better liquidity by interacting with retail.”

Secondly, he adds, there is less information asymmetry in the market between market participants, as BestEx Research’s analysis explains. 

What does this incipient regulatory focus mean for market data, institutional trading technology, and capital markets infrastructure? It’s difficult to tell at this point, but some of these complications arising from the increase in retail trading—a two-tiered market, informational asymmetries—overlap with others that the SEC has sought to tackle in other rulemakings completed during the Gensler era.

Market data pricing has already seen some impacts from the fact that so much volume has moved to retail. The Market Data Infrastructure Rule mandates that odd lots data be included on the consolidated tapes of market data published by the Securities Information Processors (Sips), and the operating plans of the Sips themselves have also proposed including odd lots on the tapes.

There could be cost implications stemming from PFOF rules.

“One thing we would like to see is whether the auction data will be available as part of the consolidated Sip feeds, or will we have to subscribe to prop feeds from exchanges and pay hundreds of dollars to access that data?” Mittal says. “Chair Gensler seems to be taking a more principles-based approach, with the goal of increasing competition. So I am hopeful that there are not going to be such loopholes.”

As the cliché goes, the devil is in the details. But it seems clear that the end of PFOF could have an impact on market data pricing. Or is this totally offbase? Whether you agree or not, I would love to hear from you: joanna.wright@infopro-digital.com