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Amid the Pandemic, Market Structure Continues to Evolve

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Change is on the horizon for electronic trading as the U.S. Securities and Exchange Commission revisits regulatory reforms in a market that has evolved considerably in the last several years.

Before the COVID-19 crisis turned everyone’s attention onto viruses, variants and vaccines, the U.S. Securities and Exchange Commission (SEC) had been busy looking at ways to improve our current market microstructure.

As institutional traders were increasing their use of off-exchange venues to trade large blocks of stocks, the SEC wanted to make that process more transparent. Starting with the adoption of Reg ATS in 2018, to their most recent proposal to expand the types of systems that must comply with Reg ATS.

Over the last two years, off-exchange trading has continued to increase, with more than 40% of all trades happening off-exchange. Trading volume has also climbed exponentially as markets have become more volatile and a new breed of retail investors are buying and selling stocks with more frequency, too.

The increase in off-exchange venue usage is driving trading volumes up and has made transparency in routing protocols and fair and equitable access to markets that much more important for institutional investors.

Fortunately, with COVID-19 restrictions starting to loosen and people eager to get past the pandemic, the SEC is once again looking at ways to assess the impact of off-exchange trading. It’s also examining the impact rebates, payment for order flow (PFOF), and market data have on our current market microstructure, and assessing various reforms to improve our markets.

The Rise of Off-exchange Trading

With trading activity climbing, competition and innovation is between ATS's and LIT exchanges is evolving and is now tied to execution quality more than ever before. Both want to improve execution quality and attract more order flow. Exchanges, in particular, are trying to win over more institutional flow by making it more effective to trade on their markets. They’re doing this, in part, by offering innovative new order types, to help level the playing field. The IEX D-Limit order type, for instance, launched in October 2021, predicts when prices are about to change, protecting traders from latency arbitrage trading strategies.

All the while, new ATS’s are entering the market and others are innovating around product. The competition to attract institutional order flow will continue to increase. PureStream, of which BMO is a minority investor, prioritizes and matches orders using percentage rate based order types to match orders. This logic focuses on improving cross rates and order completion speed. OneChronos, which will launch soon, identifies itself as a Smart Market – the technical term for markets that match counterparties using mathematical optimization. Lastly, in June 2021, LeveL ATS expanded its offering to include VWAP Block and VWAP Slicer order types to leverage LeveL ATS’s conditional order functionality.

While many are welcoming innovations for electronic trading it comes alongside reforms that could improve transparency and facilitate fair and equitable access to our markets. Why?

Because institutional market participants have an obligation to deliver best execution for their clients. As electronic trading evolves, institutional investors have access to the kinds of tools and technologies to help them trade more efficiently on and off exchange. The buy side is also working more collaboratively with their sell side partners, which provides greater trading opportunities, while everyone has become more attuned to how different techniques and routing protocols can improve performance.

Revamping Rebates and PFOF

Post pandemic, it is likely the SEC will revisit the use of rebates and their impact on market microstructure. Rebates are fees that exchanges pay brokers for trading on their platform. These fees can present a conflict of interest as it’s hard to know whether a trade is being placed on an exchange because it’s what’s best for the client or because the broker is getting compensated for directing their order to a specific market center.

In our current market structure, rebates are the status-quo, but rebates can create an incentive structure for brokers to route orders. If a broker is on a cost-plus model and cannot reach the volumes for optimal pricing tiers to minimize their cost of trading, they can drive routing toward venues that will give them the higher rebate to make trading costs more efficient. But that can come at the sacrifice of performance.

Pricing is intentionally opaque. It can be difficult to know how brokers are being compensated. Fees vary from exchange to exchange and broker to broker, and there are different compensation tiers based on volume and other opaque metrics. Even the brokers themselves often don’t know what they’re getting paid until they reconcile at the end of the month.

Some people are calling for a ban on rebates, while others feel exchanges are entitled to construct models that will attract flow to their venues. In our view, the SEC should encourage pricing to be simplified and more transparent. We think brokers should have the discretion to route where they believe they can secure better-quality executions for their clients, while institutions can assess a broker’s performance and determine its merit in order to reward them with their business.

In any case, tiered pricing should be transparent and rebates should be the same for every market participant. By standardizing compensation across the board, you’ll have a much fairer marketplace, and investors can then look at performance more objectively.

This is also a challenge in the retail market, where these kinds of rebates, known as PFOF, are being reviewed by the SEC and its new chairman Gary Gensler. “Our markets have moved to zero commission, but it doesn’t mean it’s free,” he told CNBC. “There’s still payment underneath these applications. And it doesn’t mean it’s always the best execution.”

Given the SEC’s interest in rebates/PFOF, it’s likely change will come to this part of the market, though what might happen is still unclear.

Market Data Rules in Limbo

There’s another significant change that could finally come into effect over the next few months: the national market system (NMS) market data ruling. Over the past several years, it has been common for broker-dealers to pay exchanges for access to their proprietary data feeds because the Securities Information Processor (SIP) is no longer competitive for trading. The proprietary data feeds provide a trade information advantage because they have a fuller data set than what is currently available on the SIP, and this presents an unfair information advantage. While it has become table stakes for brokers to have some level of proprietary data to compete, ultimately not having the richer data set in the SIP, for the critical data that is needed to trade, is a conflict to fair access for critical market data which includes odd lots, Depth of Book and auction data.

In December 2020, the SEC changed the rule to have more of this information appear in the SIP, which everyone can access. Unfortunately, the exchanges sued the SEC to stop them from enacting the rule; it’s been held up in litigation ever since, in part because of pandemic-related delays.

These lawsuits should resolve themselves, as the legal system starts to move again. It remains to be seen if this rule will ultimately get implemented, but we’re hopeful it will. If everyone has the same data, then brokers can make better execution decisions on behalf of their clients.

Define The Future

As the world starts to move past the pandemic and embark on a new path for the future, the electronic trading industry will continue to evolve and offer more opportunities for traders.

It’s clear that Mr. Gensler and the SEC want to bring more transparency to our markets, and with trading volumes picking up, and interest in off-exchange trading, rebates, and market data gaining steam, now is the time for reform. Institutions should be excited about what’s to come – a more transparent market means better quality trades, improved executions and increased effectiveness of our electronic markets.

Read more
Joe Wald Managing Director, Head of Electronic Trading


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