October 14, 2022

Jon Stewart interviews SEC Chair Gary Gensler—an acronym bonanza?

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Cooley LLP

Here’s an unexpected pair: Jon Stewart interviewing SEC Chair Gary Gensler on his podcast, The Problem with Jon Stewart. In many ways, the interview was remarkably financially sophisticated, with acronyms like “PFOF” tossed around pretty casually, not to mention “naked shorts,” “best execution,” “dark pools” and “lit markets.” Somebody definitely did his homework.

Of course, Stewart definitely has a point of view and, to some extent, the interview was a vehicle to express it. His main theme was the absence of a level playing field in the stock market—not everyone plays by the same rules; some big players have advantages. (Of course, Gensler has previously agreed with that concept at 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 PubCo post.) Why wasn’t the SEC doing more about it? There was a general frustration with what the SEC was not doing. Gensler responded that, in fact, the SEC had issued numerous proposals on its agenda and even adopted some of them. Why does it take so long to get rules through, Stewart asked? Is it that the process takes just long enough for a new administration to come into power and then you don’t need to deal with it? Gensler wished he had a bigger staff and then explained that the Administrative Procedure Act prescribes the lengthy process for rulemaking; when it’s not followed—and sometimes even when it is—opponents of the rulemaking take the SEC to court, often dragging the process out even further. That happens with some frequency.

Stewart relayed an audience question about dark pools, lit markets and PFOF. Gensler explained that most retail market orders wind up, not on lit markets like Nasdaq, but rather going to wholesalers on the dark market, where there was little transparency and less competitive pricing for retail investors. In addition, as a result of “PFOF,” or “payment for order flow,” retail investors may not receive “best execution.” Doesn’t that create conflicts of interest, Stewart asked? Gensler agreed. Why isn’t there a rule to prevent this? Gensler responded that there is a rule about best execution, but it’s a FINRA rule. Then, Stewart asked, why doesn’t the SEC adopt a rule?

SideBar

In remarks in June 2021, Gensler contended that “it’s appropriate to look at ways to freshen up the SEC’s rules to ensure that our equity markets reflect our mission: to maintain fair, orderly, and efficient markets, while ensuring we protect investors and facilitate capital formation.” Gensler began by identifying the three segments of our equity markets: “lit markets,” such as Nasdaq and the NYSE, are the markets that the public generally considers to be “the market,” but, for example, in January 2021, the lit markets really accounted for only about 53% percent of trading volume. The other 47% of trading volume was executed on other markets—about 9% on alternative trading systems, also known as dark pools, and 38% mostly by about seven off-exchange wholesalers. When an ordinary retail investor places a small market order to buy shares on a brokerage platform, Gensler said, “more likely than not, it won’t be routed to Nasdaq or the New York Stock Exchange. A lot of people are surprised to learn that the vast majority of such orders go to these wholesalers.” While Exchange market makers compete against each other on each order to offer the best price, wholesalers have pricing advantages because they can price their order flow by reference to a “much less competitive benchmark,” the national best bid and offer (NBBO). He also noted that there is substantial concentration among off-exchange market makers, with one firm having stated that it executes nearly half of all retail volume. Gensler believes that market concentration can deter healthy competition, limit innovation and increase the possibility of system-wide risks.

In addition, Gensler identified two types of payments for order flow, both of which “raise questions about whether investors are getting best execution.” Payment for order flow for retail trades has received most of the attention, but there are also “rebates,” payments for order flow from exchanges to market makers and to brokers. Of course, brokers with these arrangements receive more payments for higher trading volume. What’s relatively new are zero-commission brokerages, which Gensler suggested, may not be as free as they appear to investors. According to Gensler, “payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict?” For example, he suggested, is there a tradeoff between payment for order flow and price improvement for customers, with the result that customers bear the costs of “inferior executions?” It’s “best execution,” he observed, “not just better execution.” In addition, he asked whether broker-dealers may be “incentivized to encourage customers to trade more frequently than is in those customers’ best interest?” Some countries, he noted, prohibit broker-dealers from sending retail orders to wholesalers in exchange for payments. He also questioned whether NBBO was an appropriate benchmark for best execution, given that almost half of the trading volume is executed in dark pools or by wholesalers, neither of which are reflected in the NBBO. He’s asked the staff to make recommendations on all these issues. (See this PubCo post and this PubCo post.)

Stewart also raised the issue of insider trading, especially by members of Congress, and gave examples of profitable misconduct by powerful entities that end up paying relatively small penalties. Where was the accountability? Gensler did his best to explain the role of Enforcement, disgorgement and penalties, but Stewart’s concerns did not seem to be assuaged. While the SEC talks about building resilience into the system, he said, it seems that 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 lot more in the interview, which lasted for 54 minutes. An acronym bonanza you may not want to miss.

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