IEX Exchange is changing its retail price improvement programme to enhance performance for retail investors, whose increased participation has led to larger equity volumes being traded off-exchange and whose treatment has come under scrutiny by lawmakers.
There have been estimates that nearly half, 45%, of total US equity trading volume is now being transacted off exchanges and the vast majority of that is retail trades.
Ronan Ryan, co-founder and president of IEX Group, told Markets Media: “There has been an increased scrutiny on retail trading and a redoubling of focus on execution quality, which is something that IEX feels very strongly about.”
IEX’s retail price improvement programme launched in October 2019 but the exchange has filed with the US Securities and Exchange Commission to make some changes in order to provide the retail community with the ability to execute at the midpoint as detailed in this blog.
Ryan explained there two important changes. He said: “The first is that Retail Liquidity Providers (RLPs) will now get priority in the order book over other orders and the second is that if the RLP’s order is over 100 shares, it will be flagged in our direct market data feeds and in the SIP.”
Ryan stressed that the flag is really important because, for the first time ever, retail brokers will know there is meaningful liquidity of 100 shares or more at the midpoint on the exchange so there is a higher probability of interaction.
The current program does not have this flag so retail brokers have to wade into the pool while being uncertain of finding midpoint liquidity,” added Ryan. “Now, retail brokers should be more willing to send orders to IEX knowing there is RLP liquidity, while also being able to execute with the rest of the IEX book.”
Ryan said the proposals have received a lot of great feedback from the institutional broker community, from the buy side, from wholesale market makers and retail brokers.
“A lot of what we do is met with some resistance, but this hasn’t been,” added Ryan, “We have not had pushback because flagging the availability of midpoint liquidity means participants can interact with flow that would not previously come to the exchange.”
The exchange is hoping to launch the new retail price improvement programme in mid-June, subject to SEC approval.
Ryan expects to attract more Retail Member Organizations (RMOs) and RLPs under the new programme. He thinks that if IEX is successful with these initial changes, then other exchanges will also launch similar programmes.
“This is an evolving solution to an evolving environment,” Ryan added. “IEX, whether you love us or hate us, gets a lot of credit for being at the forefront of innovation and giving institutions the ability to interact with retail at the midpoint on an exchange is exactly what everybody is calling out for.”
IEX also wants to improves the on-exchange environment as it is subject to stricter regulatory oversight. Ryan explained that in 2016 the SEC rolled out Reg SCI, which provides for system compliance and integrity, but this does not cover the off-exchange space.
“As technology and the environment is moving so fast it makes sense to bring some of the off-exchange volume back into a more regulated environment” he said.
Ryan expects that if retail programmes are embraced and successful, there could be more on-exchange trading over time.
“I am pretty excited as people have been giving us additional ideas, so I would say expect to see more tweaks to this programme going forward,” added Ryan. “We’re a big believer in performance winning out, especially at a time when displayed liquidity on-exchange is on the decline.”
Payment for order flow
The increased focus on retail trading comes as the US House Committee on Financial Services is holding its third hearing, “GameStop Game Stopped? Who Wins and Loses When Short Sellers, Social Media, and Retail Investors Collide, Pt. III ?” on May 6.
GameStop shares rose 1,600% in January after users of online forum Reddit had posted that hedge funds had taken a large short position in the US video game retailer and retail investors then drove up the price. Broker Robinhood was forced to temporarily suspend trading in GameStop and other “hot” stocks in order to cover its clearing margins which led to allegations of market manipulation and unfair treatment of retail investors.
Gary Gensler, the new chairman of the SEC, said in his prepared testimony that the regulator expects to publish a staff report assessing these market events over the summer.
Gensler said: “While I cannot comment on ongoing examination and enforcement matters, SEC staff is vigorously reviewing these events for any violations. I also have directed staff to consider whether expanded enforcement mechanisms are necessary.”
His testimony also highlighted payment for order flow. In the US retail trades are not executed on exchanges but most are sold by retail brokers to market makers under “payment for order flow” agreements, allowing the brokers to offer no-commission trading to retail. The market makers internalize the flow and capture the majority of the spread, in return for offering retail investors a slight improvement on the exchange price.
Gensler said Robinhood publicly reported $331m in payment for order flow revenues in the first quarter of this year, more than triple the amount it brought in during the first quarter of last year.
The chairman also noted that the SEC recently settled enforcement action against Robinhood. Certain principal trading firms seeking to attract Robinhood’s order flow told them there was a tradeoff between payment for order flow and price improvement for customers.However, the testimony said Robinhood explicitly offered to accept less price improvement for its customers in exchange for receiving higher payment for order flow for itself.
“As a result, many Robinhood customers shouldered the costs of inferior executions; these costs might have exceeded any savings they might have thought they’d gotten from a zero commission,” Gensler added. “Finally, it’s interesting to note that neither the United Kingdom nor Canada permits broker dealers to route retail orders to off-exchange market makers in return for payments.”
The US House Committee on Financial Services has sent a staff memo which said there is a conflict between a retail broker-dealer’s receipt of payment for order flow and its best execution obligations. The memo said: “This may not always be in the best interest of the customer, particularly with respect to execution quality.”
The memo also included draft legislation to be discussed on a possible ban for payment for order flow in the form of exchange rebates, as well as payments from market centers to broker dealers.
Kyle Voigt, analyst at KBW, a Stifel company, said in a note that he believes it is highly unlikely that the draft legislation prohibiting all forms of payment for order flow and exchange rebates will ultimately pass.
The note said: “However, this does highlight the headline risk specifically related to PFOF that Voigt had expected to occur, and he expects to continue”
The House Committee on Financial Services could eventually move forward to propose a bill(s) to the House. If the House takes up the bill(s), it would then have to pass the Senate in a 60-40 vote.
“Therefore, Voigt views the passage of this potential legislation as highly unlikely,” added KBW. “Regardless, this does present headline risk and it is possible that the SEC could look to take up certain proposals even without legislative action.”
Shortening settlement
Gensler also said he believes that shortening the standard settlement cycle for equities could reduce costs and risks. He added: “I’ve directed the SEC staff to put together a draft proposal for the Commission’s review on this topic.”
The Securities Industry and Financial Markets Association, the Investment Company Institute and The Depository Trust & Clearing Corporation are collaborating on efforts to accelerate the U.S. securities settlement cycle from two days after a trade to one day (T+1).
In February of this year DTCC released a white paper on potentially moving to T+1 by 2023, but the infrastructure provider does not have the regulatory or legal authority to unilaterally change the settlement cycle.
DTCC said a move to T+1 allows the retention of the core benefits of centralized netting and risk management, while moving to a shorter settlement time. The white paper noted that multiple regulatory bodies, including the SEC, will need to be engaged to bring this initiative to fruition.
