The SEC Could Change the Markets in 2022

Change was a key theme in 2020, especially in the markets. The effects of the COVID-19 pandemic contributed to a dramatic drop in overall stock prices, followed by one of the fastest V-shaped reversals in history as well as the shortest economic recession on record.

Yet these extreme market changes may not be confined to 2020. The ripple effects of the past two years could continue into 2022, as market trends and long-term changes to market structure could prompt the U.S. Securities and Exchange Commission (SEC) to take regulatory action.


The SPAC, “Meme Stonk,” & Crypto Frenzy Domino Effect

Seismic shifts to the trading and investing landscape were happening before the pandemic ever hit with the introduction of the zero-commission trading model from brokerage firms like Robinhood and WeBull, especially among a new, younger generation of traders and investors.

Many younger, tech-savvy traders finally had the time to embark on systematic trading journeys and applauded zero commissions as a potential boon to their quant trading and their future bottom lines.

But the household income volatility and increase in remote work due to COVID-19 encouraged a surge of new retail investors, along with more activity from experienced investors. In addition, institutional traders and holdover accounts looking to take advantage of market volatility driven by the pandemic increased their activity.

A few months later, individual stocks had record price moves, driven by a social media “Meme Stonk” frenzy made possible in part by the zero-commission model.

Meanwhile, SPACs (Special Purpose Acquisition Companies) became one of Wall Street’s hottest investing trends.

Finally, legacy cryptocurrencies like Bitcoin and Ethereum, as well as social media driven cryptos like Dogecoin and Shiba Inu exploded in value, attracting another wave of traders not seen since Bitcoin’s first major rise a few years back.




New SEC Chief Proposes 49 Regulatory Changes

All these changes were front and center when the new SEC sheriff came to town.  Gary Gensler was appointed head of the SEC on April 17, 2021, taking over for Jay Clayton.  Previously, Gensler was head of the Commodity Futures Trading Commission, where he led the charge for substantial reforms to the swap marketplace.

Under prior SEC chair Jay Clayton, many considered the agency’s oversight relaxed, almost as if there was an unwillingness to rock the boat. That environment has already started to change with the new SEC leadership.

Meme stonks, SPACs, and cryptocurrencies have attracted the attention of the new SEC chair, and they can all be traced back to the rise of zero-commission trading.

According to Bloomberg Tax, Chair Gensler is laying out one of the most ambitious reform agendas in the SEC’s 87-year history, proposing some 49 regulatory changes, many to the general disdain of hedge funds, stock exchanges, and especially zero-commission online brokers.


Potential Rule Changes

The article used the term “Gensler’s Terrible 10” to describe 10 potential rule changes that may worry some algorithmic trading platforms, introducing brokers, market makers and other Wall Street giants, but some of the 10 could be more troubling than others. Delisting of Chinese stocks, Gamification rules and Security-based swap holdings (which has already been proposed) rule changes certainly could alter the landscape for brokerage firms and traders.

But changing the rules around enticing individuals to trade more frequently through the “gamification” of trading and the zero-commission model would cause one of the largest ripples in the investment pond.

Referred to as “Modernization of Market Structure,” many see changes in the current structure, with a strong reliance on payment for order flow (PFOF) as inevitable.  In an interview with Barron’s, SEC Chairman Gary Gensler said that a full ban of payment for order flow is “on the table.”

PFOF is how many brokerage firms can offer zero-commission trading, and many rely on it as their main source of income. A brokerage firm like Robinhood, for example, derives 75% of their total revenue from PFOF.  In 2020, a full 34% of those revenues came from Citadel Securities, the well-known market maker that purchases order flow in the PFOF supply chain and engages in high frequency trading. Since the brokerage firm can cover the execution costs and make money by selling the order flow, the firm can then offer the investor so-called no-cost trading.

A ban on PFOF would likely result in a scramble by brokerage firms that rely on it to operate, which could shift investor focus to firms like Lime Execution, who provide direct market access to the exchanges as well as colocation and a low latency trading platform. This would be the new, more direct path that customer orders would likely take.




Final Thoughts

The zero-commission brokerage firms would certainly not cease operations and could potentially impose a small commission on traders and investors to avoid executing retail transactions at cost.

But consumer pushback would be inevitable. Volume would potentially drop, and the focus may shift back to smart order routers and true best execution, which is often a function of speed, low latency trading, and direct connections to exchanges. There are certainly dominoes down the line that would fall as well, but the row of dominoes is long and it’s often impossible to see how far they run.