Making Markets

An interview with Douglas Cifu on the SEC

The Gamestop bubble of 2021—where the value of the company’s stock increased more than a hundred times over in just a few months—exemplified the rising trend of the meme stock frenzy. This event shed light on the roles of both retail investors and market-makers in contemporary equity markets, and more recently has contributed to the US Securities and Exchange Commission’s (SEC) justifications for its proposals to overhaul how retail investors access and invest in the US markets.

Douglas Cifu is the co-founder and Chief Executive Officer of Virtu Financial, a major retail and wholesale market-maker. In the following conversation, Cifu and Elham Saeidinezhad discuss the politics and implications of the proposed regulations, as well as the broader dynamics of equity markets. Read Saeidinezhad’s full introduction to the interview and analysis of the new regulations here.

An interview with Douglas Cifu

ELHAM SAEIDINEZHAD: Can you summarize the business of market makers? 

Douglas Cifu: Market making has always been around—we can imagine a subsistence farmer who, thanks to agricultural innovations, ultimately comes to sell her excess harvest at a post in the market. The market maker is the agent who buys corn from the farmer, collects it and holds it in a warehouse, and holds it for sale to buyers looking for corn at a later date. This involves a substantial amount of risk—the market maker accumulates quantities of goods and holds them for an unknown duration of time—during which the price of corn could fluctuate—before securing buyers. 

In the contemporary equity market, market-makers are willing to purchase and sell securities to investors looking for immediate liquidity. Like the market maker buying the farmer’s corn, today’s market maker assumes the risk of holding the position until it can find an offsetting buyer or seller who wants its inventory. As an incentive to take this risk, market makers attempt to earn a profit by offering to sell shares slightly above the price than they bid to buy shares (the bid-ask spread); however, like the market maker that bought the farmer’s corn, the market for securities can move against a market maker’s position causing it to lose money on some positions. Thus, market makers contribute to market prices through their commitments to purchase and sell all sorts of liquid and illiquid assets. 

We make markets in 25,000 different financial instruments. At any moment in time, we may be long or short any security. In practice, we aim to bridge the temporal gap between natural buyers and natural sellers. In a perfect world, we would always buy from one person and sell to another person before the market moves against our position. That world doesn’t exist, but by aiming towards this end we facilitate market liquidity overall. Over the past fifteen years, we have invested billions of dollars to build our scaled infrastructure that can access and provide liquidity across hundreds of markets and dozens of asset classes. We are motivated to provide attractive buying and selling prices because, if we don’t, we’re not going to get the business. The farmer should be able to sell her corn for a higher price if she can find a buyer willing to pay more than another buyer. That’s what market making is, and competition among market makers has significantly improved market liquidity and reduced investors’ costs. 

ES: The SEC’s recent proposals on equity market structure are intended to improve trading execution for retail investors. The proposals distinguish firms which service and often internalize clients’ orders from those which route orders to another market center, with the idea that all orders should be routed to a market center where more competition would help prevent profit incentives on the part of wholesale dealers. What is the SEC missing? 

DC: The proposal assumes that market-makers have an incentive to internalize every order in order to make a higher profit margin. But, in reality, this is not the case.  

According to the rules put forward by FINRA (the Financial Industry Regulatory Authority), retail brokers have a duty of best execution which requires them to use reasonable diligence to route orders to the best market. When a broker-dealer that is a market maker receives orders from a broker-dealer client—whether it’s Schwab, Fidelity, Vanguard or any of the 250 clients we service—we have a best execution obligation to execute the client’s order in the best market, regardless of whether that means internalizing the order ourselves or routing to another market center—such as an exchange, alternative trading system (ATS),1 or another wholesaler—if we expected that doing so would be most likely to result in the best price, immediacy, and overall execution quality for the end client. We have a committee dedicated to monitoring our execution performance and evaluating market centers, including what we internalize and externalize by routing orders to external market centers.

In addition to the regulatory requirements to deliver best execution, there are intense competitive forces that serve as an immediate check against poor performance. Both to meet our best execution obligations and to compete for order flow, we internalize more orders than we would otherwise want to internalize. However, contrary to urban legends, only about a dozen retail brokers charge payment for order flow (PFOF) and these retail brokers do not route orders to one wholesaler or another based on PFOF amounts; in fact, each broker sets its own PFOF rate and charges that same rate to all wholesalers to avoid potential conflicts. Retail brokers reward wholesalers with more order flow if they deliver better performance than others and send less order flow to wholesalers that deliver lower performance. 

Importantly, the SEC’s proposed regulations do not recognize that wholesalers service more than just retail brokerage firms such as Robinhood and Schwab. Large firms such as LPL Financial, Stifel, Raymond James, and JP Morgan’s Wealth Management Division also leverage wholesalers to get the best execution for their clients. These brokers and platforms—about 250 in total—and their best execution committees review our performance on an ongoing basis. If we don’t constantly provide exemplary execution service and the best prices, these large wealth management firms would send their orders elsewhere. There are no contracts or long-term agreements that require brokers to route orders to a wholesaler—the brokers are free to (and have an obligation to) make routing changes to send more flow to the marketplaces or wholesalers providing the best execution. After all, execution quality is one the of the key metrics by which retail brokers are measured so they have a commercial incentive to make sure their routing is optimized. So, the competitive market structure already encourages the best execution, and the existing rules by FINRA ensure that this continues.

Accordingly, wholesalers are incentivized to execute in the best market. While internalizing the order will typically provide the highest probability of being the best market, for a variety of reasons wholesalers frequently obtain shares on other market centers which we refer to as externalizing the order. When we externalize an order by filling it with liquidity obtained from other sources, like an exchange, we often must subsidize the execution quality we obtained by adjusting the order’s fill price to a more favorable price for the client. By providing this supplemental price improvement, we are able to deliver price improving executions to retail investors and remain competitive versus our peers.

Our view on these proposals is that the SEC is being over-prescriptive in trying to repeal and rewrite the existing understanding, rules, and standard operating procedures that FINRA and the industry have dealt with for the last twenty years. The proposed reforms are vague and subject to substantial uncertainties about the potential benefits, which the SEC itself acknowledges, and there’s a broadly held fear that the proposed rules will have unintended consequences for retail and institutional equity investors. The impression is that the SEC is trying to micromanage, rather than regulate, the marketplace. 

We believe in data-driven regulatory reform, not pointed rules that pick winners and losers from the outside. But at the moment, there’s no evidence that the proposed rules are objective and data driven, but rather will pointedly harm liquidity in the market and significantly increase investors’ and issuers’ costs. In practice, the best execution rule being put forward will simply ban PFOF—the per-share fee charged by retail brokers to the wholesalers they route orders to. SEC Chair Gary Gensler expressed the desire to ban PFOF a year ago, causing a bipartisan uproar. This is because it is widely recognized that payments (or rebates) to retail brokerage firms order flows don’t impact routing decisions. The rebate that wholesalers pay to the retail broker fosters competition and innovation among brokers, and enables these retail brokers to provide commission-free trading to their clients. 

The SEC could have opened a debate regarding PFOF. If it had done so, the SEC could have learned about how the market has solved for this already by offering choice to investors. For example, some brokers like Schwab and Robinhood charge PFOF while others like Fidelity and Vanguard do not. Generally, disclosing, quantifying, and regulating financial services and then allowing individuals to make their own decisions is far more effective and useful than prescriptive regulation that limits investors’ choices, such as an outright ban. The latter leads to years of SEC exams, potential fines, and litigation enforcement without improving the markets and would only make our markets less accessible for many first-time investors. 

Rather than prescribing static rules for a highly dynamic market, the SEC and FINRA’s primary job should be to look for bad players and then go after them. I’m a big believer in a principles-based regulatory regime—where established principles say a broker-dealer has to make reasonable efforts to obtain the best execution for its clients.

Additionally, we should not confuse best price with best executionBest execution means using reasonable diligence to execute in a manner that provides a good probability of achieving a price that is at least as good as prices that are reasonably available when comparing competing markets centers under the particular circumstances of the order and market conditions. When a client sends a wholesaler a big block of an illiquid stock, simply executing that order in the marketplace may move market prices overall, which—even if executed at the best posted prices available—may not be the most favorable outcome for investor’s order. Therefore, the best price for a given order should also consider the order size, the investor’s level of urgency, the time the order is received, and what liquidity looks like in the rest of the marketplace. The SEC mistakenly concludes that because the retail broker is charging a rebate, it can’t possibly offer best execution. But this doesn’t recognize the various factors that impact execution quality.

Finally, investors always have the choice of selecting a retail broker that does not charge PFOF if they dislike PFOF. We service about 250 retail brokers in the United States and abroad, and only about ten of them charge a rebate or PFOF. Regardless of whether a broker charges PFOF, these brokers satisfy their best execution obligations in large measure by sending orders to wholesalers who can provide a better price as academics have demonstrated on many occasions

ES: What is your response to the proposed changes to Regulation National Market System (reg NMS) that would reduce the minimum quoting increment—thus reducing the minimum difference between bid and ask prices for particular stocks, potentially allowing the market to quote closer to an asset’s fundamental value?

DC: In 2005, reg NMS allowed securities to be traded on more venues than only a security’s primary listing exchange. One of the trade-offs was making everything trade-in “no less than a penny tick.” 

Nearly twenty years later, there are many exchange-traded funds (ETF) and some stocks that are constantly quoted at a penny. One could make the argument that those names are tick constrained and might benefit by being allowed to quote in half-penny increments, but we should identify these symbols through data rather than arbitrarily regulating tick size. Determining whether a name is tick constrained should be a multi-factor test that also considers quoted size and average trade sizes—not simply determined by the quoted spread. Some exchanges, like the Chicago Board Options Exchange (CBOE), put out a white paper with an objective method for identifying tick-constrained stocks, which seems reasonable and is broadly supported. 

Additionally, while the SEC’s proposed new tiny pricing increments (tick sizes) of 1/10th of a penny and 2/10th of a penny are purportedly aimed at narrowing trading costs for investors, these changes are likely to have the opposite effect and harm displayed liquidity in the market. The SEC’s proposal is meant to encourage tighter quoted spreads on exchanges, but overly narrow ticks will likely push more liquidity away from exchanges.

For those tick constrained names, I think there is an equilibrium to be found. You may be able to determine that there is sufficient liquidity in sub-penny pricing to narrow the tick from a penny to a half-penny without negatively impacting liquidity. But unilaterally making ticks smaller than they otherwise would-be risks worsening liquidity for everyone—including retail and institutional investors as well as increasing costs for issuers—by removing incentives for participants to display their limit orders on exchanges.

The net result will be that it will be much more difficult for institutional investors to execute in the market and more expensive for issuers to raise capital. For context, we at Virtu Financial operate retail wholesale market making, our own multi-asset principal market making, and a very large institutional business. In our institutional business, we utilize our technology investments to provide multi-asset execution services (execution algorithms), workflow solutions, and analytics products. We and the majority of comment letters from institutional investors strongly oppose the SEC proposal to reduce quoting increments to 1/10th or 2/10th of a penny.2

ES: One of the most interesting aspects of this is the gap between the SEC’s academic theories on financial markets and what is happening on the ground. Gensler is effectively following academic theories and models, which argue that commission fees and transaction costs should equal zero in a perfectly competitive market. They believe that the price of an asset should only reflect its fundamental value, or risk-adjusted future income, and any service costs should be competed to zero. What do you say to this understanding? 

dc: I think these tensions are well demonstrated by the auction proposal. The SEC chairman thinks there is too much intermediation in the equity market, and this can be resolved by routing every retail order to an auction. Gensler’s auction proposal mandates that retail equity orders are routed to auctions conducted by exchanges where more market participants would be able to bid (or offer) in the auction. 

Gensler believes that buyers and sellers would then magically match with each other in the market at more favorable prices, and that wholesalers simply represent “unnecessary friction.” That’s like saying that a grocery store creates “unnecessary friction” because a customer could get a better price if they bought one gallon of milk from the farmer, regardless of the fact that selling milk one gallon at a time would be cost prohibitive for a farmer and there’s a cost to forcing consumers to make time for a separate trip to the farmer. Competition among and between brokers, exchanges, banks, wholesalers, and market makers serves to make the entire ecosystem more efficient and diverse for everyone. 

To that point, over the years, competition amongst market makers has reduced friction and PFOF payments to retail brokers has enabled commission-free trading for retail investors. Competition has also narrowed the bid-offer spreads quoted in the market and improved execution quality dramatically. Commissions went from $300 when I was a kid to zero today. Quoting increments and trading used to happen in 25 cents, now everything is in penny increments. 

Wholesalers are able to provide superior executions to retail investors because these are not large orders. By segmenting the typically smaller retail orders from typically larger institutional investor orders, wholesalers can fill the retail orders at a better price than what is available on exchanges. Because the retail order is for, say, a $5,000 and not $100 million, wholesalers can absorb it into inventory, expecting that the individual retail order won’t move the market against us while we’re holding the inventory, which further lowers our cost to provide liquidity. 

When we have a lower cost of liquidity, we are able to be more competitive and share that savings by providing significant price improvement back to retail investors, often getting close to midpoint execution. That’s what the wholesaler liquidity provision service is—it offers price improvement, price discovery, and immediacy of execution—not “unnecessary friction.”

It’s also important to go back to the value of wholesalers’ risk taking and its relevance for liquidity provision. As a wholesaler, we assume market risk when we provide immediate executions by absorbing positions from clients. There is a broad swath of securities in the United States with about 10,000 individual companies and ETFs listed on national securities exchanges. In today’s competitive market, retail brokers are able to leverage wholesalers’ investments in technology to service all of their clients’ marketable orders of fewer than 10,000 shares. If a retail investor is buying, we will sell, and if they are selling, we will buy. Retail brokers demand that we be there in every symbol—not just the popular or most active ones. We have a commercial expectation to ensure every order is filled and a regulatory obligation to ensure best execution.

Now, of those 10,000 stocks and ETFs, there are about 7,000 illiquid securities in which we have little natural interest in being a market maker or wholesaler.3 Providing liquidity in these thinly-traded stocks or ETFs is naturally more expensive due to the lower turnover and higher capital charges—some of these might only trade a million dollars a day or less than 100,000 shares a day. However, when wholesalers receive these orders, we must fulfill them—and we need to do a good job at it to remain competitive and fulfill our regulatory obligations. So, you can see there would be little chance that orders in illiquid symbols would find meaningful liquidity if they were sent to an auction where no one is obligated to provide liquidity. 

ES: What do you do with such unwanted inventories?

dc: Well, we fill these orders and often hold positions overnight—or as long as it takes to find the other side. As I mentioned, being a market maker involves taking measured market risk to efficiently bridge the gap in time between when a buyer comes to the market and a seller comes to the market. But under the auction proposal, if market makers don’t want to internalize those unwanted trades at the midpoint price, which we don’t, these orders would be sent to an auction where there’s no obligation for anyone to absorb the orders. 

This means that under the proposed auction rule, many of these retail orders will not be executed, or if they are, it will be at much worse prices. Wholesalers will send the orders to an auction, where, when no one wants to trade them or if the market is moving quickly, will go unfilled or will be filled at worse prices as compared to when the retail investor entered the order. By removing the competitive forces driving wholesalers to fill every order, we are looking at the potential for massive auction failures, left, right, and center—especially during the most volatile market conditions. This is a risk that the SEC acknowledges, yet unexplainably dismisses, in its auction proposal.

The head of Trading and Markets, Professor Haoxiang Zhu, seems convinced that the market will fill in that size. That’s why I noted on CNBC that the SEC thinks there’s a liquidity fairy that’s just going to show up and fill these orders. This is not how the markets work. 

Now, let’s talk about the impacts of this rule on best execution. If you’re a retail broker, such as Schwab, for instance, and you send a sell order to Virtu Financial and Virtu decides not to internalize it at midpoint, then we would send it to an auction. After the 300 millisecond auction period, the order fails to execute because nobody wants to buy the shares. At that point, the retail order’s intentions would have been broadcast to the entire market in the public auction message and the unfilled order would come back to the wholesaler. By now, the markets have moved because the market now has information about the retail order’s intent. 

Immediately, any natural buyers that might have wanted to buy from the retail seller will stop doing so—or at least lower the price they were willing to buy at to account for the recently published information about the retail sell order. When the quoted spread widens as the best bid price in the market falls below the best bid price at the start of the auction, the auction will fail. After this failed auction, the retail seller would now need to cross a bid/ask spread that is no longer five cents wide but now is ten cents wide—raising the retail investor’s execution costs. Effectively, under the proposed auction regime, wholesalers would no longer be incentivized to compete for order flow as they do now. Wholesalers will selectively provide liquidity to internalize what they want at midpoint and then, as an agent, route the remaining orders to an auction where they have no obligation to provide liquidity.   

Much of the proposal still needs to be clarified; however, in this scenario, wholesalers—acting as agents—would presumably cross the now wider bid-ask spread and return the order back to the retail broker. From my perspective, as a wholesaler, it’s actually a better result for me because I don’t have to take as much stock into inventoryI’m not using as much capital and I have less risk, but this comes at a cost: retail investors will get a much worse execution and incur higher costs to access the markets. This is bad policy and it’s bad for our capital markets.

Additionally, regulators fail to appreciate that asset managers don’t typically trade in the same stocks as retail investors and often trade at different times of the day. When an asset manager trades, they are usually only a buyer or a seller—not both—and are typically only active for a few days at a time, so they’re not constantly in the market in every symbol. So, they won’t be acting as a counterparty to every trade and will certainly not follow and fulfill auctions to provide liquidity. Most importantly, by and large, asset managers are liquidity consumers—not liquidity providers—when they want to get into a position or exit the market. Several comment letters from large asset managers go into this in greater detail, but it’s a point worth mentioning. 

Consequently, if regulators remove the competitive dynamic that obliges wholesalers to execute every order, they are effectively removing a significant amount of liquidity from the market and this change will be most acutely felt in small and mid-cap securities and thinly traded ETFs.

A market maker provides liquidity that enables investors to immediately trade and assumes the risk of the market moving against its position while it bridges the time between when one investor buys and another sells.  In exchange for offering this immediacy to the investor, market makers attempt to earn the bid-offer spread between the price it buys and sells. Any spread successfully earned is in exchange for the risk the market maker incurred for the service of holding the position in inventory. 

Under the auction proposal, regulators are attempting to remove the service provider from the market as well as any incentive or requirement to provide liquidity to every order. By removing these incentives for market makers, regulators are harming market liquidity as we know it. It is a monumental change that comes with significant risk to the market structure and capital formation. 

ES: Now, let us discuss the rules from a market or financial stability perspective. Is there any prospect of a tick size reduction becoming a systemic risk or harming liquidity?

dc: That’s a great question and the short answer is yes to both. It’s been well documented that reducing quoting increments too much can significantly harm displayed liquidity in the market. This happens for several reasons, but the end result is often counterintuitive: wider spreads and less size displayed at the NBBO.

Additionally, every time you reduce the minimum quoting increment size, you’re going to have a multiplying effect on the number of quotes going through various systems. From a systemic perspective, you have sixteen national securities exchanges and 40-50 ATSs, all with varying degrees of technology. The physics of every quote that comes through is a certain number of bytes of data, which must be processed. And some exchanges are much better than others regarding the volume of data they can seamlessly receive, process, and then publish. 

Every order that comes through has to be received by a national securities exchange and reformatted into whatever protocol they use. This all happens in microseconds. Then, it must be reformatted and republished to every subscriber, who absorbs it and translates it into its own system. We do this at Virtu: we digest these giant fire hoses of information and reduce them and process them for consumption by a market making application running in a data center. 

If you just assumed that everything was in pennies today, and then everything went to tenths of pennies, you’re potentially multiplying everything by ten—or even greater depending on how it changes participants’ behavior. In times of normalcy, like on a typical trading day, that might be manageable. But at two o’clock today, when the Fed Chairman puts out a statement, and, depending on whether or not the Fed stops increasing rates by 25 or 50 basis points, I’m telling you, there will be a burst of activity in terms of information and bytes that you couldn’t even begin to understand how voluminous it is. The systemic implications of the additional technological burden created across the market would be significant if we had ten times as much messaging due to the proposed changes because now people are sending not just one order at a penny, but sending separate orders at different fractions of penny increments to all of these other exchanges. 

Then, on top of that, if the regulations are fully implemented as they are proposed, there are going to be millions of these little retail auctions going off every day, and the volume and costs associated with the additional overhead or how millions of intraday auctions would disrupt continuous trading haven’t been considered. There will be system capacity concerns, and some exchanges may not be able to deal with the spikes in message activity. That’s when you start to have systemic problems because people’s systems could fail under the excessive load, and there will be operational and technological issues everywhere. 

That, to me, is a systemic risk because the entire market is beholden to this change.  

  1. A marketplace where counterparties can trade securities without having to tip their hands by displaying their orders to the entire market. Trades that occur on ATSs are immediately published to the public and must occur at prices at or better than the National Best Bid or Offer (NBBO).

  2. An agent typically charges a commission for the service it provides of finding liquidity for its clients’ orders. An agent’s role is to connect buyers with sellers and vice versa, without taking market risk. Therefore, agents only trade for clients if they can find another counterparty that matches their client’s order. A principal typically attempts to earn the bid-ask spread by trading with an order (as the counterparty) and assumes the market risk by holding the position while it seeks to find someone looking to take the position off its books.

  3. Typically, companies with a total market capitalization below $1 billion.

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