Play time is over kids: the SEC has adopted rules changes that will shorten the standard settlement cycle for US stocks from two days (T+2) to T+1. The changes are intended to reduce the various credit, market and liquidity risks that sprang up with the frenzied retail dealing in meme stocks. The market, the SEC feels, needs better plumbing to manage the change in the dynamics of order flow that meme stock and zero commission trading have created.
“I support this rulemaking because it will reduce latency, lower risk, and promote efficiency as well as greater liquidity in the markets,” said SEC Chair Gary Gensler. “Today’s adoption addresses one of the four areas the staff recommended the Commission address in response to the meme stock events of 2021. Taken together, these amendments will make our market plumbing more resilient, timely, orderly, and efficient.”
In addition to shortening the standard settlement cycle, the final rules will improve the processing of institutional trades. Specifically, they will require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable, and no later than the end of trade date.
The final rules also require registered investment advisers in the US to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions.
Why is the SEC acting now?
The SEC is looking to make the clearing of US securities far more robust than it was previously. The landscape for dealing in American shares has really changed in the last few years, with higher volumes or smaller retail-sized trades, frequently in only a handful of meme stocks. The previous system was not designed for these volumes.
Market commentators tell us that there is also likely to be an uptick in the fractionalisation of share trading using new digital technologies, which will break trades down into even smaller pieces. This is good for the private investor who wants to bounce in and out of fast-moving meme stocks at the touch of a button, but the clearing system, including clearing agencies and central matching services, the plumbing behind Wall Street, needs to be told to keep up.
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As more individual investors participate in the markets, as many did during the volatile trading in early 2021, it is important to understand how their orders are executed and the incentives of their broker-dealers when executing those orders. In particular, the ability of a small number of off-exchange market makers to trade profitably with retail order flow has led these market makers to negotiate agreements with retail broker-dealers to secure rights to this order flow.
In turn, this payment for order flow creates incentives with regard to the end customer whose order flow is being sold. Some individual investors might trade more frequently as commissions have fallen or been eliminated, which raises questions about the effect of the novel features (e.g., digital engagement practices) of their broker-dealers. The execution of retail orders by off-exchange market makers raises further questions for the regulator about whether individual investors may still be subject to other less conspicuous costs and conflicts of interest.
There’s no such thing as a free lunch
While these features are not necessarily the cause of the meme stock volatility, investors should be mindful of how their orders are handled, including the difference between “free” and “no commissions.”
Though retail broker-dealers have reduced commissions, some have maintained or increased other sources of revenue, such as:
- payment for order flow
- advisory services or managed accounts from broker-dealers that are dually registered as investment advisers or from affiliated investment advisers
- interest earned on margin loans and cash deposits
- income generated from securities lending
- fees from additional services.
Recent SEC enforcement actions have highlighted some of the conflicts faced by broker-dealers.
Some broker-dealers also report that younger investors and smaller accounts have been notable sources of new account openings, and this has also radically affected deal flow in the US stock market. For example, Charles Schwab has indicated that individual investor customers age 40 and below, with account balances below $100,000, are driving a greater percentage of trading volume than in prior periods. Robinhood reported that its average customer is 31 years old and has a median account balance of $240.
