KBW analysts have published a report focusing on the potential fallout on capital markets and market structure stocks from any changes in the current regulatory environment following the increased focus on high frequency trading (HFT) and payment for order flow (PFOF) as a result of the publication of Michael Lewis’s book Flash Boys.
Stocks in their coverage universe that are associated with these business practices have declined by an average 7 percent since the market close on March 28th versus a 1percent decline in the S&P 500. While KBW believes that both practices are likely to come under heightened scrutiny by regulators, they believe that any potential changes will involve a relatively substantial overhaul to market structure regulations, making this a longer-term event.
In KBW’s view e-brokers have been the most impacted by payment for order flow (PFOF) — the stocks are down an average of 10 percent “despite the fact that PFOF was referenced only a handful of times in the book.” But Lewis described TD Ameritrade’s negotiations with brokers, always over dinner in Omaha, never anything by phone or email, as worth several hundred million in broker fees. Charles Schwab didn’t have any clue how much more it could have made from brokers, said one insider.
“The market structure stocks, which are more directly linked to HFT, are down just 7% on average. While these two issues are tied together through the current market structure in the U.S., we argue that they are two separate issues. AMTD and ETFC would be the most impacted by any restrictions on PFOF, in our view.”
From the report:
“Headline Risk Could Weigh on Exchanges & Specialty Brokers: We believe NDAQ and CME are the public exchanges that could be most negatively impacted by a reduction in HFT. KCG also operates HFT desks in several markets, but could be more negatively impacted by rules aimed to limit off-exchange trading, in our view. While we think the path to regulatory change could be long, headline risk could continue to weigh on the group”
NASDAQ comes in for particular criticism for creating a variety of order types that were tailor-made to allow HFT to pick off investors.
KBW must be a model of politeness:
“We expect the SEC to act deliberately and methodically in reviewing Reg. NMS and HFT.” These problems have been around for years and the SEC has done nothing. Lewis suggest one possible reason — more than 200 staff left the SEC to join high-frequency trading firms, so a lot of the regulators have a stake in HFT success. Jeffrey Sprecher, CEO of ICE, has spoken out on market structure, saying the U.S. has too many exchanges and he doesn’t particularly like payment for order flow. But Lewis writes that ICE tried to buy IEX, the new exchange which was developed to prevent HFT from gaming the system. The SEC probably won’t do anything too quick– HFT is worth somewhere between $10 billion and $20 billion. But if the pressure builds one fast change would be to end the maker-taker payments for orders. Of course, that could knock the valuations out of several exchanges.