If you believe in the fundamental premise that markets are the best pricing and capital allocation mechanism we’ve figured out so far, then you must also believe in free and open competition.

The Markets Are a Concentrated Mess

Before we get started, I think it’s important that we all agree on one fundamental principle: Competition is good. Competitive markets, those that efficiently and effectively match buyers and sellers, provide the most optimal and desirable outcomes for market participants and for the economy as a whole. If you believe in the fundamental premise that markets are the best pricing and capital allocation mechanism we’ve figured out so far, then you must also believe in free and open competition.

This is why market concentration is such a hazard, especially in the systemically foundational finance industry. Market concentration threatens not only market stability but also market efficiency and informational accuracy.

Concentrated markets are broken markets.

Why are concentrated markets broken markets?

When most market power is concentrated in the hands of just a few firms, those firms gain several distinct advantages over other participants. The US off-exchange trading space provides a compelling example of exactly this phenomenon.

Most retail traders and investors send marketable orders through their brokers. A “marketable order” is one that is immediately executable:an order to buy at a price that is equal to, or higher than, the best offer in the market; or an order to sell at a price that is equal to, or lower than, the best bid in the market. Most retail brokers have pre-arranged deals in place with a small number of wholesalers/internalizers. These wholesalers include firms such as Citadel and Virtu. These firms have paid brokers to send marketable orders directly to them. This practice is called “Payment For Order Flow” (a/k/a PFOF). PFOF induces brokers to route orders based on who pays them, rather than who provides best execution.

Nearly every marketable retail order (over 90% according to the Chair of the SEC) is sent from retail brokers to wholesalers/internalizers, who subsequently execute these orders OTC. In this scenario, the wholesaler trades against the order itself rather than sending it to an exchange. This means we can look at the OTC retail execution market in isolation from the rest of the national market system. Small, marketable retail orders generally do not have access to lit exchanges, and are not generally routed there by their brokers.

These few wholesalers/internalizers have a huge informational advantage over other market participants. They control the off-exchange trading space and are some of the most significant participants on exchange as well. This gives them not only an informational advantage but also material control over trading prices and the NBBO. Wholesalers also enjoy massive subsidies from exchange rebates, as we will explore later.

Are U.S. markets really concentrated?

The wholesalers (and retail brokers) will try to tell you that the off-exchange internalization market is competitive. Is that true? We can measure the level of concentration in an industry using a metric called the Herfindahl-Hirschman Index (“HHI”).

The HHI is a standard measure of market concentration and is used by the Department of Justice to determine when an industry should be considered “highly concentrated.” Industries that are highly concentrated receive more scrutiny, especially when evaluating the impact of mergers and acquisitions. An HHI between 1,500 - 2,500 would be considered “moderately concentrated” and above 2,500 would be considered “highly concentrated.”

While we had expected to see an elevated HHI and an uncompetitive market, the actual measure of concentration in the OTC is still somewhat shocking. In March of 2022, and using FINRA OTC data, the OTC market scored an HHI of 2,644, when “De Minimis” trades were excluded.

This is a highly concentrated market.

In fact, we would surmise that in 2016, when Citadel bought ATD’s off-exchange trading operation from Citi, it would have not passed scrutiny if reviewed by DOJ Antitrust. A proper review would have revealed an unacceptable escalation of market concentration.

If we measure the HHI in the OTC market back to 2019, we see clear concentration throughout the time period, with a slight dip in the middle of 2021. Was that dip related to Chairman Gensler’s publicly stated concerns regarding the concentration in this market? The correlation strongly implies so, but who’s to say? (We say so. There was, indeed, a correlation.) But even then the market still remained (mostly) above the 2,500 level. Today, the HHI remains above 2,500. Even if it were to drop below 2,500, provided it remains above 1,500, it would still be considered a “moderately concentrated” market.

What does a competitive market look like?

The best example we can find is Nasdaq Nordic, which publishes trading by participant each month. When we last looked in July 2021, the HHI on Nasdaq Nordic was 578 - a highly competitive market.

We can easily see evidence that brokers who do not accept PFOF and do not exclusively route to this small set of wholesalers achieve better execution quality for their clients. This invites credible concern over the concentrated nature of the U.S. off-exchange trading market. Evidence abounds that this structure is detrimental both to markets in general, and to retail investors specifically.

What impact is concentration having on U.S. markets?

There is compelling evidence that the cost to institutional investors (think pension plans and mutual funds) increases when they are trading shares of companies that have a higher percentage of retail trading. The higher the level of trading by wholesalers, the higher the costs to institutional investors. This is a real cost that the entire economy must bear, as most investor wealth is concentrated in institutional funds.

Furthermore, the select few firms who control a significant portion of the off-exchange trading space are also responsible for a large share of on-exchange trading, leading to material information asymmetries between these firms and the rest of the market. This creates a concentration feedback loop that is exacerbated by exchange rebate tiers. Exchanges reward those firms that trade more, both on the exchange and in the market in general. This dynamic leads to increased concentration, as firms who are subsidized by these rebates gain advantages of scale over other firms.

An analysis of public data shows that firms who achieve the top exchange rebate tiers can receive over $400mm in rebates each year, not including programs tailored for individual firms (which are not technically allowed, but apparently do exist). As Chris Concannon of the CBOE explained in 2018, “five out of the top ten [firms] get a check from us… monthly.”

Stock exchanges and retail brokers are paying huge amounts of money every month to a select few high-speed intermediaries, subsidizing these firms, and giving them advantages over every other participant in the markets. Our market structure has been designed to facilitate this imbalance. The firms that benefit the most also spend handsomely on lobby and policy advocacy campaigns. These subsidies are being paid off the back of retail and institutional investors, who either receive inferior execution prices or bear the cost of the exchange technology and market data fees that their brokers are forced to pay.

If markets are to fulfill their promise of efficient price discovery and allocation of capital, they must start by being free and open. Robust competition is table stakes for functioning markets.

We are far from this threshold today. Truly, the markets are a mess.

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