Justin Schack Redux: Rosenblatt’s Market Structure Maven Makes Sense of Meme Stocks

47 minutes · September 27, 2021

While some stay obsessed with WallStreetBets and sending GameStop to the moon, Rosenblatt Securities’ Managing Director Justin Schack stays focused on something more fundamental: making sure market structure can handle the pressure, and that investors receive fair, orderly, and efficient price information for every trade. He returns to the podcast to discuss the massive influx of retail trading, how off-exchange trading has grown, and what Washington is looking to do about it.

Speaker 1 (00:03):

From the library of the New York Stock Exchange at the corner of Wall and Broad Streets in New York City, you're Inside the ICE House, our podcast from Intercontinental Exchange on markets, leadership and vision and global business. The dream drivers that have made the NYSE an indispensable institution of global growth for 225 years. Each week we feature stories of those who hatch plans, create jobs and harness the engine of capitalism right here, right now at the NYSE and at ICE's exchanges and clearing houses around the world. And now welcome, Inside the ICE House. Here's your host, Josh King of Intercontinental Exchange.

Josh King (00:46):

This year in the annals of American popular culture marks the 50th anniversary of D. B. Cooper's infamous hijacking and his flying leap from a Boeing 727 with $200,000 in cash strapped to his body. To this day, it remains a mystery what happened to the hijacker or the money, but many have speculated. Most recent was the quick scene in the Loki series from Disney, that [inaudible 00:01:13] took a symbol of DIS showing the titular character dressed as the fugitive. The hijacking also heralded the end of the glamorous days of air travel as the FAA and other agencies began to clamp down on security to make such an event unlikely to ever happen again. Certainly the Cooper hijacking brought intense media attention to the snafu that allowed one man with a slip of paper to make off with $200,000 in cash. But that isn't the full story. You see back in 1970, Congress gave the FAA responsibility for airline safety for the first time.

Josh King (01:52):

The next year, the Occupational Safety and Health Administration was established and began working with the FAA to improve the safety for airline employee work areas. Then the debut of the Boeing 737 and expansion of airline routes not only set the stage for deregulation and cheaper tickets, but also increased attention on the industry. After Cooper's crime, there were 50 hijackings in the US over just the next two years, but none were so colorful as his so they faded from our collective memory. So why am I telling you all this? It's easier to remember one major event than a slowly changing process. That isn't just true for history, but it applies to current events as well. The headline story of the market this year has been meme stocks and their impact on trading, but that obscures the bigger story of what happened over the past couple of years to set the stage for the rise of the retail investor. Innovation and market structure have allowed a more diverse group of stock pickers to enter the markets.

Josh King (03:00):

Trading platforms have allowed anyone to implement complex strategies through an app on their phone. Zero commissions means stockholders can quickly and inexpensively move in and out of positions, particularly among cheaper stocks where fees would've been prohibitive. Technology makes buying and selling fractional shares possible as well. Lowering the price point of even the most expensive blue chip stocks. All of these changes happened slowly and steadily ushering trading to the current state of affairs. Our guest today, Rosenblatt Securities' Justin Schack has been studying the underlying market structure and its development since well before anyone knew what a meme stock was. He returns to the podcast to discuss the influx of retail trading activity, how off exchange trading has grown substantially and what Washington is looking to do about it. Our conversation with Justin Schack is coming up right after this.

Audio (03:59):

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Audio (04:03):

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Josh King (05:10):

Our guest today, Justin Schack, is Managing Director and partner at Rosenblatt Securities, a New York based equities brokerage firm that serves institutional investors. Justin heads up the firm's market structure analysis team, helping asset managers and proprietary trading firms understand and navigate the complex and rapidly changing equity market landscape. Prior to joining Rosenblatt, Justin spent 14 years covering markets as a reporter for Institutional Investor magazine. In addition to his role at Rosenblatt, Justin has become a prolific media commentator and was our guest on this show back in episode 78 in January, 2019. Welcome back, Justin, Inside the ICE House.

Justin Schack (05:53):

Thanks, Josh. Good to be back.

Josh King (05:55):

So I'm going to start asking you the same question that began our conversation back in late 2018, before we dive into the structure and factors driving the market, how do you think the market's doing today and what are you seeing?

Justin Schack (06:10):

I'll probably give you a similar answer to what I think I said back then, which is that's the sort of thing I try not to focus on too much. At least market performance. I tend to just hope that stocks continue to go up over the long haul. I will say that having... Unfortunately I'm old enough to remember the dot com boom and bust and the great recession of 2008 and the market issues with the financial crisis back then. And I think there are some parallels between now and particularly the late '90s and early two 2000s. And a lot of that comes from all of the sort of newcomers to investing that we see.

Justin Schack (06:49):

A lot of people look at what's happening now with meme stocks and people that are new to brokerage accounts think that this is the first time this has ever happened, but there was a very similar dynamic in place in the late '90s and early 200s with online brokers that are now regarded as the elder statesmen of the field, the E-Trades and Schwabs and other firms of the world. But they were very new at that time and really changing a lot of the established practice on Wall Street. And I worry a little bit as someone and who's invested in stocks for the long term and doesn't really do a lot of short term trading that what happened back then when a lot of those people sort of got burned and either never came back or took a while to come back, we may be in for a repeat of that. Hopefully we aren't and I'm wrong.

Josh King (07:34):

As a recap, Justin, or for our new listeners, can you explain how your firm Rosenblatt Securities fits into the capital market ecosystem and how it's developed its current offering?

Justin Schack (07:44):

Sure. Happy to do that. So our core business is institutional brokerage and our origins are on the floor of the New York Stock Exchange where our CEO and founder Dick Rosenblatt was what was called a $2 bro broker back in the 1970s and essentially handled the sort of the overflow when the big banks and big brokerage firms, the big member firms had an unusually busy day and their own brokers couldn't handle that flow. They would rely on independent floor brokers and Dick was one of those. And Dick was one of the first people among those independent brokers to say, well, I just going to handle that business, I'm going to go directly to institutional customers, to asset managers, hedge funds, et cetera. And that is the foundation of our business.

Justin Schack (08:29):

It started on the floor of the exchange, but now, and for many years, we've had an upstairs desk where we process orders and execute orders for institutional investors. And over the years, we've diversified into other businesses since I've joined the firm and even before I joined the firm, but I've helped develop it into more of a vertical here. We have this market structure advisory capability, and we've also gotten into equity research, investment banking. And so we're becoming more of a kind of boutique investment bank and broker dealer over the past several years.

Josh King (08:59):

And yet with all those changes, I still see Dick on the floor most days. It's amazing to see his presence and the continuity that that represents. And now as we sort of turn our conversation to the topic at hand, for the uninitiated and for the people who don't follow this day in day out, how would you define what we call a meme stock?

Justin Schack (09:19):

So a meme stock is essentially, it's part of a phenomenon, as I see it, in which investors, some of whom are completely new to the market, but others that have been around trading for many years are getting involved in trading it and egging one another on at the same time and using forums like Reddit to aggregate themselves and amplify their power in the market. And there's sort of a contagion aspect to it or sort of a crowd aspect on steroids, right? Because there's so many people that have glomed onto this idea and they're fueling one another. And there's also an aspect to some of the meme stock activity and issues like GameStop or AMC, or some of the others in which these groups of individual investors kind of find one another and say, "Hey, this is my idea." "Oh yeah. I think that's a good idea. Let's pile into that. Let's keep going."

Justin Schack (10:20):

There's an aspect of it which I don't think we've ever seen before, which is very interesting. And that's that some of these folks are getting involved in these investments, not necessarily because they want to make a profit, but almost as a way to kind of stick it to the man. The issue around GameStop, particularly where I think a lot of these retail investors that were acting in concert helped trigger a short squeeze in that name that hurt some more established and sophisticated players in the market. That was part of the motivation, which I don't think we've ever seen before and has really been fascinating.

Josh King (10:53):

Here at the NYSE we went from fielding inquiries from reporters who live and breed the markets, who've been doing it for so many years like you and your former colleagues to answering calls from every late night news show to get educated. As a former journalist, how do you think the press has done in covering the niche complex market structure issues that are at play here and how has trading benefit?

Justin Schack (11:19):

That's a great question because we see this from time to time in the markets where what is usually the preserve of a bunch of nerds like me becomes front page news. And it's happened with when people discovered what high frequency trading or automated proprietary trading was in the past. And when there are big errors marketplace maybe or operational issues that might shut down trading, and it's really, really difficult. As a former journalist, I can appreciate this. If you are not covering these markets every day at the level of nuance that folks that do what I do for a living are doing it at, it's really hard for you to understand it on a short deadline.

Justin Schack (12:00):

You've got editor that's saying, I need this story in two hours or whatever the timeframe is, and you have to become an expert on that, or at least expert enough to explain it to a general audience. It's very, very, very hard to do. I mean, people spend years fully understanding this. So considering all that, I actually think the media has done a pretty good job. It's not an easy thing to do, but I haven't seen a lot of gross inaccuracies. I mean, there's always some things that you're read and you say, they could understand that a little better and maybe I'll try to call that person up and help them understand it. But I think the overall coverage has been pretty good.

Josh King (12:35):

So I mean, talking about some of the coverage, Justin, even the physics and chemistry science journal, Entropy, took a break from publishing on the latest thermodynamics breakthroughs to devote two dozen pages to an article titled, Information Theoretic Causality Detection between Financial and Sentiment Data. It explored that the stock market prices were more affected by media and social media than hard financial numbers. And unsurprisingly, the researchers concluded that the FANG+ stocks were both most covered by the media and had the largest price reactions to changing sentiment. Without going into the mathematical models that they used, do you think it's a real issue or just part of the modern market?

Justin Schack (13:20):

I think it's always been part of markets, right? I mean, there are people who believe that the markets are hyper efficient and the price always reflects the fundamentals and all the information that can be known. But I think what we see in practices is that it frequently doesn't. And there are frequently times when prices don't agree at all with fundamentals. And this is an extreme example of that, where we've had several of these issues that the prices swung wildly, totally out of whack with what the actual prospects or profitability of the companies is. But it's certainly not new. The magnitude of it perhaps is new and concerning. And, and I think it's appropriate that it's caught the attention of policy makers who are saying, look, we don't want our markets to function like this on a regular basis or for all stocks to be trading this way. So let's try to figure out what happened. And if we can correct it, make some corrective actions. I'm comfortable that it's not becoming the norm, at least.

Josh King (14:18):

So Justin, I watched your session at the Cato Institute's conference. This year's theme was fair shares, retail investors, and the future of equity markets. Exactly what we've been talking about. The first half of that panel focused on fairness and if retail investors are disadvantaged. Professor Jonathan Macy's position, which I think had some agreement from you and Professor Fletcher was that while the market has been increasingly oriented toward retail investors, the average new investor isn't able to understand market structure. Justin, is there a responsibility to make sure that investors are educated or that the market is easier to navigate? And if so, whose job is it?

Justin Schack (14:58):

Wow, that's a great question. I think there is a responsibility, right? I mean, if you think about what's happened over the past year and a half, there are new people who are individually trading directly in the markets. They own stock and they never our owned stock before. That's a good thing, right? I mean, I don't think most people would disagree about that. That that's a good thing for our markets, for capitalism, for our economy. But if they are uneducated and we wind up in a downturn where a lot of these people lose money and then leave the markets and never come back, or maybe they take 10 or 20 years to come back, then we've sort of taken one step forward and two steps back.

Justin Schack (15:34):

And so it's the regulator's responsibility to make sure that risks are disclosed appropriately and orders are handled appropriately, but it's also the industry's responsibility, right? When you're dealing with the investing public to make sure that you're treating them the right way and that they're aware of what they're getting into. I mean, you don't want to take it too far and be looking over their shoulder and stopping them from doing certain things if they are aware of the risk, but we need to have that appropriate balance struck.

Josh King (16:04):

One of the major issues in the market is that such a complex environment can be hard to know what action is causing what reaction. Earlier this week, the SEC said it was close to publishing its report on what it calls the meme stock episode. What do you guess the report's going to cover and will understanding the problem better help market participants prepare for the next episode?

Justin Schack (16:27):

It's hard to say exactly what's going to be in there. I suspect that it is going to be pretty a wide ranging because there's a lot of stuff that Chair Gensler at the SEC and other policy makers have expressed concern about related to the GameStop and meme stock episode. And there are a few things. So one was back in January and February when all of this action was kind of peaking, we saw instances of certain retail brokers saying to their customers, you can't buy this stock anymore, you can't sell this stock anymore because there was just so much activity. And there were issues with capital at the clearing house and things like that. And so there's going to be an examination of those issues, right? Should we shorten the settlement cycle. Right now when you trade, there are two days after that trade happens before that trade settles and the shares and money exchange hands between the counterparties.

Justin Schack (17:22):

That's a lot of time in which there's capital at risk. And if you shorten that window, right now it's two days, maybe shorten it to one day, maybe you take out some of that risk. And so I think that's one thing they're likely to look at. There may be some other examination of short sale, or maybe stock loan rules, because the short interest in some of these meme stocks was very, very high, and that played a role in how volatile they became. But then there was also a piece of it which deals more directly with the world that I care about and examine every day of market structure. And Chair Gensler among others have expressed concerns about something called payment for order flow in the off exchange world, which is something that's attached to a lot of retail executions. And then also about the level of off exchange trading, because most retail orders are executed off exchange and the market share of off exchange venues has gone up dramatically.

Justin Schack (18:16):

It was about 36% before zero commissions were widely adopted in the fall of 2019. It went up to 47% in January, which was a record. And we're still at about somewhere in the low to mid forties, depending on which day you look at it. And I think he's expressed a concern that we're letting the off exchange sort of private market portion get so high. And it might be damaging the quality of the public markets where price quotations are displayed, which is really central to the whole functioning of the stock market. So I think there's going to be a lot of attention paid to those issues as well. And potentially some rule proposals that follow that, that might change the way market structure works.

Josh King (18:53):

This week there was the hearing at the Senate Banking Committee that Chair Gensler testified at. And while that was going on, I think as they were discussing payment for order flow, we'll refer to it as it's slang shortening, PFOF, you tweeted, "I have no position on whether PFOF should be banned or not, but I'm willing to bet any member of the committee that if PFOF went away commissions and retail brokerage would remain at zero." So before we go more into that topic, why don't you have a position on it? And can you offer a quick summary on what PFOF really is before we dive into the current controversy?

Justin Schack (19:30):

Sure. So the reason I don't have a position is I'm usually the guy that says let's not do anything because outcomes in the market are really, really good, particularly if you consider them and compare them to what happened before the market structure started transforming 25 years ago. And that transformation has seen a lot of unintended consequences. There have been a lot of regulations that were well intended, maybe necessary at the time, but spurred outcomes that the regulators didn't anticipate, and then that change conditions on the ground and maybe necessitated even more regulations. So today we have this very, very complex system. We have 16 exchanges, we have a few dozen off exchange destinations. We have all kinds of different order types and rules on different exchanges. And it's very complex. And a lot of people don't like that. And it takes a lot of time and effort to really understand the way it works, but it delivers very, very good outcomes.

Justin Schack (20:27):

The markets are so much more efficient today for the end users, for asset owners and issue than they were before that transformation that made things more complex. And I sometimes wonder whether we got there because of a happy accident, right? It wasn't intent as much as it was, it just turned out that way. And I'm always worried about setting off a new chain of unintended consequences and maybe winding up in a worse place. So I look at the markets and say, hey, things are really good. There better be a really good reason for you to start making major changes. Defining payment for order flow, I'll try to do this in a way that's succinct and understandable for your audience. Payment for order flow stems from retail brokers, taking an order from their customer and sending it not to the New York Stock Exchange, but rather to another broker, which is often called a wholesale broker.

Justin Schack (21:17):

It's a market making firm or a dealer that operates off exchange. And the reason they do that, there's lots of different reasons why they do it. One aspect of that is that they do get at a payment. And so the wholesale market maker, a lot of these firms are also active on exchanges, but when they trade off exchange and they get a retail order, they know exactly who they're dealing with. And they have a high level of confidence that, that counterparty is a low risk counterparty and they're going to have a profitable trade. And so that is a very different situation than if they are putting a bid or an offer into an order book that's public like the New York Stock Exchange where everybody can access that quote and someone who's a little smarter than them, or more informed, might trade with them and they might have an unprofitable trade.

Justin Schack (22:02):

So the adverse selection risk, is what we often call it, in the industry is much lower in this off exchange environment. And because of that, they're willing to give up some of the quoted bid ask spread that they would otherwise get on a public market. So let's say the stock has bid for $10 and offered for $10 and 5 cents. If I want to buy the stock and I send an order to my retail broker, that retail broker will send the order to the wholesaler and the wholesaler will say, well, look, I'm true rating with Justin so I don't need all 5 cents. I'll sell it to him for $10 and 3 cents. And that's where payment for order flow comes into play. In a lot of cases, brokers that accept payment for order flow will take some of that 2 cents and keep it for themselves as revenue and the customer will still get price improvement.

Justin Schack (22:48):

So in this instance, maybe I'll buy the stock for 10.04. And my retail broker will keep a penny per share as payment for order flow. That's part of the reason why they send orders off exchange, but it's not the entire reason. And so why I said that commissions will remain at zero, I think there are two misconceptions about payment for order flow. One of them is that there is a direct link between payment for order flow and off exchange. And as I said before, payment for flow is just one of the reasons why retail brokers will send their customers orders off exchange instead of to exchanges. And I'm not going to get into all of those reasons now, but trust me, they exist and they are powerful incentives. And so if you got rid of payment for order flow, you would still all of those orders like the one I just described to you in that scenario still going to off exchange market makers.

Justin Schack (23:36):

And there are big retail brokers today that do not accept any payment for order flow and still send their customers orders to wholesalers. The other misconception is that there is this very direct, almost one to one link between the value of the payment for order flow and the commission. That as long as the broker gets payment for order flow, there's going to be no commission. And if the payment for order flow goes down, the commission has to go up. Or if it goes away completely, then there has to be a commission. And I just think when I look at the retail brokerage industry and the way retail customers act and what they care about, there will be... The locus of competition in that industry is on the commission. Retail customers look at that and they say, am I going to get a free trade at this firm? A quote, unquote, free trade at this firm?

Justin Schack (24:23):

Or are they going to charge me a commission? And I'm going to trade where I don't have to pay a commission. And that's why what you saw in 2019, there were a few firms that were doing very, very well with zero commissions and the rest of the industry said, well, we're going to do the same thing. We're going to go to zero. If payment for order flow went away, who's going to be the first firm that says, we're charging a commission now? I think if that were to happen, everybody at that firm or a large portion of that firm's customers would go to... There's always going to be that one broker that's like, "Hey, I can do without it. I'll still charge zero." And so I think that level of competition is going to be very, very powerful. And we also saw this happen once before a few years back, I think it was in 2014. There was a book called Flash Boys published that brought a lot of scrutiny to payment for order flow and other market structure issues.

Justin Schack (25:08):

There were congressional hearings about payment for order flow in which retail brokers were asked about the practice. And one of the things we saw at that time as a result was payment for order flow rates went down, but we did not see commissions go up as a result. So if that theory that, hey, the payment for order flow subsidizes low or zero commission were true, what you would've seen at that time is, well, brokers are getting less payment for order flow, they're going to have to start raising their commissions. We did not see that. We actually saw the opposite and the subsequent years and commissions have gone down to zero.

Josh King (25:39):

Back when you were an institutional investor, Justin, you wrote an article titled, What Paulson Hath Wrought about Goldman's acquisition of the specialist firm Spear Leeds & Kellogg, where you foretold, not just some of the issues that we're talking about today and that continue to impact trading, but this mounting tension between the exchanges and the brokerages. How did that set the scene for what you cover in your 2018 writing, Who Created This Mess, Anyway? Hint: It Wasn't the Exchanges.

Justin Schack (26:11):

I mean, I think we talked a little bit about this last time I was on. There's always this tension between a centralized marketplace and then the brokers or dealers who are members of that marketplace. And the brokers sort of have this natural incentive to want to internalize as much as possible, to keep their flow down, to know more about supply and demand. And that's in conflict with the larger goal of having a public marketplace that sets the price accurately. And this conflict has been sort of ebbing and flowing for a long time. Going back to the period that you referenced when that article first appeared. And at that time you had New York Stock Exchange and NASDAQ were sort of this duopoly and they were quasi-public institutions that were owned by the broker dealers. And when that changed, the tension then rose to the fore, right? Because the brokers no longer own the exchanges and regulation was changing in a way that forced the brokers to honor the exchange quotations.

Justin Schack (27:12):

And in order for them to do that, they would have to route orders to the exchanges and pay fees. It wasn't just, hey, we own this place and so we're going to do all the business ourselves. It's, now we don't own it anymore and we send order to NYSE, they charge us a fee. So we're going to do everything we can to not send orders to the exchange, internalize them ourselves. And so we had the growth of dark pools, which is part of the off exchange world. That sort of... It calmed down for a long time during the early to mid 2000s, because volumes were exploding, the markets were automating. There was a lot of markets to change that was stimulating volumes and things were generally good in the industry. Profits for brokers were good, profits for exchanges were good. And then the financial crisis and the great recession hit volumes started to come down. There was a bit of a profit squeeze on the sell side.

Justin Schack (27:58):

And I think you started to see a lot of this agitation for rule changes that would weaken the exchanges and bolster the banking and brokerage industry's positions so that they didn't feel as captive to having to pay exchanges fees. And now what we're seeing... That was sort of the dominant arc of the regulatory agenda in the previous administration at the SEC. And now since retail trading has exploded so much and we've had the pandemic and people at home, and we see retail and off exchange trading jumping so high from less than 40% to now nearly 50% and in a lot of individual securities, by the way, well, over 50 or 60 or 70%, we've seen a change in administration as well. So you have a different party in power with different priorities. And a combination of those things has kind of upended the regulatory agenda, where now there's a lot more attention being paid to the off exchange world and less of a priority on those things that were being pursued maybe two or three or four years ago.

Josh King (28:57):

After the break with Justin Schack, Rosenblatt Securities' Managing Director and partner, we're going to try to clean up the mess and see how the last three years have continued to evolve structure and where we're going to head from here. That's all coming up right after this.

Audio (29:15):

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Josh King (30:24):

Welcome back. Before the break, Justin Schack, Rosenblatt Securities' Managing Director and partner, and I were discussing payment for order flow and some of the other market structure topics that he's been focusing on. We were discussing your 2018 writing on equity market structure reforms, Justin, which was written at a time when about a third of the trades were happening off the lit exchanges, in the dark pools that you mentioned right before the break. How has that percentage changed bit by bit? And are we seeing a permanent trading habit evolution, or is the industry just seeing a transitory shift as a result of COVID?

Justin Schack (30:58):

I think it's both, Josh. I think there is sort of a secular other element to this that's related to zero commissions. And then I think there's a maybe transitory piece of it that's been more related to the pandemic and maybe new people coming to the markets. And whether those new people will still be around after we get a prolonged downturn is an open question. In terms of the growth and quantifying that a little bit, I go back to, I think, it was September, 2019, we saw 36% of total US stock volume done off exchange. And then in October, 2019 was when the major brokerage firms adopted zero commission policies. You already had a few of the newer brokers, the app-based brokers that were charging zero missions and doing very well with it. And then the rest of the industry adapted to that. And then the whole industry essentially was zero commissions.

Justin Schack (31:49):

And then over the next few months, retail participation grew and so did off exchange because most of these retail orders are executed off exchange. So by January of 2020, we were at 40% done off exchange. And then if you fast forward another year, January, 2021 was when GameStop was going crazy. We hit a record high 47%. And I believe December was 46, January and February were both 47%. And those three months were very, very active. There were a lot of individual days in December, in January, where for the first time we saw more than half of total stock market volume done off exchange. And as I indicated before, when you look at the top 20 securities by volume as a group, they are routinely over 50%. They still are now. And then there are some individual securities in there, particularly the ones that are favored by retail, some of the lower price stocks in particular, where you see over 60%, even over 70%. So the growth has been pretty dramatic in a relatively short period of time.

Josh King (32:50):

So we've come through the tenure of Jay Clayton as SEC chair. We are now several months into the tenure of Gary Gensler as SEC chair. You mentioned these numbers, average of 40% off exchange to 47% off exchange. You mentioned those instances where there have been 60 or 70% off exchange and particular names. What impact does liquidity moving off exchange have on price discovery? How concerned should we be?

Justin Schack (33:20):

I think we should be concerned. I know I am. I think it's worth asking the question. And that question is as there's more private market activity, are the public markets being harmed? And you've mentioned Dick Rosenblatt a few times during our conversation. And I've learned so much from Dick over the years. Not only in the 13 years I've been at Rosenblatt but in the several years before that, in which I knew him. And he's always someone who reminds me, look, we have to remember why markets exist. Markets exist to get the price right. Let's think about first principles and not get caught up in so much of these details that often captivate the market structure to bait. And if you're trying to get the price right, you think about it just from an economics 101 standpoint, you want to maximize the interaction of supply and demand.

Justin Schack (34:10):

I use this analogy all the time. If I'm selling my house, I don't want just you to look at it, I don't want just five people to look at it, I'd rather get 50 or 500 or even 5000 people to come look at it because then I'm liker to get a higher price and the most accurate price. And I think that's a reason. And when you think about public price discovery in the equity markets and how important that is to capitalism and our economy, and our society, that should be first and foremost, that should be paramount. And it should be the exception and not the rule that you go away from that public market price discovery process. Now, there are plenty of legitimate reasons why you might want to do that. And when you internalize off exchange, both parties can and frequently do get a better deal.

Justin Schack (34:57):

But if we start making it the rule and not the exception, what are we you doing to the price discovery function? Now, I don't think anybody knows the answer to that question, whether we're doing harm, whether we're doing damage, but I think it should be studied. I suspect, and I hope that the SEC has been studying it. I think they've been working on this GameStop report for quite a while. And Chair Gensler keeps repeating this concern about, well, the NBBO, the National Best Bid Offer on the exchanges, is it as good as it can be? The price improvement we talked about before for retail orders off exchange, are we improving on bad prices because there's so much private market activity and not enough public market activity.

Justin Schack (35:40):

I think they've been studying that. I know in the Senate Banking Committee hearing at which he testified recently, he mentioned the SEC's internal economists. And I think responding to one of senator's questions. So I hope that that division [inaudible 00:35:53] at the SEC has been studying this. And when the report comes out, we'll some evidence or some conclusions drawn by the SEC as to whether we do have a problem that merits solving. But I don't really know the answer to that question at that point, which is also one of the reasons why I say I don't really have a position on what we should do or whether we should do anything.

Josh King (36:11):

Well, I'm going to press you a little bit because the ink probably isn't dry on the report yet. And if the chairman came to you, you're a market structure expert. If he asks you what's the first step to fixing national best bid and offer problems, what would you tell him?

Justin Schack (36:26):

Well, first I'd say, figure out whether there's a problem, right? So look at market quality. I don't know whether you look at the width of spreads, the amount of liquidity available at the NBBO and see if that's changed in a negative way. And then if it has, you have to make sure that you can establish causality, right? There are a lot of things that can influence those market quality metrics, and you can't just assume that it's well it's because there's more off exchange trading. Volatility is higher now, and that might be playing a role for example. But if you do establish that, how do you fix it? There are a number of things that you can do? I mean, I think the last time I was on the podcast, we talked about the different rule sets between off exchange and on exchange.

Justin Schack (37:07):

And the off exchange rules are significantly less stringent. And maybe harmonizing those, making it a little bit more difficult, making it a higher bar that you have to clear to move out of that public market price discovery process might be helpful. So trying to harmonize those rules might be a first step. I don't want to get too into the weeds on, on different potential measures, but there's something called a fair access threshold in a rule called regulation ATS, which essentially says that if you're not an exchange, as long as you're below 5% percent market share, you cannot be regulated like an exchange. Now, that threshold was set back when I was still an institutional investor and writing some of the stories you talked about before. And the ATSs of today, which are very mature, don't have anywhere near 5% total market share.

Justin Schack (37:55):

So I'm oversimplifying that because it's actually... it's enforced on a stock by stock basis. But I think going back and revisiting some of these rules and harmonizing the on exchange off, exchange regulatory regime might be worth doing. Another thing that you could consider is look there, and this is a really extreme measure. So believe me, I'm not advocating this, but just thinking about what the possibilities are. There are other countries in which you can't internalize below a certain size, right? If the order's a block size and it's not part of the normal course of business, then you can internalize it. But if it's below that size, it has to be exposed to a public marketplace. That could be one potential rule. Another would be right now, we have what's called a trade through rule, which means you can't trade outside the NBBO.

Justin Schack (38:44):

If there's a best bid on an exchange best offer in exchange, you want to trade off exchange, you have to do at least as good as those two prices. We might move to a trade at rule, which means not that you can't trade through those quotes, but you also can't just match them. You can't trade at the best quotes. You have to significantly approve upon them. Again, raising that bar for going outside the public price discovery process. So these may be some of the things that the SEC is thinking about. While I'm somewhat relieved that there's a more balanced approach, I think, to considering the whole picture of market structure, I'm also wary of doing anything big because of the unintended consequences, a problem that we talked about earlier.

Josh King (39:24):

Let's get just slightly more granular, Justin. If we can geek out just a tiny bit more, because you set the first principle, the first activity, which is going on now, which is identifying whether there's a problem or not. But for this conversation, let's talk about maybe some of the other solutions that are being bandied about. The first, one of them concerns, tick sizes and the inability for exchanges to provide sub penny quotes. Can you explain what a tick size is and how having different rules for the lit and unlit trading venues impacts how stocks and trade in that specific instance?

Justin Schack (39:58):

Sure. And I'm happy to nerd out and geek out as much as you want. So I'm glad you asked this question. Tick size is essentially the minimum price variation. So right now an exchange, on any exchange in the United States, you can quote in increments of one penny, but no finer. So you can quote $10 and 0 cents to $10 and 1 cent, but you can't put in a quote for a fraction of a penny. The minimum variation in a quoted price is one penny, and that applies to every stock. And that one size fits all approach doesn't serve the full universe of US securities particularly well. And so one of the things that a lot of folks are looking at, and I think would actually have pretty broad support in the industry would be, and there's actually a rule in Regulation NMS that prohibits any exchange from accepting or displaying a sub penny price quotation.

Justin Schack (40:52):

Somehow reforming that rule, or maybe also implementing what's sometimes called an in intelligent or flexible tick size regime where you group stocks together and each group has a different tick size. So Europe does this already. Japan does this already. Many other markets, developed markets around the world have customized tick sizes. And the reason that, that's important is you, you take a stock like Amazon that trades for thousands of dollars per share, and you compare it with, let's say, Sundial Growers, which happens to be one of the most active stocks of the past couple of years. It trades around a dollar. The bid ask spread as a percentage of a dollar, one penny as a percentage of a dollar is a much, much bigger value than it is one penny for a multi thousand dollars stock. And so particularly for a high volume stock like Sundial, the natural bid ask spread in that stock is absolutely going to be finer than one penny, but exchanges can't display that type of market right now.

Justin Schack (41:51):

So what you see is a lot of the volume winds up going off exchange so that they can trade within that penny increment because the off exchange venues are not held to that same standard. That would also be one potential way to address the unlevel playing field between exchanges, on exchange and off exchange, would be a less dramatic, less controversial, probably more likely to be adopted way to do that. And I think if that happened, if some form of tick size reform happened, you would probably see some portion, I don't think it would be a huge portion, but some portion of the volume that currently happens off exchange might move back on exchange.

Josh King (42:27):

You mentioned Reg NMS just now, Justin. And Reg NMS and other regulation that came into force in the early part of the century is linked to our collective memory to the response to September 11th. Do you see COVID representing another watershed moment that will be seen as a major turning point for market structure and regulation?

Justin Schack (42:49):

That's a great question which I haven't thought about before. And it could, but I think it would be indirect because it's not so much a response to COVID that we're seeing right now in the policy making community. What we're seeing is a response to the meme stock phenomenon and the growth of retail and off exchange trading. And that has been fueled by COVID. We talked before about there were kind of two big up in retail and off exchange. The first was before COVID with zero commissions, but the second was the pandemic. And so I think there could be something to that where, again, it wouldn't be direct, it wouldn't be regulators said, well, we have to do this because of COVID. But the market dynamics that we've seen because of COVID are prompting scrutiny on some of these issues that could result in some pretty dramatic change. We don't know yet. Hopefully we'll know in the coming months, what exactly the regulators want to do.

Josh King (43:42):

As we wrap up, Justin, this conversation has covered a lot of ground, but is there a topic that we haven't touched on that you think is being ignored today, but is going to become a defining topic for market structure in the coming months and years?

Justin Schack (43:54):

I don't think so, Josh. I mean, I think this retail and off exchange focus is probably the appropriate focus right now. The stuff that had been on the table before that the previous administration was really pushing has been pushed back or pushed off in a lot of ways, but we may not have seen the last of that. There were some initiatives on market data at the end of the last administration that were adopted are still sort of in progress, maybe subject to some legal challenges. We don't know how that's going to work out yet, but I think given what we've seen over the past year in change, the regulators are looking at the right stuff. Question is, will they draw the right conclusions from what they're studying and take the right corrective steps, if any, and that remains to be seen.

Josh King (44:42):

So I want to end us on a positive note, Justin. Despite decades of conversations and arguments on best market structure, we've been having little bit of it today, here we are 2021, how do you think the United States capital markets compares to what existed previously and also what exists currently across the globe?

Justin Schack (45:01):

We hear the cliche all the time, we have the deepest, best capital markets in the world and most cliches exist because they're true. And I think that's the case here as well. I've spent and a lot of time examining the transformation of market structure in US equities. And there is no doubt that what exists today, even though as you intimated in your question, people argue about it all the time and always want to try to make it even better than it already is, it's light years ahead of where we were 25 years ago. I mean, the market was way more inefficient. There was all kinds of money that now goes into investors' pockets that went into various intermediaries pockets because of greater inefficiency back then. And if you look at our markets, just the level of participation, the level of volume and liquidity, and compare them with other equity markets around the world, we are the biggest and I believe the best.

Justin Schack (45:55):

And if you look at what's happened under the pandemic, the resiliency of those markets has been extraordinary, and we should all be proud of that. Particularly as so many of us were scattered to our homes, and remote sites, the industry came through that very, very, very well. Volumes were through the roof. We set volume records. And so to be able to cope with all of that, to go through circuit breakers and everything else that we had to deal with in the early days of the pandemic, we should be proud of our markets, absolutely.

Josh King (46:28):

Resiliency and light years ahead of where we were 25 years ago. Great conversation, Justin. Thanks so much for joining us Inside the ICE House.

Justin Schack (46:36):

My pleasure, Josh. Enjoyed it. Thanks.

Josh King (46:38):

And that's our conversation for this week. Our guest was Justin Schack, Rosenblatt Securities' Managing Director and partner. If you like what you heard, please rate us on iTunes so other folks know where to find us. And if you've got a comment or question you'd like one of our extra to tackle on a future show or experts at other firms like Justin, email us at [email protected] or tweeted us @icehousepodcast. Our show is produced by Pete Ash with production assistance from Stefan [inaudible 00:47:07] and Grace Devlin. I'm Josh King, your host, signing off from the library of the New York Stock Exchange. Thanks for listening. We'll talk to you next week.

Speaker 1 (47:17):

Information contained in this podcast was obtained in part from publicly available sources and not independently verified. Neither ICE nor its affiliates make any representations or warranties expressed or implied as to the accuracy or completeness of the information and do not sponsor, approve or endorse any of the content herein, all of which is presented solely for informational and educational purposes. Nothing herein constitutes offered to sell, a solicitation of an offer to buy any security or a recommendation of any security or trading practice. Some portions of the proceeding conversation may have been edited for the purpose of [inaudible 00:47:49] clarity.

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Information contained in this podcast was obtained in part from publicly available sources, and not independently verified. Neither ICE nor its affiliates make any representations or warranties, express or implied, as to the accuracy or completeness of the information and do not sponsor, approve, or endorse any of the content herein, all of which is presented solely for informational and educational purposes. Nothing herein constitutes an offer to sell, a solicitation of an offer to buy any security, or a recommendation of any security or trading practice.