Smith Research Identifies Flaw in SEC Move to Help Investors in Retail Stock Trading Surge

COVID-19 lockdowns and subsequent stimulus payments left many Americans with extra time and cash. Among the effects was a surge in retail stock trading through zero-commission brokerages. This worked to drive up the share price of meme stocks and led to market volatility.

It also has led to what would be the Security and Exchange Commission’s most significant action since issuing the Regulation National Market System set of rules in 2005 to modernize regulations for electronic trading, says Assistant Professor of Finance Thomas Ernst at the University of Maryland’s Robert H. Smith School of Business.

His new paper, “Would Order-by-Order Auctions Be Competitive?” examines the SEC’s proposed Order Competition Rule and its system “where each individual retail order goes to an individual auction as a way to improve the prices retail traders are getting,” he says.

But his findings indicate potentially worse prices.

Ernst explains that brokers currently route customer orders directly to wholesalers, “as wholesalers are willing to give retail traders a price better than the exchange price.” But wholesalers “also compete on aggregate flows; if they give bad prices on average, brokers will stop sending them orders.”

So, the design of the proposed order-by-order auctions could lead to a “winners curse” and subsequently worse prices for retail investors, Ernst says.

He further explained to MarketWatch: "These auctions are actually less competitive than the current system because market makers and exchanges would worry that they have less information about the order than their competitor, and therefore bid more conservatively. "The winner's curse is if you win the auction, it means that everyone else thought that you bid too aggressively."

Ernst co-authored the paper with former SEC chief economist Chester Spatt, now with Carnegie Mellon University, and Jian Sun at Singapore Management University.

He also presented the findings as part of the SEC’s Tenth Annual Conference on Financial Market Regulation in a panel moderated by Albert “Pete” Kyle, Smith’s the Charles E. Smith Chair Professor of Finance.

Smith’s Center for Financial Policy jointly hosted the conference on May 4-5, 2023, with the SEC, Lehigh University’s Center for Financial Services and the CFA Institute.