Carnegie Mellon University
December 14, 2022

Study: SEC Proposal to Switch to Order-by-Order Auctions Has Benefits and Drawbacks

The flow of retail orders in U.S. equities is segregated from the flow of non-retail orders, with retail brokers routing nearly all customer orders directly to market makers, who assume a best execution obligation. The Securities and Exchange Commission (SEC) is proposing a major change in market structure to provide for order-by-order auctions in an attempt to boost competition among market makers. In a new study, researchers explore how segregated retail trades should be executed. The paper concludes that “while order-by-order auctions have higher allocative efficiency than broker's routing, order-by-order auctions have less competition than broker's routing, potentially harming retail traders.”

The study, by researchers at Carnegie Mellon University (CMU), the University of Maryland, and Singapore Management University, appears as a new working paper.

“Previous research has explored whether retail flow should be segregated and its value, once segregated, but the question of how retail flow should be executed remains relatively unexplored,” notes Chester Spatt, Professor of Finance at CMU’s Tepper School of Business, who co-authored the study.

In the current market structure, retail brokers establish relationships with market makers and send individual orders to particular market makers. While retail brokers use recent data on competing market maker performance to inform their routing decisions, they do not communicate with the market maker before routing each order. Under the SEC proposal, order-by-order auctions would give market makers the option to bid on individual orders.

In this study, the researchers evaluate two methods of executing segregated retail trades: broker’s routing (which resembles the current market structure, with retail brokers determining where to route each order to maximize the quality of execution) and order-by-order auctions (the approach being promoted by the SEC in which all retail orders enter an auction available only for retail market orders, but any market participant could bid for the orders). They evaluated the latter both conceptually and by looking at Retail Liquidity Programs, which behave similar to order-by-order auctions.

Researchers used trade and quote data from the New York Stock Exchange from Jan. 1, 2022, to May 30, 2022. They examined all securities in the Russell 3000 index, as well as the 100 most frequently traded exchange-traded funds priced above $1 per share.

The idea proposed by the SEC would improve allocative efficiency, the study found: Order-by-order auctions ensure that an incoming retail market order is always routed to the market maker who has observed the lowest cost signal.

But switching to order-by-order auctions would also involve drawbacks. Market makers would obtain higher profits in the auction due to reduced competition than would obtain in the broker’s routing system. In addition, retail investors could be worse off, particularly in times of high volatility or with illiquid stocks, when market participants could opt not to provide any liquidity in the auction.

“Motivated by recent SEC calls for order-by-order competition, our work provides a theoretical analysis of two possible methods of executing retail trades,” explains Thomas Ernst, Assistant Professor of Finance at the University of Maryland’s Robert H. Smith School of Business, coauthor of the study.

“Based on our modeling, the takeaway message is that switching to order-by-order auctions comes with tradeoffs and may not serve the customer’s interest,” says Jian Sun, Assistant Professor of Finance at Singapore Management University’s Lee Kong Chian School of Business, who co-authored the study.

Summarized from a working paper, Would Order-by-Order Auctions Be Competitive? by Ernst, T (University of Maryland), Spatt, C (Carnegie Mellon University), and Sun, J (Singapore Management University). Copyright 2022. All rights reserved.