Q&A: US Equity Market Structure

The U.S. stock market is largest in the world – nearly three and a half times the next largest, China – and represents about 41% of the $110 trillion in market capitalization of equities around the globe.  Efficient and resilient market structure is key to sustaining investor confidence and participation in the equity markets. The goal of regulators and market participants is to promote market resiliency and ensure the U.S. equity markets continue to benefit investors and play an essential role in capital formation.  Below we offer some background related to the recent discussions around equity trading.  For more expanded information, please refer to SIFMA’s U.S. Equity Market Structure Primer.

The U.S. stock market is largest in the world – nearly three and a half times the next largest, China – and represents about 41% of the $110 trillion in market capitalization of equities around the globe. On average, around 10.9 billion shares are traded on U.S. equity markets every day.  The U.S. equity markets continue to be among the deepest, most liquid and most efficient in the world, with investors enjoying narrow spreads, low transaction costs and fast execution speeds.

Businesses choose to list in the U.S. knowing they can be supported by the most robust secondary markets in the world. In this way, the U.S. equity markets are a fundamental driver of economic growth in this country: they provide all types of investors with financial opportunity and incentivize capital formation that spurs business innovation and job creation.

Efficient and resilient market structure is key to sustaining investor confidence and participation in the equity markets. The goal of regulators and market participants is to promote market resiliency and ensure the U.S. equity markets continue to benefit investors and play an essential role in capital formation.

Below we offer some background related to the recent discussions around equity trading.  For more expanded information, please refer to SIFMA’s U.S. Equity Market Structure Primer.

Q:  How does a customer order get executed?

A:  Order routing is the process by which an order goes from the end user customer through execution (or cancellation). For instance, once a retail investor places an order with a broker, the order is routed through the broker’s systems to an execution venue such as a market maker or an exchange.  If the order is marketable based on current market conditions, it is eligible for immediate execution.  Non-marketable orders are not immediately executable for various reasons (e.g., the limit price is outside the current market, the order is designated for the opening or closing auction or it was an all-or-none order and the quantity is not available in the market).

Order routing has become more complex in recent years due to the variety of execution venues that now exist.  It has been reported that in December 2020 approximately 48% of the equity trading volume in the U.S. occurred off exchanges at other execution venues such as alternative trading systems (ATSs) and market makers executing orders from retail brokers.  This growth in off-exchange trading can be attributed to the tremendous competition, significant services and price improvement opportunities provided by off-exchange execution venues.

Given the complexity of the equity markets, firms have built technologies such as smart order routers that allow firms to find the best price to execute customer orders.  For instance, in the context of institutional not-held orders (i.e., the broker has price and time discretion), the broker will look at the size of the order and determine the execution strategy that will achieve best execution.  Of note, a client can self-direct the order or direct the broker to use a specific strategy, such as a volume weighted average price or VWAP strategy, which the broker must follow to execute the client’s trade, otherwise the broker can choose the execution strategy.

By law, brokers are obligated to provide best execution for their customers. To comply with this requirement, broker-dealers undergo regular and rigorous reviews to evaluate execution quality from competing venues to determine which offers the most favorable terms of execution for customers.  Some of the factors a broker must consider when seeking best execution of customers’ orders include:  the opportunity to get a better price than what is currently quoted, the size of the order, speed of execution, and the likelihood that the trade will be executed. In addition, Rule 611 of Regulation NMS focuses on the execution price of customer orders and requires brokers to either price improve orders or execute them at the best price currently available in the market (i.e., the National Best Bid or Offer (NBBO)) prior to executing at other price levels where additional liquidity may reside.  This focus on price does not tell the whole execution story. The total cost of a trade can be broken out into explicit and implicit costs.  Explicit costs can include broker commissions.  Implicit costs can include rebates and opportunity cost (e.g., time to fill, percent of the order filled at or within the best bid or offer in the market).  Consideration of these other factors is part of a firm’s rigorous best execution analysis.

Q:  What is payment for order flow?

A:  Payment for order flow (PFOF) is generally understood as the practice of market makers either directly or through exchange-sponsored programs providing payment to retail brokers in return for the brokers routing their customer order flow to them. Retail firms receive execution services from the market makers that the exchanges are not able to replicate.  For example, a market maker can price improve an order between the NBBO and provide an execution price in sub-pennies which, with limited exceptions, exchanges are unable to be replicate since Regulation NMS prohibits exchanges from accepting orders in increments of less than $.01.  Market makers also provide customer service which exchanges are unable to match due to their regulatory structure.  For example, if there is a trade error, the market maker will fill the customer order at the appropriate price and assume the price risk for the erroneous trade, which eliminates this risk for the retail broker and end customer.

Payment for Order Flow is governed by several regulatory requirements that are designed to ensure investors receive best execution and transparency:

  • FINRA Rule 5310 (“Best Execution Obligations”): This rule requires that, in any transaction for or with a customer or a customer of another broker-dealer, firms use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. FINRA requires firms that route customer orders away for execution to conduct a regular and rigorous review of the quality of executions received for the customer orders if they do not conduct an order-by-order review.
  • SEC Rule 10b-10: Requires disclosure of PFOF practices on customer confirmations. The rule requires, among other things, that a broker-dealer disclose to customers on confirmations for securities transactions “whether payment for order flow is received by the broker or dealer for transactions in such securities and the fact that the source and nature of the compensation received in connection with the particular transaction will be furnished upon written request of the customer.”
  • SEC Rule 606: Requires a broker-dealer to disclose certain order routing information, including a requirement to report in its quarterly reports the material aspects of certain PFOF arrangements the broker-dealer has in place with market makers. Rule 606 also requires, among other things, disclosure of the net aggregate amount of any payment for order flow received, payment from any profit-sharing relationship received, transaction fees paid, and transaction rebates received, both as a total dollar amount and per share for: non-directed market orders, non-directed marketable limit orders, non-directed non-marketable limit orders, and other non-directed orders.

Q:  What is short selling?

A:  The terms “short selling” or “shorting” generally refer to transactions whereby a person sells securities that he does not own.  The “short” seller commonly arranges to borrow securities from his or her brokerage firm, which will deliver the securities to consummate the transaction.  The short seller later closes out his or her short position by purchasing equivalent securities, in order to return the borrowed securities to his brokerage firm or other stock lender.  If the price of the stock drops, short sellers buy the stock at the lower price and make a profit. If the price of the stock rises, short sellers will incur a loss. Unlike a long buy-and-hold investment strategy in which an investor believes the price of a stock will go up over time, short selling is an investment strategy in which the investor believes the price of a stock will go down over time.   Short selling is used for many purposes, including to profit from an expected downward price movement, to provide liquidity, or to hedge the risk of a long position in the same security or a related security.

Many regulations govern short selling.  Some notable requirements include:

  • Rule 201 of Regulation SHO (the Alternative Uptick Rule): Under this rule, when the price of a security has decreased by 10% or more from the prior day’s closing price, short selling in that security is then subject to the alternative uptick rule. Thus, when the 10% circuit breaker is triggered, short selling in that security is prohibited at a price that is less than or equal to the current national best bid. Further, the price test restriction is required to remain in place for the rest of the trading day on which the circuit breaker is triggered, as well as for the entire following trading day.
  • Rule 203(b)(1) and (2) of Regulation SHO (the Locate Requirement): This rule requires a broker-dealer to have reasonable grounds to believe the security can be borrowed so that it can be delivered on the delivery date before effecting a short sale order.
  • Rule 204 of Regulation SHO (the Close-out Requirement): This rule requires broker-dealers to close out failure to deliver positions by purchasing or borrowing securities of like kind and quantity by T+4. This prevents market participants from selling stock short and failing to deliver shares at the time of settlement (i.e., it targets persistent fails to deliver).
  • SRO Short Interest Reporting: Several SROs provide on their websites daily aggregate short selling volume information for individual equity securities. The SROs also provide on their websites disclosure on a one-month delayed basis of information regarding individual short sale transactions in all exchange-listed equity securities. The SROs also publish monthly statistics on short interest in securities that trade on their markets.

Q:  What are Broker-Dealer Net Capital Requirements?

A:  Net capital is a measure of a broker-dealer’s liquidity.  Two notable SEC rules cover broker-dealer financial responsibility requirements:

  • SEC Rule 15c3-1 (the “Net Capital Rule”) requires a broker-dealer to have at all times enough liquid assets to promptly satisfy the claims of customers if the broker-dealer goes out of business. Broker-dealers must maintain minimum net capital levels based upon the type of securities activities they conduct and based on certain financial ratios.  For example, broker-dealers that clear and carry customer accounts generally must maintain net capital equal to the greater of $250,000 or two percent of aggregate debit items. Broker-dealers that do not clear and carry customer accounts can operate with lower levels of net capital.
  • SEC Rule 15c3-3 (the “Customer Protection Rule”) protects customer funds and securities held by broker-dealers by, in effect, forbidding broker-dealers from using customer assets to finance any part of their businesses unrelated to servicing securities customers. Under the rule, a broker-dealer must have possession or control of all fully paid and excess margin securities held for the account of customers, and determine daily that it is in compliance with this requirement.  The broker-dealer must also make periodic computations to determine how much money it is holding that is either customer money or obtained from the use of customer securities.

Q:  What is buying on margin?

A:  Buying on margin means borrowing money from a brokerage firm to purchase a security.  A “margin account” is a type of brokerage account in which the broker-dealer lends the investor cash, using the account as collateral, to purchase securities.   Notable margin requirements include:

  • Federal Reserve Board Regulation T, which includes a definition of margin-eligible securities that includes all exchange-traded equity securities. Under Regulation T, firms can lend a customer up to 50 percent of the total purchase price of a margin security for new, or initial, purchases.  Some securities cannot be purchased on margin, which means a customer must deposit 100 percent of the purchase price for such securities.
  • SRO Rules, which are the rules of FINRA and the exchanges. They supplement the requirements of Regulation T by placing “maintenance” margin requirements on margin accounts and establish other requirements for broker-dealers offering margin accounts.  Under these rules, as a general matter, the customer’s equity in the account must not fall below 25 percent of the current market value of the securities in the account. Otherwise, the customer may be required to deposit more funds or securities to maintain equity at the 25 percent level (referred to as a margin call). Failure to do so may cause the firm to liquidate the securities in the customer’s account in order to bring the account’s equity back up to the required level.


Ellen Greene is a managing director, Equity and Options Market Structure at SIFMA and Joe Corcoran is a managing director and associate general counsel at SIFMA.