Like most people, we were surprised how the entire state of Texas could have suffered such severe power outages.  But the more we looked into it what caused their power problems, the more similarities we began to notice between how Texas has set up their energy system and how parts of the US stock market currently function.  

The WSJ just published an excellent analysis of the power outage titled “The Texas Freeze: Why the Power Grid Failed” with a subtitle that read “The state’s electricity system was considered a model. This week’s power outages revealed shortcomings in the market structure.” Here are a couple of important points from the article which we think could serve as a warning to the US stock market:

• “A fundamental flaw in the freewheeling Texas electricity market left millions powerless and freezing in the dark this week during a historic cold snap. The core problem: Power providers can reap rewards by supplying electricity to Texas customers, but they aren’t required to do it and face no penalties for failing to deliver during a lengthy emergency.”
• ” If a plant trips offline and stays out of the market for an extended period, as happened this week, there is no penalty besides lost revenue.”

• “While power providers collectively failed, the companies themselves didn’t break any rules. Texas officials don’t require plant owners to prepare for the worst by spending extra money to ensure they can continue operating through severe cold or heat. “
• “Ercot devised a set of best practices for power-plant owners to prepare for the possibility of extreme cold. But the guidelines remain suggestions. The grid operator has no authority to mandate them, although it does do some spot checks. The state utility commission doesn’t even employ inspectors to visit the plants and check on whether they are winterized.”

Like the Texas energy market, the US stock market relies heavily on a handful of providers to serve the needs of many retail investors. These providers, known as market makers, pay retail brokers for the right to supply liquidity to their retail clients.  But just like the Texas power providers, US market makers are not required to supply liquidity and face no penalties if they withdraw – they are providing a discretionary service to their retail broker customers. However, just like the energy market, emergencies could emerge from the supply and demand side of the equation and these could cause some market makers to temporarily shut down.  From the supply side, a technological problem like we have seen in the past from the stock exchanges could occur at a market maker. From the demand side, the market could become temporarily imbalanced like it did during the Flash Crash and market makers could decide to reduce their liquidity provision since their risk level may have spiked up. 

While these market makers might face an angry retail broker community if they shut down their liquidity, they would not be breaking any laws nor would they have to pay any fines. At last week’s Congressional hearings, we learned that one market maker, Citadel Securities, has a particularly strong grip on the retail market.  In his testimony, Citadel CEO Ken Griffin talked about the importance of his firm to the market and also how some other market makers withdrew from the market during the Gamestop debacle:

“During the period of frenzied retail equities trading, Citadel Securities was the only major market maker to provide continuous liquidity every minute of every trading day. When others were unable or unwilling to handle the heavy volumes, Citadel Securities stepped up. On Wednesday, January 27, we executed 7.4 billion shares on behalf of retail investors. To put this into perspective, on that day Citadel Securities executed more shares for retail investors than the average daily volume of the entire U.S. equities market in 2019.”

That’s great news that Citadel was able to have provided continuous liquidity, but what happened to the other major market makers that Citadel said were “unable or unwilling to handle the heavy volumes”? What would happen if a firm like Citadel had an issue either supply or demand side?  According to a recent Bloomberg article, “Citadel Securities estimates that it commands 27% of equity volume market share in the U.S., according to the presentation, up from 21% in 2017. It’s particularly dominant in retail order flow, with 46% of the market.” If Citadel had a technical problem that forced them to temporarily shut off their liquidity, could the other market makers who “were unable or unwilling to handle the heavy volumes” during the Gamestop episode handle the additional load? 

The US equity market consists of a fragmented landscape of liquidity where market makers control a significant amount of market share and should be considered critical infrastructure. Brokers like Robinhood are not members of any stock exchange and send 100% of their market and limit orders to market makers who compete with each other for that flow. While lawmakers focused most of their attention on Robinhood at last weeks hearing, we think they missed one of the real structural issues. Considering how important market makers have become for the smooth functioning of the retail market, shouldn’t they come under more intense regulatory scrutiny?  Market makers are currently regulated by FINRA, the SEC and SROs just like any other broker but they do not fall under SEC regulations like Reg SCI or Reg ATS.  We realize that the large market makers have spent enormous amounts of money building their systems and making sure they have the best technology, but wouldn’t it make sense for regulators to have a better view? We hope that the next Congressional panel examines this issue and digs a little deeper into its potential ramifications.