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January 31, 2008

The Age-Old Debate: Centralization vs. Fragmentation

By Nina Mehta

Competition between orders? Or competition between marketplaces? Which is better? The venerable question was taken up recently at a forum focusing on alternative trading systems put on by NYSE Euronext. (The NYSE's own point-in-time crossing system, MatchPoint, launched last month.)

On the panel, two industry veterans debated the pros and cons of a U.S. stock market fragmented by dozens of individual venues, including exchanges, ECNs and ATSs.

For the debate, Joe Gawronski, president and chief operating officer of Rosenblatt Securities, an institutional agency broker, took up the cudgels for centralization, or competition between orders. Brett Redfearn, a senior managing director in the institutional equities division at Bear Stearns, argued on behalf of fragmentation, or competition between marketplaces. The debate was moderated by Robert Schwartz, a finance professor at Baruch College in New York.

On fragmentation:

Redfearn described the centralization vs. fragmentation debate as a choice between stagnation and competition. In his view, "competition and fragmentation are clearly winning." He noted that innovation spawned by competition--in the form of venues such as Arca and INET, as well as dark liquidity--has become "absolutely critical" to the evolution of the equities market.

Gawronski observed that the "goal of equities markets is to put buyers and sellers together at the right price" and that order interaction is "central to coming to the right price." Since orders "can't be in two places at once," he said, fragmentation means that many orders, therefore, can't interact.

On Regulation NMS's impact on fragmentation:

Redfearn pointed out that Reg NMS led to the current market fragmentation. First, the prospect of Reg NMS caused the NYSE to become more electronic, enabling other markets to compete with the Big Board. Second, Reg NMS's broadened trade-through rule provided "a level of protection" for displayed market centers that made it possible for them to compete with the bigger guns. However, he noted, BATS and Direct Edge, rather than the regionals, grabbed that additional market share in equities.

Gawronski said about Reg NMS: "I don't think it achieved its goals." He observed that traders don't want to post their orders out loud. In addition, the fragmentation and growth of dark liquidity means that "as a broker, you can never know you're getting best execution."

On a potential increase in fragmentation:

Redfearn observed that block-trading venues, upstairs desks and crossing entities will never disappear, because the need to source liquidity will always be present. Although he conceded that there are "too many" displayed markets, he noted that competition has done away with the olden days of a single market having 80 percent market share. Now, he said, any venue will be hard-pressed to get more than 30 percent.

Gawronski said more fragmentation is likely, noting that liquidity is increasingly being hidden. In addition, "rebate seekers" and algo traders are breaking up orders, making the market more fragmented.

On the multiplicity of dark pools:

Redfearn argued that algorithms "pull together" fragmented liquidity and prices in the market, providing access as well as a vehicle for price discovery. He added that algos that tap into dark pools cater to customer demand for hidden, anonymous executions with minimal market impact.

Gawronski replied that algos are "weak substitutes for centralization" and wondered how many of the current 37 or so dark pools OMSs reach. Liquidnet, for instance, is closed to brokers, while ITG's POSIT and Pipeline don't allow buysiders to access their pools through broker algos. He added that "cheaper fees" rather than "better executions" may also attract some orders.

On the limits of their respective positions:

Redfearn observed that the "ongoing, endless and almost inevitable debate between competition and centralization" would surely continue. He also noted that, in U.S. equities, NYSE Euronext now has the NYSE floor, Hybrid, Arca, MatchPoint and New York's joint venture with BIDS. To the extent that those entities can interact and create some centralization, he said, "that would be a good thing."

Gawronski noted that "conceptually, a centralized market is orderly, but absolute power can corrupt." What's best, he said, is a "centralized market kept honest and innovative."

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