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May 1, 2013

Uncanny Resemblance

Why on- and off-exchange trading are just not that different

By Dan Mathisson

Sir Can-a-Lot, the official mascot of Spam lunch meat, stepped up to the lectern. According to the press release, the canny knight had come to New York "to rescue the world from routine meals." At precisely 4 p.m., with the words "Glorious Spam" hanging in the background, the processed meat hero slammed down the gavel to a weak smattering of applause. Trading on the New York Stock Exchange was officially closed for the day.

At the same time, more than 20 "off-exchange" market centers called "ATSs" (Alternative Trading Systems) also closed for the day. Unlike the NYSE, they did it quietly. Fills and "Nothing Dones" were sent to customers, clearing files were processed, and employees began heading home for dinner. No mascots pranced, no bells clanged, and no TV cameras were around.

The floor of the NYSE certainly looks and sounds different from the off-exchange electronic platforms out there. And maybe that is why reporters seem to think there are big, important differences between the two. A recent editorial in the New York Times ("Trading in the Dark," April 6, 2013) called for "a strong regulatory response" to stop volume from migrating from "public exchanges" to "private trading venues." Yes, the same New York Times that has called all trading "socially useless" was now declaring off-exchange trading to be even worse.

I found myself confused by their passion for exchange trading. Because after the past decade of market structure changes, the difference between exchange trading and off-exchange trading has blurred to the point where there really isn't that big a distinction.

When you cut to the chase, there are two ways to trade in the U.S. markets: lit or dark. In a "lit" order, your bid is displayed for the world to see. In a "dark" order, your bid sits in a computer unseen. Based on market conditions, professional traders judge whether or not they are more likely to get the best price for their fund-holders using lit or dark orders. Either way, when there is a successful match, all trades must be immediately printed to the tape-trades in the U.S. cannot be done in secret.

The New York Times seems to understand the difference between dark and lit trading. But then its editors veer down an incorrect path, making a common error of equating "lit" with "on exchange," and "dark" with "off exchange." What is well known in the industry, but seems poorly understood by reporters and consultants, is that exchanges like the NYSE operate large dark pools themselves. Among the 150 or so order types offered by today's exchanges are dozens of dark varieties, as well as order types that switch between lit and dark, such as the exchange order type called "Hide Not Slide" that was the subject of a Wall Street Journal article last September.