Will action speak louder than words? Both Nasdaq OMX and NYSE Euronext have complained bitterly to the Securities and Exchange Commission about the dearth of retail orders on the public markets in recent years. Now with Nasdaq OMX’s decision to establish a "Retail Investor Auction," both of the major exchange operators are actively pursuing retail flow. Their plans pit them squarely against the big wholesalers, which dominate the retail business, but at the same time include soliciting orders from them.
Both companies need SEC approval to move forward. At presstime, Nasdaq had yet to file its proposal with the SEC. The New York Stock Exchange and sister exchange NYSE MKT, both units of NYSE Euronext, filed for approval back in October, but have run into opposition from the regulator. The SEC has until July 6 to reach a decision.
Nasdaq announced its auction proposal in May during its annual Investor Day. Eric Noll, an executive vice president responsible for transaction services, told analysts the idea was to offer price improvement on retail orders by pitting market makers against each other in special auctions. The NYSE proposal is similar, but perhaps more convoluted.
"The New York Stock Exchange has made somewhat of a big deal about their ‘Retail Liquidity Program,’" Noll said. "We think there are some problems with the structure, what they’re trying to do and, ultimately, some problems with the way that process will work. So we have created what we believe is a much more innovative and effective competitive tool."
Both exchanges are looking to compete with the big wholesalers and other internalizers operating dark pools as well as solicit flow from them. The moves represent a significant step-up in a two-year campaign attacking the brokers’ stranglehold on retail orders. Both NYSE and Nasdaq have complained bitterly to the SEC and in public forums that broker internalization is harming the public market’s price discovery process. (It has also harmed their market shares.) Now the war of words is being accompanied by action.
"This is designed to take flow back from dark trading," Noll said. "It’s going to pull business out of the dark side of the marketplace and back onto the lit venues." Part of the plan involves soliciting orders from the wholesalers by guaranteeing them a level of price improvement that they can then pass on to their customers.
Guaranteeing price improvement typically requires committing capital. Noll indicated that wholesalers may be reluctant to commit capital these days.
On the other side of the equation, the proposed model also benefits Nasdaq’s registered market makers. In the past few years, many have complained that the quality of flow with which they interact has deteriorated.
The dealers say they want to trade against retail flow, but the high-quality material often does not make it to the public market. Rather, it gets caught in the web of dark pools and wholesalers, leaving the exchanges with the more "toxic" flow.
Under Nasdaq’s auction plan, "market makers who wouldn’t otherwise get a chance to interact with that retail order flow will compete to offer price improvement," Noll explained.
The Nasdaq concept is similar to the one proposed by the NYSE. The difference is, under the NYSE proposal, the quotes are in increments of less than a penny and are hidden from public view.
The nature of these quotes has become a problem for the SEC, which is taking its time in approving the NYSE proposal. Quoting in sub-pennies is forbidden under the SEC’s Regulation NMS. The NYSE has requested an exemption from the rule.
Also problematic, according to an SEC filing, is the New York’s proposed method of alerting holders of retail orders to the availability of those sub-penny trades. The exchange wants to send out semi-blind messages called "retail liquidity identifiers," (RLIs) or liquidity flags, to participants. The messages divulge symbol and side, but not size or price.
The flags are similar to so-called "actionable indications of interest," which brokers have sent to their dark pool participants over the years. Actionable IOIs came under SEC scrutiny a few years ago because they seemed too much like quotes to the regulator. Because they function like quotes, the SEC argued, they are subject to the regulator’s bedrock quote rule. That means they must be published in the consolidated quote stream for all to see. They cannot be shared with a select group of traders.
NYSE argues the RLIs are not quotes. But if the SEC insists they are, the NYSE said, then the NYSE should receive "no-action relief" from the quote rule, as its program is beneficial to retail investors.
Industry and regulatory pressure has already forced the NYSE to make one significant change to its proposal. In February, the exchange narrowed the definition of the retail orders it would accept under the program. Despite a plan to market the program to wholesalers, the NYSE now will no longer accept their layoff, or principal, trades. Under the proposal, it will only take retail orders handled on an agency basis. Despite the obstacles, at least one NYSE exec is upbeat. "Obviously, I can’t predict the outcome, but I believe we’ve addressed all of the concerns raised by the industry and the SEC," Joe Mecane, NYSE Euronext executive vice president, told Traders Magazine. "So, I’m optimistic."
Both exchange operators’ proposals arrive during lean times for wholesalers. Volume is down as the American public avoids the stock market.
In letters to the SEC, brokers and their representatives have criticized the NYSE proposal and recommended the regulator not to rush into a decision. In public, they say they are ready for any competition from the exchanges, as their services are superior. For Goldman Sachs, a relatively new entrant to the wholesaling game, it’s all about service. "The service model behind it is incredibly important," Greg Tusar, head of electronic trading at Goldman Sachs, said at an industry conference earlier this year. "What is missing from the [exchange] model is the desk that is there to help answer questions about order flow. Or the desk that is there to commit capital when necessary. Their service model will cause it to struggle."
BACKGROUND
The New York Stock Exchange and sister exchange NYSE MKT first submitted their proposals for a "Retail Liquidity Program" to the Securities and Exchange Commission in October 2011. The SEC has put off making a decision three times. Below are the regulator’s two main concerns and the NYSE’s positions.
SEC: The NYSE plan may run afoul of the ban on sub-penny quoting in Regulation NMS.
NYSE: The ban on sub-penny quoting supports the market’s price-discovery function. It removes concerns by limit-order traders that they will lose priority in the queue due to insignificant improvements in the quote by scalpers. The rule only applies to displayed quotes. By contrast, under the RLP proposal, all sub-penny quotes are hidden and the alerts sent to traders do not contain prices. In any event, the NYSE has separately requested an exemption from the sub-penny rule.
SEC: The NYSE plan may run afoul of the quote rule of Regulation NMS. The NYSE’s alert, or "retail liquidity identifier," may be deemed a bid or offer. Thus, under the quote rule, NYSE could not limit its dissemination to select parties.
NYSE: The RLI is not a quote because it is not priced. However, if the SEC insists it is a quote, then NYSE is deserving of "no-action relief" from the quote rule because the plan benefits retail investors.
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