The war of words between the exchanges and brokers concerning off-board trading heated up in 2010, with both sides wrangling for trading flows amid a lower volume market.
On the one side are the exchanges, such as Nasdaq OMX and NYSE Euronext, who have complained they are not on a level playing field when competing against off-board trading venues like broker-dealer dark pools or wholesalers that channel trading away from the public markets.
Joe Mecane, executive vice president and co-head of listings and cash execution at NYSE Euronext, told Traders Magazine that wholesalers and other internalizers scrape the cream of the order flow off the top, leaving the exchanges with the leftovers.
"Much of the easier or more desirable orders are executed before they make their way into the public venues," he said.
Off-board trading, or "internalization," is a catchall phrase that encompasses trading by market makers, dark pools and upstairs desks. These trades occur away from exchanges and ECNs and are printed to a trade-reporting facility. The higher the internalization percentage of a stock, the less it trades in the public marketplace-and, so the theory goes, the worse prices investors get because there is less competition for liquidity.
Earlier this year, Nasdaq OMX conducted a study to examine internalization, to ascertain if there is a relationship between it and price discovery. While the exchange declined to share a copy of the study or provide more granular detail from the findings, Brian Hyndman during a February interview with Traders Magazine the report found that internalization rates in the U.S. equity markets have climbed to 30 percent from 20 percent during the last year. And that has the exchange concerned.
"We do get concerned when the chart starts to look like that and internalization starts to become a larger part of the market," Hyndman said at a recent Securities Traders Association conference. "Does that have a negative effect on price discovery? It might."
He added that dark pools or ATSs need to be on a level playing field with the exchanges to make sure internalization rates don’t climb to 50, 60, or 70 percent."
Stocks that have higher rates of internalization tend to be low-priced and high-volume, such as Citi.
Over the past year, exchanges have pushed the Securities and Exchange Commission to come up with new rules to help level the playing field between dark pools and themselves. Several ideas, such as allowing for exchanges to execute trades in fractions of a penny–sub penny–or a "trade-at" proposal were mentioned in the January Concept Release. Both proposals are geared towards giving public venues first crack at order flow before the unlit markets.
A sub-penny rule would allow exchanges to trade stocks in increments of less than a penny for lower-priced National Market System stocks. A "trade-at" rule would require brokers to send all their orders to the public markets and bar them from trading against, or "internalizing," those orders unless they took certain steps.
NYSE Euronext, NasdaqOMX and BATS Exchange sent a joint letter April 30 to the SEC requesting the regulator grant them an immediate loophole permitting sub-penny trading. The SEC has yet to act on this request.
Meanwhile the brokers stood their ground.
Credit Suisse argued in a comment letter to the SEC that competition between alternative trading systems and exchanges has been beneficial for investors. The big broker argued the competition had forced the exchanges to improve their services in recent years.
The major wholesalers added argued a trade-at rule would harm the retail investor in two ways. First, reduced competition between the public and private markets would stifle innovation. Second, the economics of a trade would move against the retail investor.
Meanwhile, Len Amoruso, general counsel for wholesaler Knight Capital Group wrote in a comment letter to the SEC, "Knight strongly opposes the concept of a trade-at rule."
Dark pools also counter that off-board trading in general isn’t going to climb much higher than its current 30 percent. Whit Conary, president of the dark pool LeveL ATS, said dark pools only make up about 12 percent of that volume, up from 8 percent a couple of years ago.
"The growth is not as dramatic as people make it out to be," he said.
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