The year 2007 is looking a lot like the year 2000-only more so. Back then the trading landscape was splintered into 10 electronic communication networks, seven stock exchanges, one Nasdaq and one dark pool-nearly 20 venues in all on which to trade. That number shrank considerably but now all of a sudden there are five ECNs, 10 stock exchanges and about 30 dark pools. Fragmentation is back with a vengeance.
Liquidity seekers are right back where they were at the beginning of the century. In 2007, they must navigate more than 40 possible execution venues in their search for a good fill.
“The outlook for 2007 is one of confusion and apprehension,” says Michael Rosen, the resident market structure expert at Los Angeles-based brokerage UNX. “We’re moving into a whole new environment.”
In 2000, it was mainly Nasdaq-and not listed-trading that was splintered. Charges of price collusion among Nasdaq market makers a few years earlier had led to new regulations from the Securities and Exchange Commission permitting the quasi-stock exchanges known as ECNs.
The systems proliferated, siphoning liquidity from Nasdaq and forcing traders to monitor multiple trading sites.
Eventually that task got easier as the ECN industry consolidated. But by then the listed world was in play. Charges of front-running by New York Stock Exchange specialists lit a fire under the SEC, which soon targeted Big Board dominance with a sweeping new rule.
The SEC’s landmark Regulation NMS and its centerpiece trade-through rule were approved in 2005. The effect has been to create a level electronic playing field for the Big Board and all who would compete with her.
The rule has spawned or revitalized 15 electronic exchanges and ECNs. It has given new clout to those market centers previously stymied in their quests for market share in listed flow.
At the end of last year, about half a dozen of these players revealed new pricing strategies aimed at winning over limit-order traders in listed stocks.
NYSE Arca actually started the trend when it quietly began paying rebates to liquidity providers in listed names. Nasdaq soon followed suit.
The Big Board’s arch-rival, which for about a year had grown volume on its book by functioning as a cheap DOT box, took to offering traders 20 cents per 100 shares to post listed orders on its book.
Several regional exchanges have also instituted the take/pay/route fee structure common to ECNs for both Nasdaq and listed trading.
The moves put the NYSE’s hybrid business on uneven footing. The floor used to be the cheapest place in the industry to trade. Now, hybrid is at a competitive disadvantage: It is still the cheapest place to take liquidity, but the most expensive place to provide it.
Some execs expect limit orders to move away from NYSE-hybrid to the venues that pay for that flow. “Pretty quickly most limits will find their way to those marketplaces,” says Steve Swanson, chief executive of ATD, an up-and-coming wholesaler. “So there will not be as much liquidity on those that do not pay.”
Swanson, though, expects NYSE-hybrid to abandon its practice of charging both liquidity takers and providers and adopt ECN-style pricing to stanch the outflow of limit orders.
Exchanges are not required to be fully compliant with Reg NMS until February, but the brave new world of electronic trading of NYSE-listed stocks is well underway. In December, the New York was already trading 2,000 of its 2,700 stocks in the hybrid environment.
Still, the full impact of Reg NMS has yet to be felt, according to execs. On February 5, the “trading phase” of Reg NMS commences. That means all market centers seeking to avail their quotes of trade-through protection must be operating in a fully automated mode.
That means, of course, providing electronic executions. But it also means exchanges must start routing out orders to other exchanges if those orders would otherwise trade through better-priced quotes.
Some execs therefore see February 5 as the real start of the competitive free-for-all. Today some exchanges are not routing out their orders. They will have to next month.
“In February, you will see a pretty dramatic change,” notes Len Amoruso, a senior managing director at Knight Capital Group responsible for regulatory affairs and compliance. “Liquidity will start to disperse away from exchanges and towards ECNs and other market participants.” (Knight operates the DirectEdge ECN.)
The direction that liquidity flows will depend to a large extent on the pricing strategies of ECNs and exchanges. Trading stocks has become a commodity business so all players are expected to regularly tweak their pricing.
Some players such as the BATS and DirectEdge ECNs even began the new year with an inverted pricing structure where they pay out more per share to liquidity providers than they take in from liquidity takers. The bargain is only good for the month of January.
But pricing isn’t everything. Exchanges and ECNs are expected to emphasize special order types and other services in their bid for flow.
One mechanism gaining traction at the exchange/ECN level is the so-called “dark” or hidden order type. Hidden orders are limit orders that are not displayed on an exchange’s book. They are not new, but are becoming increasingly popular. All market centers are expected to offer them in 2007.
“Going forward, we think the majority of limit orders placed in the market will actually be placed in a hidden or dark format,” notes Dan Mathisson, co-head of Credit Suisse’s algorithmic trading effort. “This has been accelerating tremendously.”
Mathisson maintains the exchanges’ dark order types will get more usage in 2007 than ATS dark pools, despite the mushrooming of the blind crossing networks in the past year and their promotion as the salvation of the large block trader.
“I don’t think you will see a massive movement of flow into standalone dark pools,” Mathisson says. “I do think you will see a massive movement of flow into dark order types within the Reg NMS-protected pools. This is going to be the biggest trend.”
Expect a battle royale for flow, but, sources say, expect a lot of losers too. Analysts are already predicting consolidation in the exchange/ECN sector this year. Fifteen trading centers are too many, they say.
“I don’t think the market can support so many venues and get anything done,” says UNX’s Rosen. “That’s too much fragmentation.”
Even one exchange chief agrees. “There will be a need for like-minded parties to band together to take advantage of economies of scale,” says Dave Herron, chief executive of the Chicago Stock Exchange. “What happened in the ECN world will happen in accelerated fashion.”
Herron maintains it is possible for exchanges to survive on market shares of 2 percent or 3 percent, but that their owners won’t permit it. Most of the smaller exchanges are now owned by large investment banks.
“The kind of firms behind the operations at the [regionals] are going to look for us to do things that make sense,” Herron says.
Industry execs are predicting the same outcome for the rapidly proliferating dark pools. Fragmentation is expected to be a problem here as well. Thirty intraday crossing systems are too many, they maintain.
“It’s structurally inefficient,” says Bill Cronin, a Knight executive responsible for the Knight Match crossing system. “They will collapse in on themselves.”
Most at risk, sources say, are the four so-called independents-ITG’s POSIT, NYFIX Millennium, Pipeline and Liquidnet. Those owned by the large broker-dealers will survive.
Blind crossing networks once inhabited a small corner of the trading landscape, but are now everywhere. Traders Magazine counted nearly 30 intraday systems operating or about to start operating at brokerage houses or exchanges. (See cover story.)
Most of these platforms emerged just last year, built by large brokerage houses looking to keep as much of their order flow in-house as possible. Whether or not they ultimately consolidate, the explosion in the number of dark pools is leading to frustration on the buyside. “You don’t want to be sitting in one dark pool while stock trades in another and you are left explaining to your portfolio manager that he didn’t get the trade done,” says Michael Bleich, Lehman Brothers’ head of liquidity strategy for U.S. equities.
Lehman recently launched its own dark pool called LCX, short for Liquidity Center Cross. Bleich expects more volume to be done in dark pools this year, but says that brokers must work together to resolve the fragmentation issue. Linking as many of these systems together as possible would make searching them more efficient for buyside traders. “We have been rapidly adding dark venues that we can access,” Bleich says, “and expect to do so over the next year. Our goal is to offer our clients a one-stop solution for access.” That may not be so easy. While some pools are open to linkage, many are not. ITG, for instance, recently barred its competitors from using algorithms on behalf of their customers to search its POSIT system.
Those that are open to algo probing include Instinet’s IDX, the ISE Stock Exchange’s Midpoint Match, Pipeline, NYFIX Millennium and a few others. Most of the major brokers have designed algorithms that quickly check these pools for matches. “I believe we will find ways to connect,” Bleich says, “that work for everybody.”
The Securities and Exchange Commission’s Regulation NMS trade-through rule requires market centers to do all they can to prevent trades from occurring at prices inferior to the best quotes in the broader marketplace. Reg NMS does not, however, require exchanges and the like to police trades that occur at prices worse than the second or third-best etc. prices in the marketplace. Legally, after taking out the top of book, trades can occur at prices inferior to non-NBBO prices. This is happening, says Joe Ricciardi, Knight Capital Group’s head of cash trading, and is a worrisome trend for 2007. “We are seeing that in some of the hybrid stocks,” Ricciardi says, “where they are trading at the posted inside market and then clearly printing down 5 cents through the depth of book.” The practice is especially vexing for wholesalers, Knight execs say. Under a new NASD rule, wholesalers are now obligated to provide their broker-dealer customers with “best execution.” So if an order they send to an exchange trades through a better-priced quote, they may have to provide their customer with the better price and take a loss.
Regulatory Burden to Get Heavier
Some desk heads expect their compliance duties to increase this year. They say for them the trend has been more regulatory work and less trading. Pat Fay, head trader at D.A. Davidson, says he used to spend 95 percent of his time trading and 5 percent dealing with management issues. Today, he figures he still spends 5 percent of his time on managerial concerns, but only 40 percent of his time trading. The remaining 55 percent is spent on compliance. “It’s ludicrous,” he says. “I have to sign off on 40 reports every day. It used to be a 45-hour week; now it is a 60-hour or 65-hour week.” The regulatory issues concern best execution, timeliness and prices.
Tweaking the Algos
Given the surge in new trading venues, both displayed and dark, and the requirements of Regulation NMS, brokers will be spending a lot of time recalibrating their algorithms this year. That’s the opinion of Michael Rosen, a market structure strategist at agency brokerage UNX. “Each venue has unique twists in the way it handles orders,” Rosen says, “so people like myself are going to have to get involved in the minutiae of how a trade gets executed.” Because the current crop of algorithms was built for a pre-NMS world, changes will have to be made, Rosen believes. “The problem is,” he says, “you have algorithms that are modeling the future based on the past. Well, the past will be irrelevant.” The way each exchange handles the new sweep orders is one variable to factor in, the exec notes.
Surge in Quotes
A new market data-revenue sharing plan, part of Reg NMS, will go into effect in April. The plan alters the allocation formula so that exchanges get paid partly based on the number of quotes they publish. If they choose to share their data revenues with their customers, a lot of unnecessary quoting could occur, observers predict. Traders will post quotes without any intention of trading. “You will see algo firms developing programs to try to drive quotes into the market,” says Dave Herron, chief executive of the Chicago Stock Exchange. Quotes must be accessible for one second though to qualify for payment. In that time they may get picked off.