Fragmentation Complicates Equity Market Structure

Fragmentation in U.S equity markets forces traders to balance the likelihood of execution against potential price and size improvement and other transaction costs when choosing an execution venue, according to Katie Kolchin, Director of Research, SIFMA.

Katie Kolchin

There are now 16 exchanges, 33 alternative trading systems (ATS), and multiple over-the-counter (OTC) venues. 

“This has complicated U.S. equity market structure, leading market participants to wonder if changes are necessary,” she said in the SIFMA Insights: US Equity Market Structure Analysis, Why Market Structure and Liquidity Matter report.

Kolchin said that market structure matters as it can drive liquidity and trade costs. 

“As such, market participants continually strive to create the most efficient markets. This includes adapting new technologies to achieve operational efficiencies, searching for new ways to transact and, generally, sculpting market structure to maximize efficiencies,” she said.

“Traders must balance the cost of not filling the order with the potential for price or size improvement. Firms have built technologies to address market fragmentation and seek out hidden liquidity to achieve best execution of trades on behalf of their clients,” she said.

“When routing an order, a broker can either send the order directly to an exchange (on exchange) or it can execute institutional and retail trades on a bilateral basis (off exchange),” she added.

Kolchin said that Reg NMS (Regulation National Market System) had several unintended consequences, including the rise in off-exchange trading.

There have been many discussions lately, including among regulators and legislators, about the increase in the level of off-exchange trading as a percent of total equity volumes in the U.S. 

“The level reached 41.5% in 2020 and is at 44.2% YTD 2021 (through July 30), representing increases of 4.7 pps and 7.4 pps respectively versus the historical average (36.8%),” Kolchin said.

According to the findings, much of the growth in off-exchange trading starting in 2020 has been attributed to retail investors. 

“Based on our market structure survey, market participants estimate retail investors now represent 20%-30% of total equity volumes, up from 10% historically. However, all off-exchange trading is not 100% retail trades – off-exchange trading as a percent of volumes in July was 43.1%, greater than the estimate for retail trading from market participants,” she said.

Kolchin explained that the percent of off-exchange trading is a function of market structure, and the optimal level of the percent of off-exchange trading is the actual amount in that given time period. 

“Exchanges offer pre-trade transparency but may not provide the trader with sufficient liquidity. Off-exchange trading may not offer pre-trade transparency, meaning the quantity of shares for execution could be uncertain,” she said. 

“Risk neutral traders must balance the cost of not filling the order with the potential for price improvement, the cost-immediacy tradeoff,” she added. 

According to the report, historically, off-exchange trading increases when bid-ask spreads widen, decreases when exchange depth increase, and decreases with increased volatility (which impacts bid-ask spreads). 

Academic studies suggest that the probability of execution is a critical determinant in choosing between off-exchange venues. 

“One such study found that the more trade-intense group of ATS platforms or OTC non-ATS dealers respond more elastically to spreads, depth and volatility. In other words, the percent of off-exchange trading volumes is self-correcting, ebbing and flowing based on current market structure characteristics,” she said,