Exchange’s Dark Pool Reflection

Exchanges must look to themselves and not to regulators to increase volume.

This April saw two very different takes on the future of the National Market System and dark pools in particular. In an interview with Bloomberg News, Terrence Duffy, Chairman of the CME, called for eliminating dark pools in an effort to have all equity trading occur on exchanges. Fix the fragmentation issue, and youll fix the problem, Duffy said. We need to have 100 percent of that liquidity on exchanges.

Almost as an unintended counterpoint to Chairman Duffy, investment manager BlackRock Inc. released its report U.S. Equity Market Structure: An Investor Perspective that includes the statement … dark pools are an invaluable execution tool for large orders and stocks which may be more difficult to trade due to wide spreads or low liquidity.The BlackRock report also says that trading on dark pools reduces information leakage and signaling risk for investors which lowers transaction costs and that ATSs allow investors to exert more choice over the opposing buyer and seller for a trade and potentially avoid inappropriate liquidity providers, such as predatory HFT strategies.

Currently, about 40 percent of U.S. equity trades take place off-exchange on either one of the 45 or so dark pools or on one the estimated 200 broker-dealer-run internalizers. It is no secret that Nasdaq and NYSE would like to see those trades on their exchanges. In March, the Wall Street Journal reported that both exchanges were pushing for a controversial rule to be added to a pilot program under consideration by the Securities and Exchange Commission to widen tick sizes, or the increments between price quotes, for certain companies. Known as the trade at rule, trades in the shares for those certain companies would be required to take place on an exchange unless another venue offered a significant price improvement.

Seven years ago when Reg NMS went into effect, alternative trading systems such as BATS and DirectEdge became exchanges so they could get some of the expected order flow resulting from the mandated NBBO rule. Today dark pools are enjoying ever-increasing order flow. This past February, Citadel Securities announced that trading volume on its dark pool, Citadel Connect, tripled in the last year.

What happened in those seven years not only reflects the buysides moving away from exchanges, but also the movement of retail brokers away from the exchanges. In both cases, the exchanges have been accomplices to their own downfall. In their search for new revenue streams, exchanges introduced maker-take fee programs that favored players such as high-frequency trading firms and increased costs for both the institutional and retail brokers. Under these programs HFTs are paid by the exchange for making a trade, by offering to buy or sell shares and the broker working on behalf of an institutional or retail client gets charged a fee for taking the HFTs offer.

This environment fosters an inherent conflict of interest for the broker-dealers between balancing their best execution obligations to clients and routing orders in a manner which reduces trading costs for the broker-dealer, according to the BlackRock report. On the retail side, brokers such as Charles Schwab and TD Ameritrade send their orders to other brokers who in turn fill the orders internally before sending the remainders to other internalizers or dark pools. Exchanges are the last venue to fill a retail order. By trading in this manner, retail brokers avoid exchange fees and may even receive rebates from the off-exchange venues.

In addition to its tick-size pilot program, the SEC is considering a test program that would eliminate
maker-taker fee plans for specific stocks. Rather than relying on regulation, maybe the exchanges should consider a couple of pilot programs of their own. They could reduce the cost to trade on some stocks and see if volumes increase. Exchanges need to work on making HFT strategies based on structural inefficiencies unprofitable. This doesnt mean slowing down the connections a la IEX, the buyside dark pool lauded in the pages of “Flash Boys.” It means speeding them up for everybody. Even shutting down some exchanges might be in order. As BlackRock notes, Five of the 13 U.S. exchanges do not even maintain a 1% market share, yet these venues receive the benefits of being an exchange, such as market data revenue sharing.

That will require a long hard look in the mirror.

Robert Stowsky is partner and co-founder of the consultancy Brookpath Partners and he can be reached at