Regulators have made “a fundamental shift” in how they govern public exchanges, in allowing national exchanges to tailor their operations to serve a particular set of investors.
That’s what BATS Global Markets officials are saying in analyzing rule changes granted by the Securities and Exchange Commission, which are allowing the four major exchange operators to set up programs that give special price benefits to retail investors and allow those operators to introduce subpenny tick sizes for the first time, to accomplish this.
“This approval sets the stage for a fundamental shift in the way equity exchanges operate,” wrote BATS president and chief executive officer Joe Ratterman in a newsletter discussing the SEC approval of the Euronext/NYSE retail liquidity provider program (RLP).
He believes that the principle inherent in the SEC approval means exchanges can now “segment their member firms and offer differentiated services among different exchange member firms.”
The targeted programs allow public exchanges to better compete with off-exchange venues, the operators say. More than 30% of equity trading happens off-exchange in dark pools and brokers’ internal pools of orders, according to Tabb Group.
BATS’ BYX exchange, along with its rival exchanges, are pushing to obtain more prime retail flow. They would allow retail investors to specify that they want price improvement, if available, from institutional order flow. Nasdaq, in its plan, estimates the average price improvement would work out to 50 cents on a 500-share order. The plans are designed to combat the matching of retail and institutional orders directly, inside brokers’ internal pools of orders.
SYNOPSIS:
How BATS’ Retail Price Improvement Works
Over the last several years, Ratterman said in the same newsletter, “significant equity volumes” have been transacted away from public exchanges. Ratterman estimated that some 1,300 stocks traded “more than 50 percent of the time off-exchange in June’’ of this year.
The New York Stock Exchange was the first to introduce a plan, starting its Retail Liquidity Program on August 1.
BATS followed up with its own retail price improvement (RPI) program, which starts December 17. Direct Edge and Nasdaq Stock Market have announced similar plans.
In the BATS case, its one-year pilot covers about two dozen securities, but eventually all National Market System symbols will be included.
Both the NYSE plan and the BATS plan have been allowed to use sub-penny pricing, even though this would seem to violate Regulation NMS, which, in 2005, instituted a prohibition against sub-penny prices.
The rule changes approved by the SEC as the exchanges began to set up their pilot programs are intended to help lit venues compete with dark venues.
How?
They will be able to discriminate in favor of the retail investor, through the use of sub-penny price improvement. BATS officials say their program will be unique in that orders will be matched at multiple price levels and can interact with the midpoint of the national best bid and offer. They have also been granted an exemption from some of the sub-penny trading rules.
After Ratterman wrote that newsletter to his clients analyzing the NYSE order, BATS won regulatory approval for its own retail program.
Here, BATS chief operating officer Chris Isaacson discusses this new “fundamental shift” for exchanges and how BATS’ retail program will work.
Traders: You believe your new retail price improvement (RPI) will bring in more retail business.
Isaacson: Yes, the intention is to attract more retail marketable orders to displayed exchanges.
Traders: And while other exchanges have been or will be doing the same, you think yours will be better.
Isaacson: It will be superior. It will initially be on our BYX exchange and eventually rolled out to all NMS securities and we have hidden, non-displayed midpoint liquidity that retail investors will interact with.
Traders: Your off-exchange competitors will say you are violating the sub-penny provisions of Regulation NMS and you’re not going to give the individual trader the same level of trading desk service that he or she would get from a wholesaler.
Isaacson: These are fair points. But the SEC did grant us relief on that point (the sub-penny provisions). And retail investors are already getting sub-penny price improvement through wholesalers, often at less than a tenth of a cent.
Traders: So you’re saying that exchanges are merely getting so of the same advantages that your off-exchange competitors have. But what about the criticism that investors get better service from them?
Isaacson: On the service point, the flexibility that the wholesaler has to service retail brokers is rather broad. We have to operate within the confines of an exchange.
Traders: And so?
Isaacson: From the beginning we have taken a very serious view of service and believe we can offer fantastic service. And I think if we ask our members, they would say that our service is great.
Traders: More importantly from your perspective, and that of all exchanges, you believe that the significance of these rulings is that the SEC is giving you the chance to be more effective competitor?
Isaacson: The SEC has opened the door to customer segmentation on the exchange.
Traders: And that will change how BATS conducts business?
Isaacson: Yes, in light of that, we’re going to compete more aggressively for retail order flow and try to give the retail investors the maximum price improvement possible.
Traders: Why do you believe that wholesalers have been able to take away business from you? Is it because of internalization?
Isaacson: Certainly, the rules allow for internalization.
Traders: Do you agree with it?
Isaacson: There’s a place for internalization. And we don’t believe it is bad in all regards.
Traders: But you believe that, with these rules changes, you can combat it?
Isaacson: We believe that the door being offered to segment customers, specifically retail customer order flow, that we can offer a similar program to retail customers through the fees we are offering and hopefully better price improvement than they would realize with wholelsalers.
Traders: Is the SEC is breaking new ground?
Isaacson: Yes, this is the first potential segmentation of many.
Traders: Such as?
Isaacson: If there is a retail designation, then why not also have an institutional buyside designation if this is the path that we’re going to go down. Certainly, we want the retail investor to get the best price possible. But we also want every investor to get the best price possible.
Traders: What other ways are there to slice up a market?
Isaacson: If you look at the options markets, there are various designations. There’s customer, pro-customer, firm, market maker. You’ll find we’re moving down that path.
Traders: How will your retail system differ from the NYSE’s?
Isaacson: One, we allow retail orders to execute against other non-displayed liquidity. We have mid-point liquidity. We have other non-displayed liquidity available to any and all customers that interact on BYX. Retail orders will be able to interact with that. NYSE doesn’t have mid-point.
Traders: Any other difference?
Isaacson: We’ll allow retail orders to execute at more than one price.
Traders: An example?
Isaacson: Say a retail order comes in for 300 shares to sell. And they’re going to cross the spread. If we have a retail price improving orders that is a tenth of a penny improvement or two-tenths or three-tenths of a penny improvement for a hundred shares each, we will give the retail order three executions at point three, point two, point one, maximizing the price improvement to them.
NYSE will execute those three hundred shares at only point one at price improvement for the retail. They execute at one price, while we execute at multiple prices. We allow anyone to answer RPI orders. You don’t have to be a Designated Market Maker.
