Public Exchanges Duel With Newcomers Over Trade Transparency
While most people trading stocks at home imagine their orders zipping from their brokers onto one of the nation’s stock exchanges, almost none of the trades go anywhere near those public markets.
In reality, most trades placed through online brokers like TD Ameritrade and Scottrade are sold to Wall Street firms, which accumulate and trade against tens of millions of these shares a day, rather than send them to a regulated exchange like Nasdaq or the New York Stock Exchange. The Wall Street firms then quickly flip them and turn an easy profit because they have more resources and market knowledge than mom-and-pop investors.
The trading, which takes place away from the gaze of regulators and the public in what are known as the dark markets, has taken off in recent years and steadily eaten into the portion of all stock trading that takes place on the public exchanges. Now, though, the exchanges are fighting back by looking to create dark markets of their own.
NYSE Euronext, the company that owns the exchange, is asking regulators to approve a new platform that would attract orders from ordinary investors and then divert them away from the normal exchange with the aim of getting the investor a better price. Nasdaq and the exchange company Direct Edge said they have similar plans in the works.
The proposal looks like a technical tweak to help ordinary investors. But it has become the front line in a battle over what the nation’s stock markets should look like after nearly a decade of fragmentation has resulted in over a third of all stock trades occurring in the dark, up from 15 percent in 2008, according to Rosenblatt Securities, a brokerage firm.
In the past, the exchanges have pushed regulators to force the dark markets to become better lit, but James Allen, the head of capital markets policy for the CFA Institute, said that with the new proposals the exchanges are acknowledging “that if you can’t beat them, join them.”
In doing so, they are ready to take a turn away from the idea of stock exchanges as places where all investors come together in the open and on equal footing.
“It could forever change what an exchange is and how it serves different factions of investors,” said Christopher Nagy, the founder of KOR Trading, a firm that advises exchanges and brokers. “This proposal essentially says maybe not all people are equal.”
The regulators have until July 7 to decide on the New York Stock Exchange proposal, and it is far from certain that it will win approval. But industry insiders say that even if it is rejected, the plans are forcing regulators to decide how they will deal with the vast transformation of the nation’s stock markets in the last few years.
Since a crucial regulatory change was made in 2007, the nation has gone from having two major stock exchanges to having 13 public exchanges, as well as dozens of trading platforms where stocks are traded away from the public eye. Regulators have not stood in the way of these changes, but they have expressed their discomfort with the complex current market structure, and their uncertainty about how to deal with it.
Duncan L. Niederauer, the chief executive of NYSE Euronext, said in a congressional hearing last Wednesday that the operators of off-exchange trading platforms are under less stringent oversight than the exchanges. He said that regulators should either tighten the rules on dark trading platforms or let the exchanges look more like those platforms.
The competition among platforms is credited with bringing down the cost of trading for investors of all types. But the fragmentation of the markets is also blamed for making the market infrastructure more prone to break down, as it did in the flash crash of May 2010, when stock prices plunged nearly 10 percent in 15 minutes. It happened again when the Nasdaq exchange botched the initial public offering of Facebook in May. The rise of the dark markets has also fed concerns about whether the prices of stocks can be manipulated more easily.
The practice of diverting retail shares away from public markets and into financial firms is called “internalization.” Bernard L. Madoff is credited with inventing the practice in the early 1990s through his legitimate trading firm, which was on a different floor from his Ponzi investment scheme.
Madoff realized that his firm had better indications of which way stocks were moving than did the retail investors. If his traders could see that shares in a particular company were about to tick up, they could quickly buy shares from a retail trader offering the shares at a slightly lower price and then turn around and immediately sell them for the higher price. The profits made it worth it to pay retail brokers to get the orders.
The practice took off after a series of regulatory changes over the last decade made it easier to trade off exchanges and more expensive to trade on exchanges. Today four firms — Knight Capital Group, UBS, Citigroup and Citadel — have made a business out of paying for retail trades and trading against them. These firms generally pay retail brokers 15 cents for every 100 shares they are sent to trade against, industry experts say. The internalizers were caught in the Facebook initial public offering. They paid to trade against all retail investors clamoring for Facebook shares, but when the Nasdaq exchange broke down just as trading opened they were left holding the shares. Knight Capital has said it lost around $35 million in the incident.
Some critics say that internalization is a problem because the payments the brokers receive are not passed along to the customers. The internalizers also create an incentive for retail brokers to send orders to the place where they can get the biggest payment, rather than the trading platform providing the best price.
The retail brokers contend that the internalizers allow them to get the quickest and best execution for their customers.
Exchanges have struggled to compete with internalizers because they are not allowed to trade at any price other than the publicly listed price, which is what ordinary investors see when they look at stock prices online. Internalizing firms and other players in dark markets can offer to provide a better price, even if it is just a fraction of a penny.
The internalizers will execute the trade only if their market intelligence tells them that the market is about to move in their favor, allowing them to quickly flip the trade. If the internalizers don’t want to trade against the order themselves they usually circulate it to other brokers and dark pools. Only the hardest retail orders to handle — what the exchanges refer to as “toxic order flow” — make it to the exchanges.
The NYSE Euronext plan would offer to segment retail orders into a sequestered area where registered firms could offer to trade at a price slightly better than the listed price. The orders to buy and sell would not be visible to the public.
Nasdaq has not unveiled its plan but people with direct knowledge said it would look somewhat similar and involve a mini-auction any time a retail order came in.
Some internalizing firms have expressed opposition to the plans of the exchanges. But the proposals have also come under fire from market watchers who worry about the direction the industry is taking.
Allen of the CFA Institute, which represents investors, said he understands that the exchanges need to be able to compete, but he does not want to see them accelerate the movement of markets into the dark.
“We want whatever comes out of this to be more transparent rather than less transparent,” he said.
New York Times