Do we need another stock exchange?
I’ve been asked this question repeatedly since Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial agreed Jan 7 to collaborate on seeking approval for a 14th official US stock market.
The answer? It depends on who “we” is, or are.
Adam Sussman of block-trading firm Liquidnet wrote that it’s an effort to lower trading costs which, thanks to high prices from exchanges for data feeds, have gone the opposite direction of trading commissions.
As to further fragmentation – more venues, less aggregation of buyers and sellers – Sussman says amusingly (the whole piece is funny) that “fragmentation is like having kids – after you have three of them, you just go numb to the pain.”
Michael Friedman, formerly of proprietary trading shop and technology vendor Trillium Management, said at TABB Forum (registration required) that these trading firms representing perhaps more than half of all volume resent how the exchanges keep raising prices for market data that brokers themselves create.
Before the exchanges IPO’d – all but IEX are now owned by public shareholders – they were member-owned, and members didn’t pay for data. Coincidentally the new market is called MEMX, or Members Exchange, anachronistically hailing a different era.
Friedman artfully unfolds market structure, explaining how a bid to buy shares at $9.08 at the NYSE cannot execute if the Nasdaq has a bid to buy at $9.10 because buyers willing to pay more are given legal priority and the trade must route out to the Nasdaq.
What if these firms were to route all the best trades – ones wanting to be the highest bid to buy or offer to sell – to themselves? They could conceivably ravage market-share among big exchange groups until costs fell to a new equilibrium.
I think there are two other big reasons for this new cooperative.
One is easy to understand. Brokers are required to prove to customers that they provide “best execution,” or trading services that are at least as good as the average. Paradoxically, that standard is predicated on averages for customer trades in the market – which concentrate heavily into the largest firms, including several MEMX backers.
If the order flow is consistently better than the average, it’s conceivable these firms could use their own data for free to meet best-execution requirements, a tectonic fist-bump amidst market rules.
So how would they boost odds that their data are better? Look at who’s involved. They are mostly retail brokerage firms, or firms buying retail flow.
At Fidelity, about 97% of the firm’s retail orders are “nondirected,” lacking instructions about where the trades should occur. And well over 50% of those orders are sent to Virtu and Citadel.
Schwab says 99.6% of its trades are nondirected and 70% of them go to Virtu, Citadel and UBS.
And guess what? Retail orders are permitted under rules to, in the jargon of market structure, “price-improve” trades. The NYSE says its Retail Liquidity Program “can be used by retail firms directly as well as by the brokers who service retail order flow providers.”
Interactive Brokers, a firm for sophisticated retail traders and hedge funds, says retail orders with a limit, or set price, can be hidden from display at exchanges in increments of a thousandth of a dollar better than the displayed one, and the orders will float with a changing bid to buy or offer to sell.
That is, if the best bid to buy everyone sees is $9.08, a hidden limit order can be set at $9.081 and bounce like a bobber, staying always a fraction of a penny better than visible prices.
Under market rules, stocks cannot quote in increments below a penny. But they sure can trade in smaller increments, and they do all the time.
By aggregating retail order flow that market rules give a special dispensation to be better than other orders the members of MEMX believe they can not only match more orders but create the best market data.
How is it possible? Regulators wanted to be sure the little guy wouldn’t get screwed, so they give retail trades preference. They never dreamed innovative high-speed traders would buy it, or take advantage of rules permitting these trades to have narrower spreads.
It may work.
The problem is that the advantage MEMX hopes to leverage is a regulatory one that gives special access to one kind of activity. (Editorial note: As we’ve written repeatedly, it’s just as Exchange Traded Funds have proliferated not by being better but through unique regulatory advantages giving them a private, wholesale block market with no transparency).
What’s it mean to investors and public companies? Investors, you could be picked off because MEMX could have compounded capacity to price-improve non-displayed orders. Public companies, something other than capital-formation is driving markets, which is not in your best interest.
We’d prefer a fair, level playing field serving investors and issuers, not rules permitting exceptions traders can game.