Call it “NYSE vs. the Internalizers, Round Two.” In what amounts to its second stab at competing with broker-dealers that match orders outside of the public markets, the New York Stock Exchange is looking to replicate the functionality of a dark pool under a proposal filed with the Securities and Exchange Commission in November.
The goal of the NYSE’s “Institutional Liquidity Program” is to encourage trading in size by offering brokers and exchange market makers two new hidden order types that will allow them to transact in the dark. The proposed one-year pilot program would target a specific segment of the NYSE’s customer base much as the exchange’s 16-month old Retail Liquidity Program does.
Both programs are structured to compete against services offered by brokerages that match up institutional and retail orders with similar orders or the brokers’ own positions inside the brokers’ automated trading systems.
“When we launched the RLP, we spoke with a lot of institutions, and part of those discussions revolved around the possibility of doing something similar with institutional-type orders,” said Joe Mecane, head of U.S. equities at NYSE Euronext, parent of the New York Stock Exchange. “So, as we’ve gotten some experience with RLP, the question is: Is there a different mechanism that would work better for larger-type orders?”
For the past few years, NYSE Euronext and other exchange executives have repeatedly complained that broker-dealers were syphoning orders away from the public markets, and internalizing them, or matching them up within the brokers’ own operations. In other words, wholesalers-such as Citi, KCG Holdings and Citadel-cordon off retail flow, while bulge bracket brokers steer their institutional customers’ orders into their own alternative trading systems, or dark pools.
By steering their customers’ orders into their own systems, the brokers deprive the public markets of valuable orders and potentially impair the price formation process, NYSE and other exchanges have charged. Brokers trade about 37 percent of all shares away from the exchanges, according to data published by BATS Global Markets.
The exchanges themselves have made their unhappiness with dark pools known. Earlier this spring, NYSE Euronext’s Duncan Niederauer, Nasdaq OMX Group’s Robert Greifeld and BATS Global Markets’ Joseph Ratterman traveled to Washington, D.C., to meet with SEC officials in closed-door meetings. Later, with Nasdaq OMX, the NYSE pressed regulators and legislators to make changes to the market’s structure that could drive more flow to the exchanges.
At the same time, the two largest exchange operators have taken steps to compete with the internalizers. In 2011, the NYSE proposed its RLP, which promised price improvement on qualified retail orders. That is a service traditionally offered by wholesalers.
Brokers fought the initiative, but the SEC ultimately approved it. RLP launched in August 2012 and was quickly copied by Nasdaq. The program has not been a huge success, however, accounting for only about 1 percent of NYSE’s share volume.
A New Strategy
Now comes round two.
“The proposal arises out of the competition between the exchange and non-exchange venues for block trading interest and the growth of institutional trading on less regulated and less transparent execution venues,” the NYSE told the SEC in its filing for the Institutional Liquidity Program.
Under the proposal, the exchange is seeking to mimic the practices of a typical broker-dealer dark pool by conducting all trades in the dark and restricting the counterparties to large buyers and sellers. The setup is intended to insulate buyside traders and their agents from the alleged predatory behavior of high-frequency traders that inhabit the stock exchanges.
In contrast to the activity in broker-dealer dark pools, however, trading in the NYSE’s version does not take place in a vacuum. Before any trades occur, traders must take into consideration the prices displayed on the NYSE’s book. Those displayed quotes have precedence over any non-displayed orders. “These orders will never execute in front of displayed liquidity on the book,” Mecane said of the two new order types that form the basis of the proposal.
The scheme wins plaudits from one critic of contemporary market structure. Joe Saluzzi, a partner at agency brokerage Themis Trading, is an outspoken critic of the proliferation of professional, or high-frequency, traders at exchanges, and the exchange policies that make their strategies possible.
“This is remarkably fresh thinking from the New York Stock Exchange,” Saluzzi said. “Equity trading venues need to provide better protection for long-term investors, and this proposal demonstrates a spirit of innovation that regulators have been seeking for the past 15 years.”
The NYSE has created two order types that interact with each other out of sight of the rest of the market. Both are non-displayed, or hidden, limit orders. One order type would be used by exchange market makers in amounts of 500 shares or more. The other would be used by brokers representing institutional orders in amounts of 5,000 shares or more. The NYSE will send out an alert to members when one of these orders is available.
The brokers’ orders-known as “institutional liquidity orders”-can match with any order on the exchange’s book, including the new market-maker orders and other ILOs. The market makers’ orders-known as “oversize liquidity orders”-can only match up against ILOs.
For the dealers, the minimum size of the proposed OLO is intended to encourage them to quote in size. If they know in advance that they will only be interacting with other large orders, they “might be more willing to show a little more size,” Mecane noted.
To the Limit
Besides the size restrictions on the order types, the NYSE is also hoping to limit interactions to big traders by giving first dibs to incoming orders to those traders bidding or offering the most.
So, in contrast to the exchange’s standard price-time priority methodology-which benefits the fastest traders-under the proposal, the NYSE is instituting a price-size-time methodology. Trades will be allocated to those suppliers of liquidity with the largest quotes first-and not necessarily to those at the top of the queue.
This would not be the first time an exchange has experimented with price-size-time priority. In 2010, Nasdaq rechristened its newly acquired Philadelphia Stock Exchange as “Nasdaq PSX”-which stood for “Price-Size Exchange”-and incorporated the allocation methodology. By giving liquidity suppliers priority based on the size of their orders, rather than their rank in the queue, Nasdaq was trying to build volume on large trades. The minimum quote size was 2,000 shares. PSX failed to gain traction, however, and Nasdaq repurposed it as a price-time marketplace for exchange-traded funds earlier this year.
Although the NYSE is promoting its new program as one that encourages trading in size, there will likely be many exceptions found in the small print. An ILO can actually be as small as 100 shares, as long as it is part of a larger 5,000-share “parent” order. This reflects the reality of the marketplace, according to Mecane, where large parent orders are broken up by algorithms and fed into the market in much smaller chunks. The goal is to be “algo-friendly,” Mecane added.
If a broker does send in a large ILO, he can set a floor under the size of the trade. If he were to send in a 5,000-share order, for example, he could limit the size of any order with which it interacted to, say, 2,000 shares.
This “minimum triggering volume” helps institutional brokers guard against possible gaming, Mecane explained. “If they’re worried about gaming or trading against smaller orders because they think the trade would cause information leakage, we give them the ability to set a minimum triggering volume,” he said. “That way they can make sure they don’t do a trade unless there 2,000 shares or 5,000 shares or whatever available.”
By the same token, there are restrictions on ILOs that prevent traders from using the order type to sniff out information. An ILO cannot be part of a two-sided quote, or order, for instance. It can only be a single order. It cannot be used as part of a market-making or spread-trading strategy. In other words, a trader can’t use an ILO to both buy and sell 5,000 shares, looking to profit from the spread.
“The point is to reduce gaming,” Mecane said. “If you are putting something in as an ILO, it’s because you have the intent to build up a specific position on one side of the market.”
The SEC noticed the NYSE’s proposal on its website on Nov. 21. The proposal was published in the Federal Register on Nov. 27.
Comments are due to the regulator 21 days after that.
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