It was a time when dark pools were rising in popularity – venues that provided liquidity and anonymity – everything the buy-side need to execute its orders away from predatory traders. These up-and-coming venues were also places where an institutional trader could find block liquidity easier than on an exchange.
These might have been the best of times for a buysider.
But they were also rapidly becoming the worst of times for the exchanges.
Order flow was moving to these new upstarts at a clip the tried-and-true bourses were unaccustomed to. Long the only game in town, the exchanges had gotten comfy with their market share and could just sit back and collect trading revenue. Where could the order flow go, they jested.
It went to the brokers, who hearing first the complaints of front-running and block liquidity, created venues specifically designed to combat these and other practices that were seen as harming price discovery ad best execution. It was the rise of Crossfinder, BX and others.
One exchange, Nasdaq OMX, decided to fight back. The operator sought to rely on its then fledgling Boston stock market to buck up its declining market share by snatching back order flow it says it has lost to dark pools. But how? And would the buy-side sent it the order flow rather than the dark pools?
Fast forward to today and it is obvious that dark pools, while coming under increased scrutiny from within the industry, regulators and even the federal government, have changeed the trading landscapee and did siphon off order flow that was never recovered. So what did exchanges like Nasadq do?
They diversified. Rather than face dwindling profits and take sustained hits to its bottom line, Nasdaq, and others got into other businesses, such as technology. A Nasdaq spokesman told Traders Magazine that the exchange works with Goldman Sachs and manages its dark pool’s technology.
“Plus, we operate the Trade Reporting Facility which handles the majority of dark flow,” the spokesman said. “Nasdaq is alive and well as we innovated and found a way to adapt and overcome.”
Charles Darwin would be proud. And so would Gunnery Sergeant Thomas Highway.
The following article originally appeared in the August 2009 edition of Traders Magazine
By Nina Mehta
Nasdaq OMX Group is relying on its fledgling Boston stock market to buck up its declining market share by snatching back order flow it says it has lost to dark pools. But pricing changes that go into effect on Tuesday could pare back Boston’s market share.
The exchange operator’s January market share in equities was 27.1 percent. In July, according to Barclays Bank, it was 22.2 percent, including 2.3 percent from Nasdaq OMX BX, which has grown rapidly since its January launch. Yesterday, for instance, BX executed a record 3.16 percent of the industry’s volume, beating its Wednesday record of 3.04 percent.
Nasdaq has used Boston to stave off what would otherwise be a bigger market-share rout. It has done this by appealing to liquidity takers on BX with a 6-cent rebate per round lot. The only other market with low pricing for liquidity takers is Direct Edge’s EDGA market, which charges takers nothing.
“We wanted to do something uniquely different from what we were doing on the Nasdaq platform, which has a high rebate and high take fee,” said Brian Hyndman, senior vice president for transaction services at Nasdaq OMX Group. “With BX, we wanted to be first in brokers’ routers–not so much to compete with EDGA, although in hindsight it looks like we were [competing with that market]–but really to compete against the dark pools.”
Many broker-operated dark pools have low fees for executions, compared to the access fees charged by exchanges and electronic communication networks. Some pools also use automated indications of interest to find contra-side liquidity if they don’t have a match within their own pool, further reducing the likelihood that initially unmatched flow will head to the public markets.
Aside from BX, the only markets that have increased their market share this year are Direct Edge and off-board trading generally. “Dark pools have been the biggest beneficiary of growth this year,” Hyndman said.
NYSE Euronext and BATS Global Markets have seen their matched market share decline since last winter. NYSE Group, which includes the markets run by NYSE Euronext, traded 28.4 percent of consolidated volume in July, down from 33.2 percent in January. BATS had 10.8 percent in July, down slightly from 11 percent in January.
According to Hyndman, attractive pricing for liquidity takers has pushed BX to the top of broker-dealers’ routing tables. That, in turn, encourages liquidity providers to post limit orders on BX, despite the lack of a rebate, since they’re subject to less adverse selection, he said. In this context, adverse selection refers to the likelihood of getting executed when the market is about to move against those placing the orders in the market.
The current market environment of low-priced stocks also favors BX’s model. “Low-take-fee [markets] have gotten a lot of the volume in low-priced stocks recently,” Hyndman said. “A penny spread in a low-priced stock is a lot wider than a penny spread in Google, so there’s greater opportunity for wholesalers to internalize flow.” In his view, that makes venues with no access fees, or a rebate in the case of BX, attractive to brokers.
“Stocks trading at $30, $40 or $50 a year ago are now trading at $3, $5 or $7,” Hyndman said. “That has contributed to the success of Boston.”
According to data from Barclays Bank, BX has done particularly well in actively traded, low-priced stocks. Last week (the week of Aug 17), BX accounted for significant trading in the most active stocks listed on NYSE as well as Nasdaq. In NYSE-listed names, it represented 7.2 percent of trading in Citigroup, 3.8 percent of Bank of America, 4.6 percent of General Electric and 4.5 percent of Ford. In Nasdaq-listed securities, BX traded 2.5 percent of QQQQ, 5.2 percent of E*Trade and 3.4 percent of Intel. Fifteen of the 10 most active stocks on NYSE and Nasdaq combined were less than $20.
Against this backdrop, Nasdaq OMX is now making a change to BX’s pricing that could cost it some market share. On Tuesday, the company will change BX’s pricing so the company earns money from its Boston market instead of losing money.
Instead of a 6-cent rebate for liquidity takers, BX’s new rebate will be 1 cent. And liquidity providers will shift from no fee or rebate to a 3-cent fee. That pricing will apply to Tapes A and C (NYSE- and Nasdaq-listed securities, respectively). Tape B, which includes all other equity securities, will shift to a 16-cent fee for takers and a 14-cent rebate for providers.
Previously, Tape B, like Tapes A and C, had inverted pricing with a 6-cent spread, which meant that BX lost 6 cents for every 100 shares traded. Now, BX will earn 2 cents per 100 shares.
Hyndman expects the new pricing to put a dent in BX’s market share because the pricing will no longer be inverted. “It would be foolish to think our market share doesn’t go down a bit,” he said. “But the plan was to go to a positive [spread] capture.” He added: “My guess is we lose some market share, maybe 20 to 25 percent.” At the same time, Hyndman observed, more firms are joining BX every day. The exchange now has 90 to 100 customers trading on it daily.
