Nasdaq OMX has found evidence that too much internalization harms the quality of trades executed in the public markets, according to an unfinished study by the exchange operator.
Nasdaq’s chief economist, Frank Hatheway, is conducting a study that measures the impact of internalization on the market quality of individual securities. The study finds that when internalization levels approach 40 percent of a stock’s volume, price discovery is impaired.
"Frank has worked on a number of studies that show, in a subset of stocks, that market quality starts to degrade [when internalization levels] come closer to 40 percent," Brian Hyndman, a Nasdaq senior vice president in charge of transaction services, said at a recent industry conference. "It’s not across all 8,000 stocks, but the more liquid ones."
In a subsequent interview with Traders Magazine, Hyndman said there wasn’t enough data collected yet by Nasdaq to support or disprove the 40-percent-threshold theory for market deterioration, but more data collection and study is being done.
The study follows on the heels of an SEC Concept Release which, in part, seeks comment on the pluses and minuses of trading away from the public markets. The regulator wonders if rules should be put into effect that would drive more trading to the displayed markets.
"Internalization" is a catchall phrase that encompasses trading by market makers, dark pools and upstairs desks. These trades occur away from exchanges and ECNs and are printed to a trade reporting facility.
The higher the internalization percentage, the less a stock trades in the public marketplace, and according to the study, investors get worse prices because there is less competition for liquidity.
Hyndman declined to share a preliminary copy of the study or provide more granular detail from the findings. However, Hyndman acknowledged that internalization rates in the U.S. equity markets have climbed to 30 percent from 20 percent during the last year. And that’s what has him concerned.
A research note released in January by the U.S. brokerage arm of Macquarie similarly reported that off-board trading had increased from 18 percent in January 2008 to 31 percent in January 2010.
Hyndman said stocks that have higher rates of internalization tend to be low-priced and high-volume, such as Citi. He also said there are stocks with internalization rates greater than 40 percent–outliers with rates reaching 50, 60 or even 70 percent. Conversely, he said, as a stock price rises, internalization levels decline.
Some industry officials, however, contend that Nasdaq’s concern is more bottom-line oriented and less about market quality. That’s because lower volumes impact their revenues: "Of course the exchanges are concerned," he said.
One trading official points out that it is dangerous to base decisions on arbitrary numbers. An internalization rate of 40 percent may be bad news in one stock but acceptable for another.
"What is a problem in one symbol might be perfectly fine in another," said Bill Karsh, chief operating officer for Direct Edge ECN and a former head of business development at wholesaler Knight Capital Group. That is especially true for large block trades, he said. A trader seeking to trade a million shares is unlikely to take his order to the public markets if volume averages 100,000 shares a day. If 90 percent of the trade is done in a dark pool and only 10 percent is done on an exchange, "Is that such a bad thing?" Karsh asked.
Hyndman speculated that the reason stocks will be traded internally or in a dark pool is that sub-penny pricing is used, which results in tighter spreads and better pricing than in the public markets.
Hyndman said that at its current 30 percent level, internalization is still within its "natural" or acceptable range, which he pegged between 20 and 30 percent, possibly with 25 percent being optimal. He added that as trading has become more electronic and volumes have grown on stocks listed at Nasdaq, internalization rates spiked for some Nasdaq listed stocks first, but then spread to stocks listed on the New York Stock Exchange and on Tape B.
Whit Conary, president of the dark pool LeveL ATS, said that it is unlikely that off-exchange trading will reach 40 percent. He added that dark pools only make up about 10 percent of that volume, up from 8 percent a couple of years ago. "The growth is not as dramatic as people make it out to be," he said.
Defending off-board trading, Conary said that during the 1987 stock market crash, floor specialists couldn’t handle the trading volume and it took hours to complete a trade. Now with electronic off-board trading, technology allows traders to get their orders done in seconds, even during market fluctuations.
