For the past decade, the New York Stock Exchange (NYX) has watched its share of trading volume slowly erode. While a lot of that volume simply vanished as individual investors pulled an estimated $300 billion out of U.S. equity mutual funds since 2009, plenty of it was grabbed by upstart competitors: Public exchanges Direct Edge and BATS, launched in 2005 and 2006, respectively, now account for a combined 17 percent of all equity trading volume in the U.S. Today the NYSE handles about 22 percent, down from around 80 percent in the late 1990s.
What’s really vexed the NYSE is all the trading that’s been lured off public exchanges, and either executed internally within wholesale brokerages or on private trading venues known as dark pools. Today about 30 percent of all equity trading in the U.S. goes off “in the dark,” where it is not subject to the same rules, regulations, and disclosure policies that govern public exchanges.
Now the exchange has a plan to recover some of that lost volume. Last week the Securities and Exchange Commission approved the NYSE’s pilot program called the Retail Liquidity Program, or RLP. Slated to launch on Aug. 1, the RLP’s intent is to draw retail trades back to the NYSE.
A key feature is that traders using the RLP will be allowed to quote share prices in fractions of a cent. SEC rules require public exchanges to quote stock prices in full cents, rules that don’t apply in the same way to dark pools and wholesalers. In addition, market makers using the RLP will not be required to make their prices public.
One incentive for market makers to use the RLP will be that all orders on it will come from individual investors. A market-making firm would much rather trade with an armchair investor with an E*Trade (ETFC) account than it would a sophisticated hedge fund that may know something it doesn’t, or worse, a high-frequency trading program reacting to market signals.
The RLP is a hybrid that splits the difference between a totally closed private dark pool where trades are not disclosed and a fully transparent public exchange where prices are displayed to everyone. Not quite dark, not quite perfectly lit, the RLP is more like the gray area in the middle. “It straddles the on- and off-exchange world,” says Ed Ditmire, an exchange analyst at Macquarie Group. “It might not be as transparent as a fully lit exchange. But on the other hand it’ll be part of a highly regulated institution where there will be a great deal of competition for prices.”
According to the SEC’s approval (PDF), under the RLP a “new class of market participants” (including designated market makers) will be able to “provide potential price improvement, in the form of a non-displayed order that is priced better than the Exchange’s best protected bid or offer.” In other words, the lower sub-penny prices will not be displayed. However, the public data feed will indicate when there are better prices available, which dark pools don’t do.
The approval comes after a months-long public-relations campaign by NYSE officials aimed at drawing attention to problems it associates with the rise of some dark pools that operate similarly to exchanges—an overall lack of pricing transparency and their ability to discriminate between customers by charging different participants different amounts. In a phone interview in May, NYSE Chief Operating Officer Larry Leibowitz lamented the direction the market has gone in the last few years. “After the financial crisis, we wanted to create a market with more transparency,” he said. “Instead, it’s gotten darker and more opaque.”
In a July 4 Financial Times Op-Ed titled “It’s time to bring ‘dark pools’ into the daylight,” NYSE CEO Duncan Niederauer wrote that all this off-exchange trading has created a “two-tiered system” that’s led to the “erosion of faith in the efficiency and effectiveness of capital markets.”
Joe Saluzzi, co-head of equity trading at Themis Trading, is highly critical of the RLP. “Niederauer’s [FT] piece was wonderful,” says Saluzzi. “He rightly points out that dark markets are damaging price discovery and discriminating between participants. But that’s exactly what this program is going to do. It doesn’t help the market, it helps the NYSE.”
NYSE officials say that while the RLP does borrow a few elements from dark pools, it brings them into a more regulated, transparent platform. “The important part around this program is that it replicates some of what happens in non-exchange markets and brings it into an exchange environment where it’s subject to the rules and oversight that exchanges are known for,” says Joe Mecane, the NYSE’s head of U.S. equities.
Now that the SEC has approved the RLP (albeit on a trial basis), other exchanges may ask for similar powers. Nasdaq (NDAQ) has said it is working on its own version of a similar program. BATS and Direct Edge declined to comment. It will be interesting to see how Direct Edge reacts, since two of its owners are Knight Capital and Citadel, two of the largest wholesalers in the U.S., which stand to lose retail order flow should the RLP succeed.