Credit Suisse Securities, the broker that runs the world’s largest equities dark pool, will begin operating a stock market by the end of March, according to Dan Mathisson, head of the firm’s electronic trading unit.
The venue, Light Pool, will be the first U.S. electronic communications network to be started in five years. The ECN is aimed at institutional investors such as mutual funds, hedge funds, pensions and endowments. Unlike existing exchanges, Light Pool will employ a system to classify users by how they trade as a way to set prices and keep out unwanted speculators.
The Credit Suisse Group AG unit is launching the venue as industry executives and some investors criticize the fragmentation of markets among 13 U.S. stock exchanges, 3 ECNs and more than 40 dark pools, or private platforms run by brokers to trade stocks without displaying bids and offers. An ECN is a computer system for matching buy and sell requests that competes with the New York Stock Exchange and Nasdaq Stock Market.
“There’s a real need for a new kind of displayed market where all the rules are set with long-term investors in mind,” said New York-based Mathisson. High-frequency trading, which encompasses computer-driven strategies whose common thread is the rapid submission and execution of orders, accounts for at least half of U.S. equities volume, according to the U.S. Securities and Exchange Commission. “Our idea is to forego that chunk of the market and create a niche market with rules aimed at long-term investors,” he said.
Increasing automation and competition have reduced the NYSE and Nasdaq’s share of trading in securities they list from as much as 80 percent in the last decade. Now, less than 30 percent of trading takes place on their main exchanges as orders are dispersed to more than 50 competing venues, almost all of them fully electronic. Twenty years ago, fewer than 10 exchanges competed for the bulk of U.S. equity trades.
Firms that fail to meet standards aimed at protecting long- term investors won’t be allowed directly on the Credit Suisse venue, said Mathisson, head of the broker’s 250-person Advanced Execution Services group. Credit Suisse will subsidize the ECN, which isn’t expected to be initially profitable, as a service to its institutional clients, he said.
Light Pool is built on the same technology used for Crossfinder, the brokerage’s dark pool. That system traded 2.8 percent of U.S. equities volume, or nearly as much as the next two largest -- Sigma X from New York-based Goldman Sachs Group Inc. and Getco Execution Services in Chicago -- combined, according to a Dec. 21 report from Rosenblatt Securities Inc.
While some orders may move from the dark pool to the new market, the addition of Light Pool will boost Credit Suisse’s overall volume, said Dmitri Galinov, head of liquidity strategy who oversees trading products including those platforms. Credit Suisse began testing Light Pool last month with several clients trading General Electric Co. shares. It expanded to a dozen stocks last week.
Development of Light Pool began a year ago as a hedge against potential regulatory restrictions on dark pools. The chief executive officers of exchange operators such as New York- based NYSE Euronext and Nasdaq OMX Group Inc. have urged the SEC to impose more requirements on dark pools, which grew to more than 12 percent of equities trading in November, from less than 9 percent two years earlier, data from Rosenblatt show.
As its regulatory concerns diminished in 2010, Credit Suisse switched its focus to creating a public displayed market for institutional investors worried they weren’t getting optimal executions on exchanges that cater to high-frequency firms.
While the ECN may eventually get “a few percentage points” of market share, building a rival to the New York Stock Exchange or other markets isn’t the goal, Mathisson said. The aim is to reduce what traders call negative selection, or the likelihood of clients getting executions when the market is moving against them, by banning certain users and eliminating orders and practices that cater to high-frequency firms.
“The focus is on minimizing information leakage,” Galinov said. “We want to incentivize resting orders on Light Pool, reduce negative selection and the number of times clients are picked off by other traders.”
Exchanges in recent years have competed for volume from high-frequency firms such as Getco LLC, Tradebot Systems Inc. and Hudson River Trading LLC that have replaced many traditional market makers driven out by increased electronics and quotation increments of a penny instead of eighths of a dollar.
Competition for high-volume firms pursuing a range of strategies that depend on speed has come at the expense of long- term investors, who trade with players that offer liquidity even as they try to avoid those seeking to uncover what institutions are buying or selling, Mathisson said.
Bats Global Markets in Kansas City, Missouri, and Jersey City, New Jersey-based Direct Edge Holdings LLC, which operate two exchanges each, started out as ECNs before converting to exchanges. Light Pool has no plans to become an exchange, in part because the SEC requires brokerage owners of exchanges to keep their ownership stake below 20 percent, Mathisson said.
Bats, which began trading in 2006, is owned by a consortium of 11 banks and proprietary trading firms while Direct Edge is owned primarily by Knight Capital Group Inc. in Jersey City, New Jersey, Goldman Sachs Group Inc., Citadel LLC and New York-based International Securities Exchange, the third-biggest U.S. options venue.
Bloomberg LP, the parent company of Bloomberg News, operates an ECN, as does New York-based Citigroup Inc.
Light Pool’s volume will initially come mainly from Credit Suisse algorithms, or automated trading strategies used to execute blocks in smaller pieces for clients, Galinov said.
Credit Suisse outpaced rival brokers by claiming almost 9 percent of U.S. equity trading by institutional customers, weighted by commissions paid per share, according to a June report by Greenwich Associates, a Stamford, Connecticut-based research firm. The company is also one of the top five providers of algorithms for 69 percent of asset managers surveyed, a December report by Tabb Group LLC in New York said.
The broker’s clients and firms accessing Light Pool directly will be automatically classified based on an initial period of trading behavior and placed in one of three categories: contributors, neutral users and opportunistic traders. The criteria for defining a firm will be automated and objective, “with no human intermediation,” as is required for public markets, Galinov said. The aim is to determine whether firms are systematically profiting from their trading activity in ways that could hurt institutional clients, he said.
Opportunistic firms, which Galinov says include some high- frequency trading companies, will be kicked off the platform and prevented from providing orders or executing against bids and offers directly through Light Pool. They’ll instead have to go through the Jersey City, New Jersey-based National Stock Exchange, where Light Pool will also publish its quotes.
ECNs must make their quotes publicly available through a registered exchange such as NSX or a platform operated by the Financial Industry Regulatory Authority. Since trading on Light Pool will be more expensive and slower for those firms, they’re not likely to use the ECN, reducing the negative selection investors experience, Galinov said.
Contributors, which will include long-term investors, will receive a “significant” rebate when they trade against orders resting in Light Pool, while neutral firms, or those whose behavior falls between the other groups, may or may not get one, Galinov said.
Although pricing hasn’t been finalized, he said the rebate for contributors taking liquidity may be the highest in the industry, currently 14 cents per 100 shares on CBOE Stock Exchange and Nasdaq OMX BX.
Driven by ECNs a decade ago, the largest U.S. equity exchanges have adopted pricing programs that reward firms for posting bids and offers on their platforms after years of reform cut the profitability of market making. Faster computers and measures such as pricing stocks in penny increments reduced the price spread that once compensated professionals for providing liquidity, spurring exchanges to pay rebates to firms that carry out a similar function through high-speed strategies.
For its contributors segment, Light Pool will copy a pricing trend pioneered by Direct Edge’s EDGA Exchange that eliminates the fees to execute immediately, or pays the takers of liquidity and charges those posting orders. This appeals to fee-conscious traders including asset managers and firms that may be willing to search for liquidity on several venues.
The biggest exchanges also try to draw orders from institutional investors. NYSE and NYSE Amex give brokers on their trading floors who often represent asset managers pricing benefits and execution advantages that general users don’t have. Nasdaq recently introduced a program that seeks to attract long- term traders by giving them higher rebates when their quoting activity relative to trades meets certain numeric thresholds.
Light Pool will also avoid certain types of orders and trading practices exchanges have permitted in a speed-focused marketplace that may hurt asset managers, Galinov said. It won’t allow buy and sell requests such as “day intermarket sweep orders,” which traders sometimes adopt to be first in line for executions when a stock price moves by a penny, he said.
While the ECN’s proprietary data feed provided to firms will list bid and offer quotations at multiple prices, it won’t -- unlike NYSE Arca, Nasdaq and BZX Exchange -- disclose executed trades since recipients would get that information before the rest of the market receives it from public sources.
Traders can use information from private data feeds, which are thousandths of a second faster than public sources, to gauge what the publicly disseminated price will be moments later. Speed-focused firms won’t be able to compare trade information to buy and sell requests displayed in Light Pool’s order book in their rapid-fire hunt for signs of larger orders from institutions, whose trading may move share prices, Galinov said.
Light Pool also won’t allow practices that give computer- driven traders clues about hidden orders from bigger traders, Galinov said. In a May paper, broker Themis Trading LLC upbraided Bats Global Markets and Nasdaq for revealing certain transaction information on their data feeds that traders could use to try to predict the presence of larger orders not publicly displayed. Bats and Nasdaq subsequently changed their practices, allowing customers to mask that information.
“Our data feed will be useless to high-frequency traders who play what I call liquidity-detection games,” Mathisson said. Those practices prevent institutions from getting the best prices for their trading, he said.
Credit Suisse will benefit if Light Pool attracts volume or if customers get better results because of changes exchanges adopt in response to the ECN, Galinov said. Even as the ECN loses money based on transaction costs, more market share increases the chance the broker will gain additional volume from clients for which it will earn a commission. Brokers charge clients per-share commissions and usually pay a fee or receive a rebate by trading on exchanges.
“The gamble here is, Can we actually create a market that serves the needs of long-term investors and builds volume?” Mathisson said. “The goal is to create a cleaner pool of liquidity. Success won’t be defined by market share but whether we created a pool that quantitatively has lower negative selection for our institutional clients.”
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