NYSE Euronext and Nasdaq OMX Group Inc. (NDAQ), the biggest owners of American stock exchanges, are urging U.S. legislators to support changes to rules that caused a proliferation of broker-run markets that draw orders away from public venues.
Dark pools and brokers should be required to provide better prices than those available on exchanges or offer quotes publicly at the best levels, the companies said in a written presentation to staff of the House Committee on Financial Services that Bloomberg obtained. Lawmakers are holding hearings on the structure of U.S. markets in Washington on June 20. Dark pools, unlike exchanges, are private venues that execute orders without displaying bids and offers in advance.
The Securities and Exchange Commission should explain why Regulation ATS, approved in 1998 to integrate alternative venues that compete with exchanges listing stocks into the broader marketplace, “remains sound policy,” NYSE Euronext (NYX) and Nasdaq OMX said. That rule and another set of changes the SEC approved in 2005 overhauled trading and led to the creation of more than four dozen venues that compete with the New York Stock Exchange and Nasdaq. Executives at both companies have pushed for changes to how dark pools operate over the last three years.
“Too much fragmentation and darkness can undermine investors’ perception of a fair and orderly market,” the New York-based exchange operators wrote. “This can become a macroeconomic issue if investors lose confidence and exit the market.” They also said that “investors would be better served by a unified model that regulates markets and trading systems according to their function rather than their status.”
Richard Adamonis, a spokesman for NYSE Euronext, and Joseph Christinat of Nasdaq OMX declined to comment.
The NYSE and Nasdaq have seen their share of trading in the securities they list drop to less than 27 percent as venues providing cheaper costs and more flexibility about how orders are executed gained traction, according to data compiled by Bloomberg. Dark pools and brokers use stock prices established by exchanges when they match buy and sell requests. Almost one- third of U.S. equities volume traded away from exchanges this year, Bloomberg data show.
Dark pools accounted for 13.6 percent of U.S. equities volume in April, according to data compiled by Rosenblatt Securities Inc. Crossfinder, owned by Credit Suisse Group AG (CS), was the largest, trading 126 million shares daily, followed by Goldman Sachs Group Inc.’s Sigma X, Knight Capital Group Inc.’s Knight Link system and Barclays LX, owned by Barclays Plc, the May 31 report said.
The average execution size for all except four of the U.S. alternative trading venues, or ATSs, tracked by Rosenblatt was less than 300 shares, comparable to what occurs on exchanges, according to the report.
The exchanges said in their presentation that block trades should be exempt from their policy recommendations about changes to dark pools.
“The problem exchanges confront is pretty simple,” Justin Schack, managing director for market structure analysis at Rosenblatt, said in a phone interview. “Volumes have come down and the piece of the pie the exchanges have is getting smaller at the same time. If you’re a public company like NYSE Euronext and Nasdaq OMX and a sizable portion of your revenues come from transactions in U.S. equities, that’s not good.”
Greg Tusar, head of U.S. electronic trading at Goldman Sachs Execution and Clearing, a unit of New York-based Goldman Sachs Group Inc. (GS), said it’s important to distinguish between “potential business model pressures” and issues related to the structure of the U.S. equities market.
“Increasingly broker-dealers are bringing together buyers and sellers in electronic environments, either as ATSs or market makers,” he said in a phone interview. “They have functional similarities to what exchanges do. However, it’s important to recognize that exchanges and broker-dealers operate in different regulatory structures with different responsibilities. Broker- dealers have customers and best-execution obligations to those customers, while exchanges do not.”
Exchange executives have said they’re at a disadvantage to dark pools they compete with since they must publish their rules publicly and seek SEC permission for changes, while alternative venues can implement new offerings more rapidly.
Dark pools can also allow users to trade with or avoid certain types of participants, which isn’t permitted for exchanges. The flexibility brokers have has helped them take volume from exchanges and has resulted in public markets becoming destinations of “last resort,” the exchanges’ report to the House financial services committee said.
Dark pools, human traders at banks, and wholesalers, a category of market makers that executes orders for individual investors sent to the firm from retail brokers, provide competition to exchanges, Jamie Selway, managing director and head of liquidity management at Investment Technology Group Inc. (ITG) in New York, said in a phone interview. Policy changes would reduce the trading options available to investors, he said.
ITG’s Posit venue traded about 46 million shares a day on average in April, according to the Rosenblatt report.
“The nice thing about competition to exchange monopolies is that it disciplines them,” Selway said. “Competition can come from other exchanges like Bats or Direct Edge, or brokers who compete with exchanges as liquidity providers, either as dark pools or as internalizers committing capital.” Wholesalers are a type of firm that internalizes orders away from exchanges.
Selway is on the board of the two exchanges owned by Bats Global Markets Inc. in Lenexa, Kansas. Direct Edge Holdings LLC in Jersey City, New Jersey, and Bats compete for orders with exchanges and dark pools.
Regulation ATS, implemented 13 years ago, may warrant a “facelift” including more transparency about trades in dark pools, Selway said. He added that exchanges also have advantages such as revenue from the sale of market data and lower clearing costs than brokers.
“Raising the bar a little bit for ATSs and making it easier for exchanges to pass rules isn’t an unreasonable position,” Tusar said. Goldman Sachs has “advocated for some time to have ATS filings be made public,” he said.
While competition among exchanges and other venues lowers costs for investors, “excessive fragmentation” increases what they pay, NYSE Euronext and Nasdaq OMX said, without providing information about fees or higher prices. A complex equities marketplace “requires a greater reliance on technology” and creates more risk across all venues, the companies said.
The so-called flash crash on May 6, 2010, showed that “liquidity evaporates quickly when it is spread too thinly across the numerous lit and dark market centers operating in the U.S.,” the companies said. A mutual fund company’s automated sale of futures without regard to price set off the 9.2 percent intraday plunge in the Dow Jones Industrial Average (INDU), according to a 2010 report from the SEC and Commodity Futures Trading Commission.
Nasdaq OMX Chief Executive Officer Robert Greifeld declined an invitation to testify at the June 20 hearing on market structure, according to two people with knowledge of the plans. William O’Brien, CEO of Direct Edge, will participate, according to Jim Gorman, a spokesman for the company. Executives from NYSE Euronext, Getco LLC, Invesco Ltd. and Knight have also received invitations to testify, according to one of the people, who wasn’t authorized to speak publicly about the planning.
Exchanges caused two botched initial public offerings in the last three months that spooked investors.
Nasdaq’s mishandling of orders in the Facebook Inc. IPO on May 18 led to at least one investor lawsuit against the exchange operator. Industry losses tied to the malfunctions were close to $200 million, Knight CEO Thomas Joyce said June 7. Bats withdrew its own IPO on March 23 after it couldn’t get its first trade to be published properly. The CEOs of both companies faulted their own exchanges for the problems.
Increasing the ability of investors’ buy and sell orders to come together on exchanges helps produce prices that are more accurate, Rosenblatt’s Schack said. The movement of volume away from exchanges may be a concern for some brokers and market participants, he said.
“It’s very difficult to tell at what point price discovery gets damaged,” Schack said. “If it’s OK that 30 percent of volume is done off-exchange, would 40 or 50 percent be bad? The problem for market participants and regulators is that if you don’t know where that threshold is, you may not know until it’s too late and price discovery has deteriorated.”
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