The U.S. Securities and Exchange Commission approved a pilot plan that will allow some orders to go undisplayed on the New York Stock Exchange as a way for the biggest stock trading venue to attract individual investors.
NYSE Euronext said in a statement yesterday the program will begin Aug. 1. The company sought permission in October to create a new class of retail liquidity providers that would be allowed to reserve and keep hidden bids and offers for smaller investors with prices that beat those in the rest of the market.
The NYSE’s share of trading in companies it lists fell below 25 percent in May from 82 percent in 2003 as more transactions were handled by brokers through a process known as internalization, data compiled by Barclays Plc show. While the new arrangement has been labeled a “dark pool” by some analysts, exchange executives say it’s not the same thing.
“The big difference in the program is it’s still operated in the exchange framework,” Joseph Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext, said yesterday in a phone interview. “While we are able to segment retail customers, all the rules about how we treat retail customers differently are filed and standardized and submitted to the SEC,” he said. “Dark pools can discriminate with complete discretion.”
Dark pools, unlike exchanges, are private venues that execute orders without displaying bids and offers in advance. They also aren’t required to seek regulatory approval every time they change a rule.
Most orders from individual investors who trade through retail brokers are sent to wholesalers such as Knight Capital Group Inc. and Citadel LLC, who pay the brokers for sending them. The wholesalers can then execute the orders internally, instead of going to an exchange, as long as they provide prices that match or improve upon levels in the public markets.
Orders from individual investors are attractive to market makers and asset managers because the senders, unlike professional traders, aren’t expected to know more about short-term price movements than the firm on the other side of the trade. Soliciting the orders could lure more trading volume to NYSE, Mecane said.
Under the exchange’s program, two new categories of brokers would be created: retail member organizations and retail liquidity providers. Orders from a firm in the first group or a broker acting on its behalf could trade against hidden orders at the exchange intended only for retail clients.
“The NYSE is responding to competition from wholesalers and dark pools,” James Angel, a finance professor at Georgetown University’s business school in Washington, said in an e-mail yesterday. “They are doing the, ‘If you can’t beat ’em join ’em,’ thing.”
NYSE Euronext’s plan may provide an incentive to retail brokers such as E*Trade Financial Corp. and TD Ameritrade Holding Corp. to send orders directly to the exchange. As more retail orders come in, the institutional investors who trade on the exchange would see more retail orders, attracting institutional investors and more business to NYSE Euronext.
Knight, one of the main market makers on the NYSE, said in December that the plan could disrupt trading by dismantling a ban on quote increments of less than 1 cent. That, in turn, could require technology upgrades and changes to trading rules, according to Leonard Amoruso, Knight’s general counsel.
“Retail orders are going to be executed basically within a dark pool within the exchange,” Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York, said in a phone interview yesterday. “You won’t be able to see those orders because they’re going to get a better execution price than the displayed price. You’re going to wind up creating a subpenny market within the market that won’t be displayed.”
About 10 percent of U.S. equities volume comes from individual traders, according to NYSE’s Mecane. Discount and other brokers that cater to those clients often turn to wholesalers for orders that can be traded at the market’s prevailing price.
Charles Schwab Corp. sent 99 percent of its orders to UBS AG in the second quarter of 2011. TD Ameritrade sent 74 percent of its market orders in NYSE-listed stocks to Citadel and 21 percent to UBS in the third quarter last year.
NYSE Euronext executives have argued that the increase in orders traded away from exchanges erodes the ability of buyers and sellers to interact and yield prices that are deemed reliable. About 30 percent of equities trading takes place over-the-counter, with those transactions based on prices established on exchanges, according to data from Bats Global Markets Inc.
The pricing reverses the traditional fee structure on the biggest U.S. exchanges, which normally pay firms adding liquidity and charge as much as 30 cents per 100 shares for those trading against existing orders. Exchanges pocket the difference. The 30-cent cap was set by the SEC.
NYSE’s designated market makers, which include units of Barclays Plc, Getco LLC, Knight and Goldman Sachs Group Inc., along with the exchange’s so-called supplemental liquidity providers, such as automated firms Virtu Financial LLC and Hudson River Trading LLC, could supply orders for retail brokers through the program. Mutual funds and other investors could furnish orders for individual traders, although their fee would be higher than what NYSE’s liquidity providers pay.