Nearly four months after flubbing its own IPO, BATS, the third-largest stock exchange in the U.S., has announced plans to follow the lead of the NYSE Euronext and ask the Securities and Exchange Commission for permission to price stocks in fractions of a penny. Under current securities law, exchanges are banned from doing so. But speedy wholesale brokers such as Citadel and Knight Capital are exempt from that law. As a result, over the last few years the brokers taken almost all the retail order flow away from exchanges by offering better prices to small investors. Today, almost one-third of all U.S. stock trading volume takes place off public exchanges, either through wholesale brokers that match buy and sell orders internally, or inside a collection of private trading venues known as “dark pools,” the biggest of which are operated by Credit Suisse and Goldman Sachs.
Last month the SEC approved NYSE’s Retail Liquidity Program (RLP), a pilot program aimed at grabbing back some of that retail order flow that’s been lost to “the dark,” where prices are not publicly displayed. Ironically, it was Knight’s botched effort to update its trading software in preparation for NYSE’s RLP that ended up costing it $440 million on Aug. 1. The RLP is a sort of quasi-dark pool. It allows a certain class of market participants (including designated market makers such as Citadel and Knight) to choose whether to improve prices on retail orders by pricing them in fractions of a cent rather than in one-cent increments.
Unlike a public exchange, however, those lower sub-penny prices are not displayed. The public data feed does indicate when there are better prices available, which dark pools do not do. So while NYSE’s RLP isn’t as closed as the dark pools it’s now hoping to compete against, it’s certainly not fully transparent, either. The BATS proposal, called the Retail Price Improvement (RPI) program, appears to have a few distinct differences compared with RLP. Rather than being executed in a fully separate arena, orders that flow into the RPI will be able to interact with the natural liquidity of the main exchange at BATS. That might be something the SEC has an issue with. “It almost seems like a free-for-all,” says Sang Lee, a market analyst at Aite Group. “They may run into some issues with the sub-penny rule there.”
Clearly these moves show the exchanges are now on the offensive. They’re done sitting back and watching the dark pools and wholesalers continue to take their business away, hoping perhaps that the SEC would eventually step in. And it was only a matter of time before the other exchanges asked for the same sub-penny pricing authority the SEC granted the NYSE. But there’s something not quite right about combating darkness with more darkness. For years the exchanges complained that the markets were becoming less transparent. Now, they’re dimming the lights themselves.
While these programs aren’t necessarily as transparent as the fully public exchanges, Ed Ditmire, an exchange analyst at Macquarie Group, says “they are incrementally bringing more of the market toward the more transparent end of the spectrum.” True, but isn’t that where the entire market was a decade ago?