NYSE Retail Order Pilot Draws Competing Plans from Bats, Nasdaq
Nasdaq OMX Group Inc. (NDAQ), Bats Global Markets Inc. and Direct Edge Holdings LLC are working on plans to compete with the New York Stock Exchange’s initiative to attract individual investors through superior prices.
The exchange operators are developing strategies to deliver lower prices to retail investors who want to buy and higher prices to those selling. The Securities and Exchange Commission approved a pilot project to be started by NYSE on Aug. 1 to furnish individuals with prices at least one-tenth of a cent better than those available to mutual funds, high-frequency traders, brokers and other market participants.
The program is aimed at helping NYSE to compete with so- called equity wholesalers, a category of market makers that executes orders for individuals sent to them by retail brokers such as TD Ameritrade Holding Corp. (AMTD) and Charles Schwab Corp. Knight Capital Group Inc. and Citigroup Inc. are among the largest wholesalers trading orders away from exchanges at prices that match or improve on the levels offered publicly.
NYSE’s program “highlights a fundamental shift in the way the SEC views exchanges and the way exchanges may ultimately wind up operating,” Joe Ratterman, chief executive officer of Bats, said in a phone interview. “This is a major, major fundamental shift or step in the direction of segmenting your customer base. While Bats would prefer that we hold to the old doctrine, clearly the SEC has paved the way for a change to that doctrine and we absolutely will respond.”
Exchanges historically provided “fair and open access” on the same terms to all participants, Ratterman said. Now they’re being allowed to offer “disproportionate economics and disproportionate access based on participant type,” he said. While the SEC is permitting NYSE to give retail investors better prices, “it’s a slippery slope” that could allow exchanges to further differentiate between users, Ratterman said.
He didn’t provide specifics about the program that Bats, based in Lenexa, Kansas, would propose for retail investors.
About 10 percent of U.S. volume comes from retail clients, according to Joseph Mecane, co-head of U.S. listing and cash execution at NYSE Euronext. (NYX) The SEC authorized the 12-month pilot on the New York-based NYSE and NYSE MKT, a separate venue owned by the parent, on July 3.
NYSE is combating a “tiered market” in which retail orders that can be traded at prevailing prices never make it to public exchanges that aggregate buy and sell interest from asset managers, brokers and other participants to determine stock prices for investors, Mecane said. Allowing exchanges to deliver better prices benefits individuals and lets the venues compete for orders that are attractive to market makers, he said.
“This is not increasing the tiering that already exists in the market,” Mecane said in a telephone interview. “It tries to create a more open, efficient, competitive process around the segmentation that already occurs with retail orders, but in an exchange environment.”
William O’Brien, CEO of Direct Edge, called NYSE’s plan a “milestone” and said his company would offer a program to provide better prices and more shares to retail customers. Like Bats, Direct Edge in Jersey City, New Jersey, operates two exchanges. NYSE Euronext and Nasdaq OMX each have three. A total of 13 U.S. exchanges exist to trade stocks.
“Price is not the only aspect of execution quality,” O’Brien said in a phone interview. “What the average investor really wants when they want to buy or sell is to get their entire order immediately filled at that price. Price and size are both elements that matter to retail investors so I think you’ll see elements of both in our program.”
Direct Edge’s biggest broker-dealer owners include Knight (KCG) and Citadel LLC, both large wholesalers. UBS AG and Citigroup round out the four main firms that trade with retail clients.
What’s most significant about the SEC’s approval of NYSE’s program is the “ability of exchanges to provide targeted outcomes” for some users, O’Brien said. “The notion of fair access was that if you’re not doing it for everybody, you can’t do it for anybody. At least with retail investors, that’s clearly allowed now.”
The CEO of Knight, which has criticized NYSE’s plans to the SEC, said today that exchanges’ interest in bidding for retail orders is a “rush to the bottom” because it allows bid and offer quotes at increments less than 1 cent. That’s currently not permitted by the SEC since the disadvantages are seen as outweighing the benefits of minimally better prices. The SEC exempted NYSE’s and NYSE MKT’s programs from the ban.
NYSE’s effort is an “instrument crafted by our friends at 11 Wall Street in an attempt to garner more retail market share,” Thomas M. Joyce, chairman and CEO of Knight, said today on a conference call. “Let the games begin.”
Market makers that internalize orders as wholesalers can provide better prices and payments to retail brokers, Joyce said. While competition may hurt Knight by shrinking the volume of retail orders it gets, the company’s market-making business at NYSE would offset part of the loss, he said. Knight can “defend our place in the market quite ably,” he added.
NYSE’s program would create two new categories of brokers: retail member organizations and retail liquidity providers. Orders from a firm in the first group including a broker acting on its behalf could trade against hidden orders at the exchange intended only for retail clients. While both the price and number of available shares won’t be displayed, the exchange will indicate in a public data feed whether there are buy or sell orders for a specific stock intended for retail customers.
Orders submitted to the exchange for individual investors could come from market makers at NYSE, automated traders, asset managers and others. So-called designated market makers and supplemental liquidity providers authorized by NYSE will get better pricing than others supplying orders for retail clients.
“Ultimately it benefits retail, because when market makers have a sense of who the other side of the trade is, they’re generally willing to give better prices to that customer,” Mecane said. “If you’re just trading and have no idea who you’re trading against, you’ll be less willing to make aggressive prices than you would be if you knew the other side wasn’t a proprietary trading firm.”
Most retail orders in the program will probably initially come from wholesalers who don’t trade with all the buy and sell requests they get, Mecane said. Those orders may get better prices than they’d otherwise receive because a wider range of participants will be competing for them, he said.
Firms submitting retail orders to NYSE can also allow them to trade with public buy and sell requests at the exchange or on other venues, Mecane said. NYSE hopes that will increase retail trading with “visible quotes” and encourage liquidity providers to supply bids and offers for other types of investors at the exchange, he said.
Thomas Peterffy, chairman and CEO of Interactive Brokers Group Inc. (IBKR), a Greenwich, Connecticut-based securities firm that operates a market-making unit, said NYSE’s program could backfire on retail investors by alienating market makers.
Such traders may be less willing to quote aggressively on exchanges if others are getting slightly better, hidden prices, Peterffy said in a conference call yesterday. That could cause the bid-ask spread, or difference between the price at which traders are willing to buy and sell shares, to widen, yielding worse prices for investors, he said.
Institutional investors such as mutual funds also won’t get the benefits of the retail programs that exchanges offer, according to Ratterman of Bats. While it’s important to give individuals the best trades possible, many people invest for their retirement through pension or mutual funds, which won’t have access to the better prices, he said.
About half a dozen firms currently plan to be retail liquidity providers when the pilot program begins next month, Mecane said. A few others may also register as supplemental liquidity providers in order to join the program, he said. He said he hopes NYSE will increase its share of trading in stocks it lists by “low single digits” within a year.
Nasdaq OMX also intends to compete with NYSE’s retail liquidity program. The New York-based company’s effort will take the form of automated auctions for orders from individual investors, Eric Noll, executive vice president for transaction services, said at the exchange operator’s analyst-day conference on May 10.
A written presentation said the auctions will be similar to those run on options exchanges, in which market makers vie to win the retail investor’s order by providing the best price. The auctions last less than a second.
The program will “re-segment the market, attract flow from the dark pools for retail investors, give them a live auction process for them to get price improvement” through market makers competing with each other, Noll said. Nasdaq hasn’t yet submitted a proposal for its equities auction system to the SEC.
NYSE plans to forego revenue from transaction fees and will lose money from trades in its retail program as it tries to build customer interest, according to Mecane. Bats was first to adopt the pricing tactic as a way to get new customers and grab trading from rival markets in early 2007.
Instead of employing what’s called maker-taker pricing that pays the suppliers of bids and offers and charges those trading against them, NYSE will initially pay 5 cents per 100 shares to retail firms taking liquidity from the exchange, Mecane said. That won’t match the 20 cents for every 100 shares that TD Ameritrade gets from wholesalers, according to an estimate from Raymond James Financial Inc. in a report on July 9.
Retail liquidity providers who offer quotes to individuals through NYSE will pay no fee while firms such as asset managers that supply orders will pay 3 cents per 100 shares unless they meet a volume tier that allows them to trade for free, Mecane said. The exchange will therefore lose 5 cents for every 100 shares bought or sold when individuals trade with market makers. The fees are subject to SEC approval.
Whether NYSE’s retail project prompts the SEC to reassess issues such as allowing quotes at increments of less than 1 cent for all investors may depend on how much traction the program and others like it get, Mecane said. Another topic exchanges have pushed is a rule intended to make it harder for brokers to trade away from exchanges unless they provide better prices.
“I don’t think it answers or changes most of the major market-structure questions that are out there,” Mecane said about the retail program. “But to the extent it does become very pervasive, it could put the discussion on the table.”
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