Where Has All the Stock Trading Gone?

Public exchanges lose out as stock trading moves to dark pools and wholesalers
Photograph by Paolo Pellegrin/Magnum Photos

It’s been a rough few months for NYSE Euronext, owner of the country’s biggest stock exchange. In February, European regulators scrapped its planned $9.5 billion merger with Germany’s Deutsche Börse over concerns it would create a monopoly in exchange-traded derivatives. NYSE Euronext’s first-quarter profit tumbled 44 percent, driven by a decline in trading volume. And in April, Facebook announced it would hold the most anticipated initial public offering in years on Nasdaq, NYSE’s arch rival.

That’s not to say things are much better at Nasdaq OMX, the second-largest U.S. equities exchange owner. Since 2000 its share of U.S. stock trading has fallen by a third, to 22 percent. Both exchange companies are contending with similar forces: an overall slowdown in trading, the rise of smaller public exchanges such as BATS and Direct Edge, and the increasing number of trades being executed “off exchange”—either at wholesale brokerages or on private trading venues known as dark pools. Since January 2008 the share of trades executed off public exchanges has increased, to 32 percent from 26 percent, according to market research firm Tabb Group. Nasdaq and NYSE “are getting a smaller bite of a shrinking pie,” says Sang Lee, an analyst at Aite Group.

NYSE has diversified, buying electronic exchange Archipelago Holdings in 2006 and the American Stock Exchange in 2008 and expanding into markets such as derivatives, which now account for 29 percent of net revenue. It’s exploring ways to make money by providing technology software and market data to other exchanges and brokers around the world. “Fifty percent of our revenue is no longer dollar-denominated,” says NYSE Chief Operating Officer Larry Leibowitz.

The exchange is also going on a PR offensive, with Leibowitz and Chief Executive Officer Duncan Niederauer warning regulators and the public about the dangers of off-exchange trading and urging regulators to take a closer look at dark pools. “After the financial crisis, we wanted to create a market with more transparency,” says Leibowitz. “Instead, it’s gotten darker and more opaque.”

Nasdaq shares NYSE’s concern about off-exchange trading. “Dark trading has real value for investors,” says Eric Noll, an executive vice president at Nasdaq. “However, we believe in the primacy of the lit market where all investors on and off exchange ought to benefit from unimpaired transparency and price discovery.”

Credit Suisse’s Crossfinder and Goldman Sachs’s Sigma X are the largest of about 40 dark pools operating in the U.S. The dark pools’ share of trading volume has more than tripled, to almost 14 percent at the end of last year from 4 percent in early 2008, according to data compiled by Rosenblatt Securities. The brokerage companies that operate them say dark pools increase execution speeds and lower transaction costs compared with public exchanges. Overall, off-exchange trading “has resulted in a much more robust and competitive market,” says Leonard Amoruso, general counsel for Knight Capital Group, a broker that operates a dark pool and also executes stock trades internally.

Most dark pools were set up in the mid-2000s, taking advantage of regulatory changes that encouraged more electronic trading. Initially they served mainly as havens for institutional investors to buy and sell stocks without letting other traders know what they were up to. As the dark pools handled more volume, they attracted high-frequency traders—speed-focused firms that use computer algorithms to buy and sell—taking more volume off public exchanges, says Aite Group’s Lee. “Their initial purpose was to take large block orders off exchange, but that’s gone by the wayside,” says Cheyenne Morgan, a research analyst at Tabb Group.

Public exchanges are subject to more regulatory requirements than dark pools are. For one thing, they must file extensive data on trading activity to the Securities and Exchange Commission. Exchanges also must treat all customers equally. Since dark pools are run by brokerages, they can discriminate, granting access only to certain firms and charging them different prices. The way Leibowitz sees it, if dark pools are going to function like exchanges, they should be regulated like them. “The bar either has to be raised for dark pools or lowered for exchanges,” he says. Knight’s Amoruso does not agree. “They’re two different business models,” he says. “They shouldn’t have the exact same rule structures as exchanges.”

Equity wholesale operations, which execute trades by buying stock themselves and selling from their own inventories, represent another challenge for public exchanges. Run by companies including Citigroup, UBS, and Citadel, they attract business from TD Ameritrade, Charles Schwab, and other brokers that process a lot of small orders from individual investors. Their appeal is that they can offer slightly better prices—a fraction of a cent higher for sellers and lower for buyers. SEC rules require public exchanges to quote prices in increments of at least one cent.

In October, NYSE asked the SEC for permission to provide prices in fractions of a cent so it can compete with wholesalers for retail traders. “We just want to be able to replicate” what the wholesalers do, says Leibowitz. The SEC is considering the proposal. Nasdaq says it may ask the agency for similar flexibility to allow it to compete for trades from individual investors. Knight Capital and the Securities Industry and Financial Markets Association, a lobbying group that represents big Wall Street banks, strongly oppose the plan. UBS has told the SEC it generally supports the NYSE proposal but believes it should also be approved for dark pools and other trading venues. “UBS welcomes competition,” says spokesman Christiaan Brakman.

Whether or not the proposal is approved, NYSE and Nasdaq will keep up their crusade against off-exchange trading. “The real way to deal with this is to take it up as a public policy issue,” Leibowitz says. “It’s not a major impact on our bottom line if we go from 25 percent to 27 percent” market share in equities trading. “This is about the quality of the public markets.”