Killing Dark Pools Is CME Chairman’s Fix for Broken Stock MarketMatthew Leising
Terrence Duffy, who as executive chairman of CME Group Inc. oversees the world’s largest futures exchange, has a solution for those seeking to fix the U.S. stock market: kill dark pools.
While all futures trades happen on exchanges such CME Group’s, only about 60 percent of American equity volume does. The rest takes place on venues including dark pools, where orders are hidden until transactions are completed. That hurts investors because it obscures the true price of stocks, Duffy said yesterday during an interview at Bloomberg News headquarters in New York.
“Fix the fragmentation issue, and you’ll fix the problem,” Duffy said. “We need to have 100 percent of that liquidity on exchanges.”
Duffy’s position aligns him with his biggest rival: Jeffrey Sprecher, the chief executive officer of IntercontinentalExchange Group Inc. Sprecher’s company, which like Chicago-based CME Group has its roots in futures, recently bought the New York Stock Exchange, giving it about 20 percent of the nation’s equities volume. NYSE and its rivals have lobbied the U.S. Securities and Exchange Commission to enact rules limiting the amount of trading on dark pools.
In Duffy’s idealized stock market, even though trades could still be distributed across multiple exchanges, dark pools and other off-exchange platforms would be eliminated. There are currently 13 stock exchanges, with ICE, Nasdaq OMX Group Inc. and Bats Global Markets Inc. the biggest operators. Beyond that, there are about 45 alternative trading systems, including dark pools.
Futures trading is more concentrated. CME Group, where 14 million contracts a day changed hands in February, has its own clearinghouse, setting it apart from stock markets such as the NYSE. The clearinghouse requires investors who buy a contract on CME Group’s markets to return to the same exchange to sell it. Nasdaq OMX CEO Bob Greifeld in March called that a monopoly.
In contrast, stocks can be bought on one exchange and sold on another because they are all linked to one third-party clearinghouse, Depository Trust & Clearing Corp.
Duffy said the futures market model, known as the vertical silo, is superior because it doesn’t let high-frequency traders use the same arbitrage strategies they deploy in stocks. Trading of Standard & Poor’s 500 Index futures occurs in only one place, eliminating ambiguity about prices, he said.
“Everybody has to come to the same four walls in order to get it, so in return you don’t have fragmented prices of the S&P basket all over the place and you know what the real value is,” he said during the interview yesterday. “I’m a proponent of actually knowing what the price is.”
Most of the biggest U.S. broker-dealers own dark pools that trade stocks. Michael Lewis’s latest book, “Flash Boys,” argues that they act as a key intersection between high-frequency traders and brokerages’ investor clients. The banks, Lewis says, charge HFT firms for the right to trade against orders placed by their brokerage customers.
The NYSE and Nasdaq last year asked the SEC to implement a trade-at rule, which would keep trades off dark pools unless the transactions provide better prices than are available on public exchanges.
Some investors have defended dark pools. BlackRock Inc., the world’s largest money manager, said they let institutions execute large blocks of stock.
“Although dark pools have increasingly been characterized as a negative element of U.S. equity markets, BlackRock believes that dark pools are an invaluable execution tool for large orders and stocks which may be more difficult to trade due to wide spreads or low liquidity,” according to a BlackRock report this month. “BlackRock supports greater transparency in dark pools to the extent that it is not detrimental to the benefits obtained from dark execution.”
Lewis argued in “Flash Boys” that high-frequency traders, exchanges and broker-dealers have rigged the U.S. stock market. Duffy disputed that.
“‘Rigged’ is a very, very dangerous word, in my opinion, and a bit reckless,” Duffy said, highlighting the more than 500 percent rally in U.S. stocks during the past 25 years. “I took quite a bit of offense to it.”
CME Group also depends on high-frequency traders, which make up about 40 percent of the exchange’s business, Duffy said.
CME Group was forced recently to upgrade its computer systems to eliminate a potential advantage that some of the fastest traders could exploit. Previously, traders found out that their orders were completed before other CME Group customers were told, possibly giving them time to buy or sell on other exchanges with knowledge of that execution. Duffy said CME Group fixed that.
“Those latencies have been shrunk dramatically,” he said.
Duffy rejected the notion that CME Group is a monopoly.
“There’s nobody prohibited from competing with us,” he said. The difference between equity and futures markets is that only the latter create the products they trade, he said.
“With all due respect to my friend Bob Greifeld, he runs a very different business,” Duffy said. “He doesn’t innovate those companies, he lists those companies for trade. We innovate the products we have,” he said. “We put a tremendous amount of money in R&D to come up with products that no one else thought of.”
That wasn’t how Greifeld saw it in March.
“Monopolies are great if you own one,” he said during a panel discussion at the annual Futures Industry Association conference in Boca Raton, Florida, paraphrasing a quote he recalled hearing from an investor. “We have yet to find a customer who is in favor of the vertical model,” Greifeld said, referring to the system in place at futures markets such as CME Group and ICE.
Nasdaq spokesman Rob Madden declined to comment on Duffy’s comments yesterday.
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