Exchanges Fight Back Against the Dark Pools

Retail investors who trade stocks through online brokers like TD Ameritrade and Scottrade probably thought their orders were routed to regulated exchanges. But this morning in a New York Times article, they learned that most trades sent via online brokers are zapped to sell side firms who trade against these shares – millions of shares a day – and then flip them to earn an easy profit.

Brokers who are armed with more market intelligence than the average investor - and technology - can figure out which orders to trade against. And those that are rejected – known as toxic or exhaust - are apparently sent to the primary exchanges.

This has become a controversial issue as more than 30 percent of all stock trading is occurring through dark markets or dark pools plus internalization engines. In public testimony last week before the House Financial Service Subcommittee’s hearings on market structure, Joseph Gawronski, president and COO of Rosenblatt Securities, said that although the complex market structure "generally results in better outcomes, for both retail and institutional investors, than the one it replaced," the explosion in off-exchange trading in recent years was one such cause for concern. According to Rosenblatt’s analysis of public data, 16.4 percent of US equity volume was executed away from markets that display price quotes in January 2008. By January 2012, non-displayed trading had more than doubled, to an all-time high of 34.2 percent. In May, the off-board trading figure slipped to 31.2 percent of U.S. equity trades. About 14-15 percent of that total is done in automated platforms known as dark pools, mostly registered as ATSs, that match buy and sell orders without displaying public quotes.

Now exchanges are fighting back. According to today’s New York Times article, “Public Exchanges Duel with Newcomers Over Trade Transparency", NYSE Euronext, owner of the New York Stock Exchange, is asking regulators to approve a platform that would separate retail order flow from the exchange and seek to earn a better price. Nasdaq OMX and Direct Edge are said to have similar plans. The alternative would be to impose tighter regulations on dark pools to blunt their advantage over the exchanges.

But if the exchanges were to siphon off the retail orders into a separate dark pool, presumably to attract more flow, wouldn’t this undermine the concept of an exchange, where all investors come together in the open and on equal footing? On the contrary, the new plans put forth by the exchange could increase the darkness.

This is a genuine dilemma for the exchanges because they need to be able to compete with the dark venues, which are pulling in their customers. According to the Times, exchanges are struggling to compete with internalizers because they are unable to trade at a price other than the publicly displayed price, whereas dark pools are able to provide a better price. On the other hand, exchanges are paying the high-frequency/electronic market makers to route orders their way, so the entire market structure is convoluted and conflicted.

Ironically, Bernard Madoff, who is sitting in a jail cell for his Ponzi scheme, is credited with inventing the automated process of internalization through his legitimate brokerage firm. Madoff viewed the retail order flow as uninformed and therefore, safe to trade against. His firm would buy the shares at a lower price and then instantaneously sell them at a higher price, pocketing the profit, which subsidized his ability to pay the retail firms for order flow. His firm promised to match the national best bid or offer (NBBO) from exchanges, and claimed to give them price improvement. Fast-forward back to today, the question is whether retail investors are getting better prices in the dark pools operated by wholesalers, or are they at a disadvantage by not interacting with the broader price discovery process on exchanges?

In written testimony last week submitted to the House Financial Service Committee’s hearings on market structure, Gawronski wrote: “The majority of trades executed in dark pools receive significantly better outcomes than would be readily available on exchanges.” He explained most of the volume is executed at the midpoint of the National Best Bid/Offer spread, meaning that both customers are receiving significant price improvement. Also, we know that it’s possible for institutions to execute at larger sizes on dark pool than on exchanges, where the average trade size is around 200 shares.

But shifting to the retail investor, Gawronski testified that approximately 10 percent of the off-exchange market share is retail orders executed as principal by wholesale dealers. “In the vast majority of cases, these wholesalers either match the NBBO or offer de minimis price improvement – or about 10 percent of the spread.” While the discount brokers receive rebates about 10 to 15 percent of the 100 shares traded, retail investors see none of this cash, he noted.

But, the wholesalers don’t always make money. Recently, four wholesalers — Knight Capital, UBS, Citigroup and Citadel – which have made a business paying for retail order flow and trading against it – lost millions in the Facebook IPO. According to the New York Times article, “They paid to trade against all retail investors clamoring for Facebook shares, but when the Nasdaq exchange broke down …they were left holding the shares.”