Market Structure:

As Securities Markets Face Regulatory Scrutiny Conflicts Flare On Fragmentation, Dark Pools, IOIs

Originally published June 8, 2009

NEW YORK — In a US securities trading marketplace that has become fragmented and opaque, exchanges and alternative trading systems (ATSs) are grappling with how to achieve transparency and fair treatment of all orders in the market, all the while holding their breath for what regulators may have to say on these subjects.

“Our market structure has gone astray,” says Lawrence Leibowitz, Group Executive Vice President and Head of US Markets and Global Technology at NYSE Euronext. “In the past 15 years, order handling rules, decimalization and Reg NMS were all designed to increase transparency, level the playing field, and encourage limit order display. We now live in a completely fragmented market with 50 or so dark pools where there’s a privileged club of people who get to see the marketplace as a whole.”

Even the definitions of market fragmentation and light or dark liquidity are subject to debate among executives of major trading venues. “The word ‘fragmentation’ has a bad connotation,” says William O’Brien, Chief Executive Officer of Direct Edge ECN LLC. “Good markets are looking for ways to virtually re-aggregate that liquidity in ways that make sense for their customers. What’s changed over the last few years is that a lot of that has been automated. Access to that liquidity is now integrated into the continuous market. This gives the customer the option to interact with that liquidity within a product that gives them the certainty of an exchange execution.”

Dark pools have come to mean more than just the few broker-sponsored liquidity pools that originally internalized flow, according to Robert Hegarty, Managing Director of Market Structure at the Depository Trust & Clearing Corporation (DTCC). Adds Jamie Selway, Managing Director at White Cap Trading LLC, “Dark pools as a catch-all term encompasses block crossing, internalization and everything.”

The political winds and potential regulation are all pointing toward transparency, a reaction to everything considered “dark pools,” observes Hegarty. “Transparency is going to be one of the biggest factors changing these markets, and getting out of grouping everyone in the same category,” he says.

No matter how fragmentation and the nature of liquidity may be defined, in the current marketplace, participants rarely know where their orders are being executed or where the liquidity is, according to Leibowitz. “The broker-dealers can find anything they want to justify that it’s a best execution,” he says. Referring to previous executive roles he held at buy- and sell-side firms, Leibowitz adds, “We used to ask how the NYSE got information into the hands of the specialists. It popped up later in the form of enhanced liquidity providers [ELPs].”

As a competitor to the NYSE, however, O’Brien objects to what he sees as opacity in the current NYSE structure, “Your model has more tiers than Yankee Stadium,” he declared, while speaking on a panel with Leibowitz at a May 20 conference organized by the Securities Industry and Financial Markets Association (SIFMA). “Different methods of participation are O.K., if everyone has the ability to do it, which in some models they do and some models they don’t. But more importantly, is it benefitting the customer? There are different [aspects] around liquidity, lower transaction costs and reducing market impact. Yet you won’t let the customers decide what works or not.”

The changing definitions of fragmentation and liquidity, and the attendant changes in market structure have also led to changes in how indications of interest (IOIs) are considered and handled, according to O’Brien. “Some don’t want to respond to orders, they want to respond to IOIs,” he says. “As Nasdaq is aiming to do in its Genium implementation [a new multi-asset trading platform], you would effectively indicate that you are about to route out an order. It is basically asking customers to step up and match the national best bid or offer [NBBO] before routing out the order, within a pre-defined period of time the customer set.

“If our customer on the other side doesn’t want the opportunity for someone to step up and interact with that order, they turn that dial all the way down to zero,” he adds. “We’re not dictating to the end customer. We’re giving the customer a variety of [choices], if they have the desire to interact with non-traditional liquidity and lower transaction costs to reduce the market impact.”

IOIs have evolved from manual indications to the buy side about big orders into electronic small-size orders that are not publicly displayed, according to Matthew Lavicka, Managing Director and Chief Operating Officer, Cash Equities, Goldman Sachs & Co. “It’s so fast that it’s more a function of what is actually happening,” he says. “If it is in fact actionable, and it looks and smells like a quote, it probably is a quote.”

Electronic IOIs present a market fairness issue, according to Leibowitz. “You’re sending an order to someone who hasn’t shown that they have that interest,” he says. “It’s information that’s leaked from the system and no one else [has it] available. There is no surveillance on it.”

Still, customers have a choice whether to use such orders, counters O’Brien. “They have some routing disclosure obligations to customers,” he says. “For every customer using your application, their underlying customer is the order source, to determine whether that accesses that amount of liquidity, whether they have price and size improvement for execution cost, and if that outweighs the potential risk of a short period of exposure causing you to miss a market. Let the customer decide how long the period of exposure is, because someone might be comfortable with 50 milliseconds, while another with 5 milliseconds. This has empowered people to decide what is best for their firm.”

For the NYSE, the trading floor has transformed rather than disappeared as many industry executives once predicted it would. “You will see firms roll out trading ‘superbooths’ on the floor where you can actually operate a whole trading desk on the floor of the stock exchange,” says Leibowitz.

To some extent, Leibowitz welcomes regulation intended to promote transparency. “Transparency is the hallmark of a fair and efficient market,” he says. “We can build all the solutions we want, but without the stick, the carrot won’t really help. We look forward to working with the Treasury and the other agencies to find a way to make a solution that works for the industry but also for the regulators. At the same time, we need to make sure that we don’t harm competitiveness and the innovative nature of our market. The question is how to strike the balance between heavily structured, high-barriers-to-entry monopolies and anarchy.”

Addressing opacity and fragmentation in the markets also requires consideration of locked and crossed markets, Selway of White Cap Trading points out. “What if one exchange is operating from one set of assumptions and rules and another is operating based on a different set?”

Dark pools, however maligned, are necessary to complete certain institutional orders, according to Alfred Eskandar, Global Head of Corporate Strategy at Liquidnet Inc. “Displayed markets cannot handle the demand that (some) institutional orders require, so how else would you get them done?” he says.

Overall, the loss of assets has made the market a tougher one for trading, according to Selway. “Informationally, it is an incredibly difficult market in which to invest,” he says. Pointing to increased automation of exchanges, Selway adds, “Within a month, three senior executives left Nasdaq [recently] to go to high-frequency trading shops. That tells you something. On the traditional sell side, banks are shutting down proprietary trading books. There seems to be a good deal of fragmentation on the sell side.”

Regulatory authorities and Congress are still debating and considering what regulatory functions will rest with which authority, which in turn will affect governance of market structure and trading issues. Many industry observers believe the Federal Reserve will have the responsibility to regulate systemic risk, meaning how firms whose failure would create systemic risk will be governed.

Regulatory change will have a greater impact on the markets than any of the previous developments and changes concerning liquidity and fragmentation, believes Hegarty. “It doesn’t matter what kind of firm — buy side, sell side, hedge funds — the oncoming regulatory structure changes will have the biggest impact on this industry over the next five years,” he says. “It will change the game in ways you can’t even imagine now.”



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