Exchanges Vexed Over Dark Pools

Terry Flanagan

Exchange executives are concerned that an increasing percentage of volume is being conducted at off-exchange venues, such as dark pools and broker crossing networks.

The development runs counter to the spirit of a single national market system, and instead has created fragmentation and segmentation, they say.

“Retail limit orders aren’t interacting with retail market orders anymore,” said Larry Leibowitz, chief operating officer at NYSE Euronext, at a congressional hearing on market structure in New York on Monday. “Spreads haven’t gone down since [Regulation] NMS and toxicity is worse.”

The existence of dark pools has made it more difficult for the public exchanges to function. The issue is one of striking a balance between competition and fragmentation, in Leibowitz’s view.

“We’re not saying that internalization shouldn’t take place, but at some point we need to ask whether we are trying to create more segmentation or create a market for the greater good,” he said.

The exchanges have been forced to counter with dark order types and dark pools of their own.

For example, NYSE Euronext has estabished a new class of market participant, Retail Liquidity Provider (RLP), which is required to provide price improvement for certain retail order flow, in exchange for which they receive economic benefits.

“Our RLP system differentiates order flow based on customer type, but the problem is as you add these new systems you are introducing an added layer of complexity,” Leibowitz said. “Is adding more dark pools a good thing from a public policy standpoint?”

The International Securities Exchanges’ chief, Gary Katz, noted the interrelationships between the options and equities markets.

“As a result of retail order flow, that is, good order flow, being taken off-exchange and removed from the lit market, there is a fragility in equities, which is the underlying market that allows the capital markets to function, both equities and options,” he said.

Unlike equities, options transactions are not permitted to take place off-exchange.

“There are no dark pools in options,” Katz said. “The SEC needs to understand that broker-dealers need to interact with customer orders via internalization, but there needs to be a balance between removing that order flow and having to participate in the lit market.”

Regulation ATS facilitated the development of numerous non-transparent trading systems, known as dark pools, as well as transparent electronic communication networks, or ECNs, that disseminate public quotes.

Prior to the adoption of Reg ATS, the U.S. equity markets were primarily characterized by trading on transparent floor-based exchanges, with some blocks trading upstairs on broker-dealer block desks, and some retail orders executed internally by over-the-counter market makers.

The concern is especially acute for thinly traded stocks. “We are concerned that lack of incentive to display liquidity will be challenging, and are already seeing this with small to madcap stocks,” said Leibowitz.

The competition presented by these new trading centers has changed the operations of exchanges, upstairs block desks, and over-the-counter market makers, which suggests a reexamination of our market structure is warranted, said Leibowitz.

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