One is reportedly the loneliest number.

It takes two to tango.

Three times a lady.

It takes the human eye 350 milliseconds to blink.

[broadstreet zone=”53777″]

Four years ago, 50 percent or thereabouts was deemed to be the threshold of when offboard or non public trading would cause the equities market structure concern. Traders and pundits felt that at this “magic number” many bad things would happen. The argument went that as more flow moved away from the public exchanges and either into dark pools or stayed on a trading desk to be internalized it would lead to a deterioration of market quality. It was argued that increased offboard trading could lead to less public price discovery – one goal of the exchanges at the time – and hinder best execution. One the other hand, more off board trading would could prevent information leakage and promote block trading.

David Weisberger, CoinRoutes

So, fast forward and the debate seems to have faded as the market is more concerned with boosting trading in small caps, too much regulation and crypto currencies. Or is it?

David Weisberger, principal at CoinRoutes and long-time observer of the equities market, told Traders Magazine that concerns over offboard trading and a “magic number” depend on who one asks in the market.

“In Europe, the regulators clearly care, as they are about to ban a lot of the off board trading,” Weisberger began. “In the US, there has been an increase in single-dealer dark pools as firms building Systematic Internalizers in Europe realized that they can leverage the same technology to offer liquidity from their Central Risk Books or market making platforms.”

Exchanges still care as they did before, but have bigger issues and want to be thought of as technology companies, he continued. As an example, Weisberger said Nasdaq opted to facilitate dark venue creation rather than fight it. “That’s why they built the platform to support Goldman’s dark pool.”

Spencer Mindlin, Aite

Spencer Mindlin, capital markets analyst at Aite Group said that despite 20 to 30 percent of volume taking place off-exchange, one doesn’t hear investors complaining much about execution prices and price discovery.

“If broker internalization of retail order flow is a problem, and price discovery is impacted, then we should seek to understand why such a market failure persists, Mindlin began. “So, for those that say market fragmentation is a current problem for whatever reason, I’d encourage a root cause analysis for what persists fragmentation before implementing prescriptive rules that try and rein in fragmentation, rife with their own unintended consequences.”

What Mindlin does hear investors complain about are things like the institutional challenges for sourcing liquidity in illiquid stocks, potential conflicts of interest, and the increasing costs of market data. It’s not clear to him that forcing market consolidation and curbing broker internalization will solve these problems.

So, is there or isn’t there a magic number? And what is it, if it exists?

“Most people look at this in a way like the famous definition of pornography – ‘I’ll know it when I see it’,” Weisberger said. “No one wants to commit to a number, but everyone says that there is some level where price discovery is hurt. Part of the problem, however, is that dark liquidity, on exchange, has reached high levels for many stocks. Particularly in very high-priced equities, since odd lot quotes are effectively “dark” to the SIP, a majority of trading in many expensive names is dark.”

Mindlin said it’s hard to know where the equilibrium between on-exchange versus off-exchange trading should be. And to him it’s unlikely that the threshold would be the same for all stocks.

“It doesn’t seem like the price discovery mechanism of the market is broken,” Mindlin said. “The market has a pretty good idea of what the price of a stock should be at any given moment in time. And if there was a problem, it’s likely the regulators and industry would hear about it. What does seem somewhat broken is the liquidity discovery process. And while most retail investors are unlikely to have any complaints, institutions deal with the complexities of liquidity discovery every day. And I think that’s less a function of market venue proliferation, but more a result of a regulatory-driven market structure.”

This article originally appeared in the December 2013 edition of Traders Magazine

Magic Number

How much is too much? Industry officials are starting to worry that the increase in off-board trading will lead to a deterioration in the quality of the U.S. stock market.

By Peter Chapman

How much is too much? Industry officials are starting to worry that the increase in off-board trading will lead to a deterioration in the quality of the U.S. stock market.

Is there a magic number?

As the amount of trading done away from the public markets has surged in the past year to record highs, industry officials are starting to worry the trend will lead to deterioration in the quality of the U.S. stock market.

With fewer shares being bid for on the nation’s stock exchanges, the validity of the market’s best prices could be called into question. In the argot of stock traders, “price discovery” may be compromised.

“We need to look at what is happening,” Joe Gawronski, president and chief operation officer at Rosenblatt Securities, told the crowd at the Investment Company Institute’s annual market structure conference this year. “Off-exchange trading hit 38 percent in September. That is a big number. It’s a dramatic increase since 2008. A record.”

In early 2009, off-exchange trading accounted for 21 percent of total volume, according to a report published last year by CFA Institute. Last fall, it stood at 33 percent. As Traders Magazine was going to press, it was 38 percent. Nobody knows for certain what’s driving the surge. Nor does the industry agree on whether there exists some magic number that will trigger a deterioration in overall market quality.

“I have to disagree with anybody who says that 30 percent or 40 percent or whatever can’t be good,” Gregg Berman, an associate director in the Securities and Exchange Commission’s Division of Trading and Markets, said at the ICI gathering. “Why can’t it be a good number? What’s wrong with having 30 percent or 40 percent? We need to know what the actual effect is that people care about, such as price discovery or market quality.”

If the number is not 40 percent, then maybe it’s 50 percent. At that level, a study conducted by CFA Institute last year concluded, bid-ask spreads start to widen and market quality deteriorates. “If the majority of order flow is filled away from pre-trade transparent markets, investors could withdraw quotes because of the reduced likelihood of those orders being filled,” the report noted. “As investors become dis-incentivized from displaying orders, bid-offer spreads are likely to widen.”

Most off-board trading is conducted by institutional brokers matching orders in alternative trading systems-such as dark pools-or wholesalers making markets for retail brokers. A lesser amount is traded in ECNs or over the telephone.

There is little difference in the rates of off-exchange trading among small-, mid- and large-capitalization stocks, according to CFA Institute. The group’s study did note, however, that dealers internalized a much higher proportion of small caps than mid or large caps. CFA Institute attributed that to the wider spreads of small caps and thus fatter dealer profits. By contrast, the study noted that dark pools matched a smaller percentage of small-cap names than mid or large caps.


For one exchange operator, the numbers have gone high enough. “We’ve produced data,” Joe Mecane, head of U.S. equities at NYSE Euronext, operator of three U.S. stock exchanges, said at the ICI conference, “that gives evidence that at the levels we are, that we do have a problem.”

Mecane believes it’s time to stop talking about magic numbers and start taking action. He wants to see wholesalers pay more for the orders they internalize and move toward a market structure that prioritizes limit order display.

Gawronski, whose firm has long had a presence on the New York Stock Exchange, shares his concern. “Between 10 percent and 15 percent of executions are retail marketable orders that never see the light of day,” Gawronski said. “They get executed by wholesalers. It’s a separate part of the ecosystem, and it’s not contributing to price discovery.”

The largest wholesalers are KCG Holdings, Citadel Securities, G1 Execution Services (just acquired by Susquehanna International Group), Citigroup and UBS.

Internalization of retail orders by wholesalers is the largest contributor to off-board trading, according to CFA Institute data. It is also the likely driver of most of the growth in off-board trading in the past two years, said Greg Tusar, co-head of global execution services and platforms at KCG Holdings. That’s because “institutional volume turnover has decreased,” he said at the Securities Industry and Financial Market Association’s market structure conference this year.

In its report, CFA Institute suggested the wholesalers should be reined in. Because they intercept so much desirable “uninformed” retail flow, adverse selection risk increases at the exchanges, discouraging traders from posting limit orders, it claimed.


CFA Institute suggests that regulators should require wholesale market makers to provide a higher level of price improvement on their retail orders-by as much as a penny or half the spread-or route their orders away. This is known as a trade-at rule and is already under consideration by the SEC.

At least one buyside trader sees value in a trade-at rule. “It’s extraordinary that someone can price improve by one-hundredth of a penny,” Andy Brooks, T. Rowe Price Associates’ head of equity trading, said at the ICI conference. “For gosh sakes, are you kidding? It seems to me that a trade-at rule naturally needs to be on the table so people are required to seek significant price improvement in order to internalize an order.”

Wholesalers are vehemently opposed to a trade-at rule and have argued that any rule that forces them to provide 1-cent price improvement-i.e., bettering the customer’s price by a penny-would drive them out of business.

At the SIFMA gathering, Dave Weisberger, an executive principal at wholesaler Two Sigma Securities, declined to address the pros and cons of wholesaling. Rather, he argued that any industry discussion about the impact of off-board trading on market quality needs to define its terms.

For Weisberger, “market quality” does not necessarily refer to price discovery on the public exchanges. Rather, it means lower transaction costs and trading efficiency. “The way you define the debate will lead us to where we want to go,” he told the SIFMA crowd.

“What does the institutional investor really care about?” Weisberger asked. “That they can buy stock at a reasonable price compared to where it was on the screen before they started to buy it.”

Weisberger’s comments echo those who say the market’s best prices are meaningless for the large institutional buyer or seller because there are typically relatively few shares associated with those prices.

“We’ve done a terrific job from a market structure perspective at helping the retail investor,” Tusar said, adding, “but potentially made the job much more difficult for the institutional investor with respect to finding liquidity in larger sizes.”

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