Some former regulators and academics say so much trading is now
happening away from exchanges that publicly quoted prices for stocks
on exchanges may no longer properly reflect where the market is. And
this problem could cost investors far more money than any
shenanigans related to high frequency trading.
When the average investor, or even a big portfolio manager, tries to
buy or sell shares now, the trade is often matched up with another
order by a dealer in a so-called "dark pool," or another alternative
Those whose trade never makes it to an exchange can benefit as the
broker avoids paying an exchange trading fee, taking cost out of the
process. Investors with large orders can also more easily disguise
what they are doing, reducing the danger that others will hear what
they are doing and take advantage of them.
But the rise of "off-exchange trading" is terrible for the broader
market because it reduces price transparency a lot, critics of the
system say. The problem is these venues price their transactions off
of the published prices on the exchanges — and if those prices lack
integrity then "dark pool" pricing will itself be skewed.
Around 40 percent of all U.S. stock trades, including almost all
orders from "mom and pop" investors, now happen "off exchange," up
from around 16 percent six years ago.
This trend is "a real concern," John Ramsay, former head of the U.S.
Securities and Exchange Commission's (SEC) Trading and Markets
division, said on the sidelines of a conference in February. "We
have academic data now that suggests that, yes, in fact there is a
point beyond which the level of dark trading for particular
securities can really erode market quality."
Given the $21.4 trillion worth of U.S. stocks that were traded in
2012, even a small mispricing can move the needle by tens of
billions of dollars.
Lewis' new book — "Flash Boys: A Wall Street Revolt" — says that
high speed traders bilk that kind of money from investors every
year. He focuses on how high-frequency trading firms use ultra- fast
telecom links, microwave towers and special access to exchanges to
gain an edge over other traders.
The U.S. Justice Department is investigating high-speed trading for
possible insider trading, Attorney General Eric Holder told
lawmakers on Friday. Other regulators and the FBI have also
confirmed they are looking into potential wrongdoing by
high-frequency stock traders.
But whether or not high-speed trading is sinister, revenues for
these firms have been declining for years: in 2013, they were about
$1 billion, after peaking at around $5 billion in 2009, according to
estimates by Rosenblatt Securities. If, as Lewis says, these traders
are doing nothing more than ripping off the rest of the market, it's
a shrinking problem.
Meanwhile, as the revenue from high frequency trading has waned,
trading outside of public exchanges has been on the rise,
threatening to roll back decades of progress towards more
EXCHANGES ARE LAST RESORT
A brokerage has several ways to fill customers' orders. It can match
buy and sell orders from its own customers, known as
"internalizing," or sell its orders to another broker that can do
Brokers also send trades to "dark pools," which are similar to
exchanges, except the fees are lower and they are anonymous, with
orders going unreported until after they have been executed. And
finally, they can send trades to exchanges, where they will have to
pay higher fees.
"The exchanges have basically become the liquidity venue of last
resort," said Manoj Narang, chief executive of HFT firm and
technology vendor Tradeworx.
Around 45 dark pools and as many as 200 internalizers compete with
13 public exchanges in the U.S.
Top internalizers include units of KCG Holdings <KCG.N>, Citadel,
UBS <UBSN.VX>, and Citigroup <C.N>. Dark pool operators include
Credit Suisse <CSGN.VX> and Morgan Stanley <MS.N>. All of the firms
declined to comment, or did not respond to requests for comment for
With the incentive to use the public market eroding, many traders
increasingly see exchanges, which are often described as "lit"
markets because of the pricing transparency, as battlegrounds for
high frequency traders, said Rhodri Pierce, of the CFA institute.
The result is an increasingly splintered market.
[to top of second column]
"So much of the U.S. equity order flow is in now in the dark, or
siphoned off, that it never hits the lit exchanges, and there is
just a lot less in the way of trading opportunities," said Mark
Gorton, CEO of high frequency trading firm Tower Research Capital
In an attempt to win back some of the retail orders, exchanges such
as IntercontinentalExchange Group's <ICE.N> New York Stock Exchange,
Nasdaq OMX Group <NDAQ.O>, and BATS Global Markets, have allowed
brokerages to place dark pool-style orders on their platforms, with
the trade hidden until after it is executed. NYSE, Nasdaq, and BATS
declined to comment.
There is no doubt that trading costs on U.S. markets are low, and
that retail investors get a better deal than they did two decades
ago. But U.S. and global trading transaction costs have actually
been rising for the past two years, according to a Credit Suisse
report on February 20. That may suggest the benefits from
off-exchange trading are no longer accruing to investors as much as
they previously did.
A major concern with off-exchange trading is that brokers who
internalize trades and offer dark pools do not provide any data to
the market before the trade is executed. On a stock exchange, when
an order is sent in, the price of the stock is adjusted and everyone
with a data feed sees it.
Dark pools only report data after a trade has occurred. At that
stage, information about the trade has little influence on the
The pools were originally created for institutions to trade large
blocks of stock without creating a large impact in the market. If an
order of 1 million shares was tracked, people on the other side of
the trade could quickly jack up prices and the original investor
could easily pay more than expected.
But much of the trading isn't like that now — the average size of
orders in dark pools has shrunk to around 200 shares, similar to
levels on public exchanges.
"There are potential costs from this trend of having more and more
trading being traded away from exchanges," said the CFA's Pierce.
IEX, a new trading platform heralded in Lewis's "Flash Boys" as a
fairer place to trade, aims to become an exchange once it gains more
volume, but is currently a dark pool. Its average order size is
around 750 shares.
"If the shift becomes too egregious to off-exchange markets, then
there are no lit exchanges to price against," said Brad Katsuyama,
CEO of IEX. "I don't know if we are necessarily at the imbalance
yet," he said.
Pierce released a study on off-exchange trading in November that
showed that once more than half of the trading volume in a
particular security is done on dark venues, the ability to properly
price that security becomes difficult. The price discovery process
can begin to erode when off-exchange trading in a security surpasses
as little as 10 percent, according to a study by Carole Comerton-Forde
and Talis Putnins of the University of Melbourne.
Regulators in Canada and Australia have taken steps to curb the
growth of dark trading in recent years by requiring, for instance,
that off-exchange trades be of a minimum size or have a
significantly better price than can be found on an exchange.
Authorities in Europe and Hong Kong are eying similar rules.
"Observing some of the trends in U.S. markets and elsewhere and
seeing that dark trading activity in Canada was slowly growing we
felt that we wanted to put some very important principles in place,"
said Wendy Rudd, head of market regulation at the Investment
Industry Regulatory Organization of Canada.
(Reporting by John McCrank; additional reporting by Sarah Lynch;
editing by Daniel Wilchins, Martin Howell)
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