NYSE Euronext and Nasdaq OMX Group Inc., their share of American equity markets squeezed by venues that sprang up in the mid-2000s, told legislators Tuesday that too much trading occurs in dark pools, hurting investors.
Exchanges and private, broker-run dark pools are subject to separate regulations that impair the price-setting process and make it harder for public venues to compete, executives from the largest stock market operators said. Trading that occurs away from exchanges, excluding the biggest venues known as electronic communication networks, or ECNs, has doubled since early 2008, according to data compiled by Rosenblatt Securities Inc.
Members of a U.S. Senate subcommittee heard both sides Tuesday in the debate over off-exchange venues, which have risen to prominence since the 1990s when new rules enabled automated systems to compete with the main markets. While proponents say dark pools spur competition and help investors trade more easily and without affecting prices, exchanges say regulators have let the venues grow too freely without rules for fair access and equal treatment of participants.
“As a result of this advantage, large broker-dealers continue to move more order flow into their own private trading venues for a ’first look’ before routing on to the lit public markets,” Joseph Mecane, head of U.S. equities at NYSE Euronext, said in written testimony. “We’ve seen two markets evolve -- the lit, public, regulated and accessible market versus the dark, selective and private non-transparent market.”
Complexity and fragmentation has increased in U.S. equity markets, with trading now spread across 13 stock exchanges and about 50 dark pools. High-frequency trading, the obligations of market makers and the fees exchanges charge or rebate to users have come under scrutiny since the May 6, 2010, flash crash, when the Dow Jones Industrial Average briefly plunged 9.2 percent. A third of U.S. volume occurs away from exchanges.
Dan Mathisson, head of U.S. equity trading for Credit Suisse Group AG, which operates the world’s largest dark pool, called Crossfinder, and Investment Technology Group Inc.’s Chief Executive Officer Bob Gasser told senators that exchanges aren’t being disadvantaged and transactions in dark pools shouldn’t be limited without evidence they’re causing harm. ITG’s Posit dark pool began matching orders daily at scheduled times in 1987.
NYSE, Nasdaq Stock Market and other public venues compete with dark pools and brokers that “are able to employ different practices than exchanges with far less oversight and disclosure,” Mecane said. Some non-exchange markets allow firms providing liquidity to trade only with certain types of clients, a practice not permitted on exchanges, he said. The CEOs of NYSE Euronext and Nasdaq OMX, both based in New York, have argued for several years that different regulatory regimes for dark pools and exchanges create an unlevel playing field.
Trading away from exchanges and the biggest ECNs was about 33 percent in October, compared with 16 percent in early 2008, according to Rosenblatt data. While dark pools, which don’t display orders publicly, accounted for less than half the off- exchange volume two months ago, their share has increased about threefold since the first quarter of 2008, the data show.
New national trading rules implemented in 2007 led to more transactions away from exchanges, “which denies market participants a clear view of trading interest in a given stock,” according to testimony by Eric Noll, executive vice president and head of transaction services at Nasdaq OMX. Stock prices established by exchanges underlie those of equity futures and options and are deemed the reference price for transactions in dark pools, he said.
From 2008 through 2010, big banks expanded their dark pools by using them as the first destination to which their trading desks routed orders, Justin Schack, a managing director and partner at Rosenblatt in New York, said in a phone interview.
“A lot of what they used to internalize in their upstairs business they now systematically internalize in their dark pools,” Schack said. “It took some firms quite a while to get every customer desk, principal desk and proprietary trading desk to prioritize their internal dark pool first.”
At least 40 percent of trading occurs away from exchanges for more than 3,000 U.S. securities, according to Mecane. For the 709 securities listed on NYSE MKT, formerly known as the American Stock Exchange, 42 percent of trading took place off-exchange in November, he said.
“This level of off-exchange activity erodes the incentive for market makers to continue to trade the less-active securities, has a negative effect on price discovery and threatens to further decrease the incentives for companies to go public,” Mecane said. He urged policymakers to adopt “similar levels of rules and oversight for activities that occur on different venues.”
Regulators in Canada, Australia and Europe have instituted or are weighing rules to limit the amount of trading away from exchanges. ITG’s Gasser said efforts in Canada and Australia may already be reducing liquidity and raising trading costs.
“Regressing to an oligopoly of U.S. exchanges is clearly not the answer,” Gasser said. “There’s no evidence to suggest that competition and fragmentation have damaged price discovery or harmed capital formation.”
Credit Suisse’s Crossfinder, the world’s largest dark pool, traded almost 109 million shares on average each day in October, or 1.8 percent of total U.S. equities volume, according to Rosenblatt data. Sigma X, a venue run by Goldman Sachs Group Inc., was the next largest with more than 87 million shares executed each day, the data show.
The 19 U.S. dark pools tracked by Rosenblatt accounted for 13.4 percent of total equities volume in October, the New York- based broker said. Knight Capital Group Inc.’s Knight Link system was next with 80 million shares traded each day in October, followed by Barclays LX, owned by Barclays Plc, with 78 million shares a day, Rosenblatt said.
Exchanges, unlike dark pools, are responsible for monitoring trading and working with the Securities and Exchange Commission to ensure that the markets remain “strong and fair” for investors, Noll said.
“Only exchanges have the authority and responsibility to oversee broker-dealers as they interact with the market,” Noll said in his prepared remarks. “Exchanges alone adopt member and market regulation rules, develop automated surveillance systems to detect rule violations and discipline broker-dealers that violate rules and harm investors.” Exchanges also set and enforce rules and halt trading in an emergency, he said.
Alternative trading systems, which include dark pools and electronic communication networks such as Citigroup Inc.’s LavaFlow ECN and Zurich-based Credit Suisse’s Light Pool, “are not entrusted to regulate and discipline their users in this manner,” Noll said. These venues could register as so-called self-regulatory organizations if they chose to accept the duties imposed on exchanges, he said. All exchanges are SROs.
“One need only look at the list of SRO responsibilities that registration triggers to understand why so few of our lightly regulated competitors voluntarily take that step,” he said of alternative venues.
Bats Global Markets Inc. and Direct Edge Holdings LLC, which built their markets as ECNs to compete with the NYSE- Nasdaq duopoly in 2005, are now exchanges. Bats converted in 2008 to reap the financial benefits and greater control it had over its systems as a regulated market. Direct Edge made the leap in 2010. They operate four of the 13 exchanges, with six more owned by NYSE Euronext and Nasdaq OMX.
Exchanges and brokers don’t have the same responsibilities for overseeing markets because of their regulatory status. Public exchanges receive market data revenue for the sale of information about transactions and quotations. They also have civil immunity from liability for technology breakdowns that are their fault. Dark pools, in contrast, have a duty to get their clients the best trade possible and face limitations on how much market share they can amass and still remain private.
Revenue from the sale of consolidated or public market data totaled $464 million in 2008, the SEC said in a report in 2010. Net income for the 11 exchanges and Financial Industry Regulatory Authority that year was $449 million. The three stock exchanges now owned by NYSE Euronext received almost $180 million while those now owned by Nasdaq OMX got almost $144 million. Finra earned $61.6 million from market data that year.
Credit Suisse’s Mathisson said that the market-data revenue of about $400 million a year the exchanges and Finra get is a “government-granted windfall” that far exceeds the regulatory expenses it’s supposed to offset. He urged policymakers to overhaul the data-revenue plans. Finra gets the funds for trading that occurs away from exchanges including on dark pools.
Credit Suisse executed 12.4 percent of U.S. equity volume this year, most from 1,600 institutional clients including mutual and pension funds, according to Mathisson. That occurred on exchanges, in dark pools and on other venues.
“Given that real-time data is a government-granted monopoly, and market data prices are not set by the market and are not subject to competition, the investing public is arguably being overcharged for market data by approximately $400 million a year,” Mathisson wrote. He also said exchanges should not have immunity from prosecution for financial losses they cause.
Executives in charge of electronic trading at Morgan Stanley told the SEC in a March 2010 letter that the activities of exchanges and brokers were starting to overlap and should be kept distinct by the agency. The different roles of exchanges and brokers became blurred as technology and electronic trading enabled them to engage in businesses away from their traditional turf to increase profits or save money, William Neuberger and Andrew Silverman said.
The conflicts between exchanges and brokers, which are also their member firms and ran their markets before exchanges converted into publicly traded corporations, are occurring against a backdrop of technology breakdowns that have hobbled the confidence of some institutions and retail investors.
Technology problems that led to Bats withdrawing its initial public offering in March and Nasdaq’s botched IPO for Facebook Inc. two months later drove the impression of technical mishaps run amuck. Knight Capital Group Inc.’s accidental trading because of a software malfunction on Aug. 1 produced more than $450 million in losses and pushed the market-making company to the brink of bankruptcy.
Smaller anomalous trading or difficulties with exchanges’ data feeds occur almost daily.
Still, the percentage of equities trading canceled after transactions occur is at a nine-year low, according to data compiled by NYSE Euronext. This year, 0.18 percent of U.S. equities volume was voided by exchanges or Finra because the trades were deemed erroneous, down from 0.23 percent last year and a high of 0.43 percent in 2004, the data show.
Exchanges introduced new rules for when they cancel trades after the 2010 flash crash. They also implemented curbs that halt trading when a stock moves 10 percent in five minutes, limiting the number of errant trades that may have to be voided.
Technology and market-structure developments in recent years have emphasized speed, increased the cost of maintaining networks and trading infrastructure, and “created unnecessary complexity and mistrust of markets,” even as they brought investors benefits, NYSE’s Mecane said. He urged Congress and the SEC to simplify what he called a “complex ecosystem.”
U.S. equities volume was 6.4 million shares a day so far in 2012, a 17.5 percent decline from last year’s daily average of 7.8 billion shares and down 34 percent from 9.7 billion shares a day in 2009, according to data compiled by Bloomberg. To counter declining volume, exchanges are trying to diversify their revenue away from U.S. equities by increasing their derivatives and technology businesses.
“If you’re Nasdaq or NYSE and you’re a publicly traded company, your U.S. equities business is suffering not only from lower volumes but a smaller share of those volumes,” Schack said. “It’s a double whammy and that’s part of the reason why exchanges complain that there’s too much dark trading. The less- selfish reason is the question about whether high levels of dark trading damage price discovery.”
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