Saturday, February 23, 2013
Wading Into Dark Pools
The NYSE’s dark pool for small investors hasn’t been disruptive to trading as some had feared, in part because it’s still so small.
The New York Stock Exchange announced last summer that it was launching a new venue for orders called the “retail liquidity program.” The idea, the exchange said, was to level the playing field between retail investors and institutional traders, giving individuals better pricing terms on stock transactions that only they could access. The proposal caused a small firestorm among the bourse’s rivals; they worried that the NYSE was muscling in on their turf and could disrupt order flow. It’s been about six months, so how has the program done?
First, we need some basic information. The exchange said at the outset that this new system would “provide potential price improvement to incoming order flow in the form of nondisplayed interest that is better than the protected best bid/offer.” What does that mean? Price improvement is the execution of an order at a better price than what’s being publicly quoted.
The phrase “nondisplayed interest” is industry code for a dark pool—a fluid, private institutional stock market that trades large amounts of shares outside of the normal stock exchanges. Here anonymous participants, often hedge funds or high-frequency traders, can enter orders that, if matched by others in the pool, get executed. The price of the trade has to be at or between what’s known as the national best bid or offer. So the NYSE was creating a dark pool that would give the small investor a chance to get a better price.
Some questioned the Big Board’s motives because more than half of all stock orders are completed outside public exchanges. That doesn’t please the NYSE and may cut liquidity for small investors.
Other exchanges and electronic clearing networks complained that it could hurt the order process. In the past, established exchanges like the NYSE were prevented by the Securities and Exchange Commission from offering price improvement. The private venues offering price improvement usually used the exchanges’ publicly displayed prices as a basis for comparison. If the NYSE was offering price improvement, the relationship would change, possibly creating order problems, said critics.
As far as we can tell, the NYSE liquidity program, which doesn’t allow algorithmic or black-box trading, is a minor success and hasn’t disrupted order flow. However, that could be due to the limited number of retail brokers participating. The NYSE says that about nine million shares per day are being exchanged in the system now, up sharply from its start but still a small piece of the action.
Interactive Brokers added the NYSE retail liquidity program as soon as it came online, says Steve Sanders, executive vice president of marketing and product development. So far, Sanders says customers who have executed trades on the RLP have enjoyed price improvement and exchange rebates that have reduced their trading costs by about $0.0023 per share. In January, IB customers executed three million shares via the new exchange.
Don Montanaro, CEO of TradeKing, says that orders placed by his clients are processed through a variety of smart routers from a number of liquidity-providing partners, and that some of those routers connect to the NYSE RLP. “We do not provide our clients with the ability to direct specific orders,” Montanaro notes.
A couple of online brokerage officials say that they do not route to the NYSE at all, because they want to keep their clients from incurring added trading costs.
Shawn Herrin, a senior vice president at eOption, says his firm’s routers do not access the NYSE program. His clearing firm, Apex Clearing, “has put a number of restrictions on our ability to use non-Apex destinations,” he says. Herrin expects that situation to change later in the year.
Owing to some of these limits, Montanaro says it’s too early to tell about the RLP. But, he adds, “More liquidity and price improvement are always good for small investors. If they can grow the volume and liquidity, it should be beneficial.”
Published in Barron’s, February 18, 2013.