Last December, the SEC’s Mary Schapiro announced the regulator would be seeking public comment from the start of the year “on a range of issues relating to dark liquidity in all of its forms, as well as the impact of high frequency trading in our markets.”
While the issue of dark pools and electronic communication networks (ECNs) has fetched a fair share of attention in the media, a little less scrutiny has befallen the SEC’s other area of concern — the practice of broker-dealer internalisation.
This refers to banks and larger brokers matching incoming orders against their own customers’ trading flow, before sending the flow through to dark pools or the public market. It’s something smaller and more traditional brokerages cannot compete with, due to their more modest balance sheets and client flows.
And, as the commission’s concept release showed in January, it’s certainly not a small section of flow that is being traded this way. Note the following chart from the SEC’s report, in which the pink area reflects the portion of internalised trades in the US:
Although as Traders Magazine noted in February this year, Macquarie has estimated that figure could have risen to as much as 31 per cent in January 2010.
It’s interesting to observe then, that in its quest for enlightenment the SEC has centred on the following point regarding the practice (emphasis FT Alphaville’s):
Low-Priced Stocks. There may be greater incentives for broker-dealer internalization in low-priced stocks than in higher priced stocks. In low-priced stocks, the minimum one cent per share pricing increment of Rule 612 of Regulation NMS is much larger on a percentage basis than it is in higher-priced stocks. For example, a one cent spread in a $20 stock is 5 basis points, while a one cent spread in a $2 stock is 50 basis points – 10 times as wide on a percentage basis. Does the larger percentage spread in low-price stocks lead to greater internalization by OTC market makers or more trading volume in dark pools? If so, why? Should the Commission consider reducing the minimum pricing increment in Rule 612 for lower priced stocks?
All of which is particularly interesting in light of the recent tendency for some severely trashed financial stocks — among them Citi, Fannie, Freddie and AIG — to experience inexplicably high trading volume surges on no news whatsoever.
The so-called penny rule refered to above, by the way, was brought in by the SEC in 2005 to replace the fractional quoting system. It was hoped the rule would modernise the market system.
The rule effectively prohibits “market participants from displaying, ranking, or accepting quotations, orders, or indications of interest in any NMS stock priced in an increment smaller than $0.01 if the quotation, order, or indication of interest is priced equal to or greater than $1.00 per share.”
But broker-dealers themselves are allowed to delve into sub-penny prices if they can improve on the the National Best Bid and Offer (NBBO). The problem is, they only have to improve on the bid or offer price by as little as 1/100th of a penny to capture a juicy near 1-cent spread for themselves — which critics say is not a meaningful enough improvement to justify holding back orders from the public market.
Meanwhile, as the SEC points out, the smaller the price of the stock, the greater the potential basis-point differential on the bid-offer spread relative to the stock’s price — which increases the incentive for broker-dealers to internalise trades in this way.
As Brian Hyndman, a Nasdaq senior vice president in charge of transaction services, noted at a recent industry conference according to Traders Magazine:
Hyndman said stocks that have higher rates of internalization tend to be low-priced and high-volume, such as Citi. He also said there are stocks with internalization rates greater than 40 percent–outliers with rates reaching 50, 60 or even 70 percent. Conversely, he said, as a stock price rises, internalization levels decline.
No surprise then that six months on, and specifically post flash-crash, public comment on the topic has been increasingly focusing on the issue of internalisation and sub-pennying.
As one commenter noted:
Currently the market is two-tiered. There are those(broker-dealers) who can see all my orders, and then there’s the individual who cannot see the sub-penny orders or any orders for that matter. Hardly a fair market if you ask me.
The following, meanwhile, was the comment from Bright Trading – a professional stock trading company which has been particularly critical of the practice:
The only time the displayed order on the NBBO is filled from an incoming retail market order, is when the OTC market maker of the broker-dealer passes on the chance to trade against its customer’s order, and there are no undisplayed orders hiding in dark pools in front of the NBBO order. As a result the only retail orders getting through to the publicly displayed NBBO, are the orders that the first two market participants have passed on. If the first two participants have passed on the opportunity to trade against the order, there is a good chance that the incoming market order is on the right side of the market (in the short-term). Hence, the only NBBO orders that are filled are those that are more likely wrong (in the short-term). The displayed liquidity provider is “sub-pennied” when they’re right, filled when they’re wrong. As liquidity providers become discouraged, they will place fewer passive limit orders in the short term and ultimately leave the trading markets. This will lead to less depth in the market and larger spreads, both increasing the cost to investors in the long term.
It could be said that some of this was proved by the May 6 flash crash, when a whole host of limit orders submitted by traditional investors — clearly on the wrong side the market — were suddenly the only ones to be filled en masse.
The SEC has now moved into the direct consultation phase on the matter, having held its first roundtable on the issue last week.
Related links:
Was 2009 the year of the market maker? – FT Alphaville
SEC/CFTC: ‘Yes, yes, we’re on the case…’ – FT Alphaville
Did futures cause the ‘flash crash’? – FT Alphaville
ETFs and the ‘flash crash’ – FT Alphaville