NYSE Retail Liquidity Program: If You Can’t Beat ’em, Join ’em …

Categories: Equity Investments, Market Structure, US SEC
Rhodri Preece, CFA

That’s seemingly the thrust of the NYSE’s plans to establish a “retail liquidity program.” Frustrated with its loss of market share to broker/dealer internalizers and other non-displayed trading centers, the exchange seems to want to play the internalization game itself.

The substance of the NYSE’s plans is contained in a recent submission to the SEC. The proposal would allow retail orders to execute against non-displayed trading interest within its systems, in the form of “retail price improvement” orders, all the while offering a payment for that order flow. Sound familiar?

Competitive Landscape

Leaving the merits of this proposal to one side for a moment, the NYSE has a valid argument. The loss of business to the off-exchange markets partly reflects the fact that internalizers can play by a different set of rules than the exchanges. Capitalizing on this advantageous position, broker/dealers have built-up their own exchange-like businesses which now account for around one-quarter of total volume in the U.S. equity market. Collectively, this represents a bigger slice of the pie than any individual exchange’s share.

While broker/dealers have fostered greater competition and, along with electronic communications networks (“ECNs”), helped dismantle the exchanges’ prior-held monopoly — clearly a good thing — the problem is that the internalizers operate under a different set of rules. For example, they do not have to display their trading intentions, and they can intercept order flow that would otherwise be routed for execution against displayed trading intentions (a.k.a. limit orders) posted on the exchanges. This is compounded by the sub-penny rule, which effectively prohibits sub-penny price quotes. Because internalizers don’t have to display quotes (they are “dark”) while the exchanges do, it is easy for internalizers to match or beat the prices on the exchange by dealing in sub-penny price increments, on the premise that it offers customers “price improvement.” But this improvement is nominal at best, often to the tune of $0.0001 per share.  So, given the competitive landscape, it’s not hard to see why the NYSE wants to join the bandwagon and jump into the internalization game as well.

Loss of Incentives

Now, on to the merits (or lack of them) of this proposal. In short, whilst it might be profitable for the exchange in the short-term, it will likely hurt investors in the long-term.

As CFA Institute has noted in its comment letter to the SEC, non-displayed internalization pools remove the incentive for market participants to display orders. Because broker/dealers can step in front of displayed limit orders by internalizing marketable retail order flow, the submitter of the limit order often does not get filled. However, when their displayed orders do get filled, it is often because they are on the wrong side of the market. In other words, the internalizer “cream-skims” the desirable order flow and sends any unattractive orders to the exchange.

This practice has a corrosive effect on the willingness of investors to display limit orders, which, crucially, are the building blocks of price discovery. This corrosion carries a significant and greater cost to market integrity relative to the small benefits accruing to the retail investor from the (at best) nominal price improvement gained from internalization of their orders.

As a result, the “toxicity” of the exchange will increase as the order flow routed to exchanges will increasingly consist of sophisticated, often high-frequency, order flow. In other words, the liquidity pool will be less diverse. This, in turn, will lead to fewer limit orders and hence, lower market depth and wider bid-offer spreads as market makers seek greater protection from the risk of “adversely selecting” (or interacting with) this more toxic order flow. Furthermore, institutional investors will increasingly seek out liquidity in dark pools to avoid the poorer quality of executions offered on exchanges. Worse, given that the displayed market acts as a reference market that supports price formation in the dark or off-exchange markets, trading costs could increase in those markets as well. That is, the initial loss of displayed liquidity creates a negative feedback loop that hurts all types of investors.

An interesting twist is that the NYSE likely shares this view. It even acknowledges the potential negative impact of its proposal in its submission to the SEC. Considered in that context, does the exchange really want to play the internalization game, or simply force the SEC’s hand into levelling the playing field? Whilst the proposal should be rejected, perversely it could improve the situation if it causes the SEC to reassess the regulatory framework surrounding internalization and develop a more consistent set of rules.

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