Market Structure

U.S. Equities

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Issue of transparency Exchanges, dark pools, and internalization

Differ in pre-trade transparency All have post-trade transparency

Exchanges Once trade is executed, it is immediately reported to the

consolidated tape, and published Dark pools

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Traditional exchanges Electronic limit order book markets (e.g., NYSE, TSX) Bid and ask prices, size of the orders are posted Buyers and sellers need to “cross” the bid-ask spread

for a transaction to take place

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Electronic Communications Networks (ECNs) Example of Alternative Trading Systems (ATSs) Similar to exchanges, but do not provide:

Listing services Market surveillance, oversight responsibilities

Active in the 1990s, but many have been acquired by exchanges Instinet, now part of NASDAQ Archipelago, now NYSE Arca

Today, one major stand-alone ECN left (LavaFlow) < 2% of volume

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US Exchanges, March 2012

Source: CFA Institute Market Structure report 2012

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Dark Pools Registered as ATS for regulatory purposes Lack of pre-trade transparency

Orders are not fully displayed to others Different shades of darkness

Complete darkness Security, size of order, buy or sell, but no price

Orders are matched anonymously Benefits to buyers/sellers of securities

Hide information Reduce market impact of the trade

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Dark pools Benefits (cont’d)

Reduce trading costs - system may cross offsetting customer orders at the midpoint of the nation best bid and offer (NBBO)

Can restrict access to certain market participants (e.g., high frequency trading firms) discriminatory

16 dark pools in the US as of March 2012 Ranking by size: Credit Suisse Crossfinder, Goldman

Sachs Sigma X, Knight Link, Getco GETMatched, Barclays LX, Deutsche Bank SuperX, UBS PIN, Morgan Stanely MS Pool......etc.

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Internalization OTC market makers internally execute order flow

against their own accounts Account for almost 100% of all retail market order

flow (some limit orders may be routed to exchanges) May or may not be related to the retail brokerage

firm Large retail brokers have their own OTC market makers Small retail brokers have an order flow agreement with

several market makers (who pay the brokers $0.001 per share)

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Internalization No pre-trade transparency to other market participants Examples: Proportion of market orders in NYSE stocks routed

to OTC market makers (in %)Retail Brokerage

OTC Market Maker E*Trade Charles Schwab Edward Jones

Citigroup Global Markets

5.2 0.1 18.2

Knight capital 8.4 13.4

Citadel 17.1 0.2 30.0

UBS Securities 7.4 99.7 6.1

E*Trade Capital Markets

61.9 32.2

Total 100.0 100.0 99.9

Source: CFA Institute Market Structure report 2012

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Internalization

2023-04-22Source: CFA Institute Market Structure report 2012

“Issue of preferencing”

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Transparency Exchanges

Pre-trade transparent In the US, account for 2/3 of volume

Dark pools Not pre-trade transparent In the US, account for 8-13% of volume

Internalization Not pre-trade transparent In the US, accounts for 18% of volume

Issues: fairness - incentive to provide quotes, speed of price discovery due to fragmentation

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Post-trade transparency Exchanges, dark pools, and internalization

Differ in pre-trade transparency All have post-trade transparency

Exchanges Once a trade is executed, it is immediately reported to the

consolidated tape, and published (real time) Off exchange trades

Trades are reported to a Trade Reporting Facility (TRF) through FINRA in the US, IIROC in Canada (within 30 sec)

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Smart order routing example

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For institutional clients

In this example, first to dark pools, then to exchanges

Sell 15,000

shares of XYZ

Portfolio manager

Sales and trading

Investment bank

Routing logic:1. Dark pools2. Exchanges

Dark pool 15,000 shares

available

Dark pool 25,000 shares

available

Dark pool 33,000 shares

available

Exchange CBid size: 800

Exchange BBid size:

1,500

Exchange ABid size:

2,200

800 shares 700 shares 500 shares

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Final note According to Regulation ATS, introduced in 1998, if an

ATS executes > 5% of the trading volume of a stock, then must provide pre-trade transparency But according to the SEC, this threshold has not been

met