Growing Number of ‘Attractive’ Orders Skimmed from Public Markets

Those who have followed the flash-order controversy know that NYSE Euronext was an early (if not the first) critic of the practice, and that we have since been consistent in denouncing the use of flash orders both in the equities as well as options markets. 

So it will come as no surprise that on 15 December, 2010 we filed a comment letter asking the Securities and Exchange Commission to reject proposals from the DirectEdge exchanges that would actually increase the reach of the markets’ flash mechanism, even as the SEC has proposed to ban the practice.  For those new to the topic, I strongly recommend reading our letter, which is only six pages.

What might be surprising, however, are two tables in the letter that detail:

• The growing imbalance between orders that participate in price discovery and the increasing number that do not, the latter of which include flash orders as a component; and
• The related “toxicity” levels on the public exchanges as increasing levels of “attractive” orders are skimmed from the public markets.

Quoting from the letter:

“…[W]e reiterate our concerns about the broader growth trend for liquidity that does not participate in the price discovery process, of which flash orders are a component.  Over the past four years, there has been a dramatic increase in the level of activity that is reported to the FINRA Trade Reporting Facility (TRF) – almost tripling in some cases, with absolute values in excess of 40% in many small-cap names.”

Now forgive me, but the table feature on our new blog platform is not yet up to snuff, so I’m translating the data into bullets:

• For NYSE-listed issues, the portion of all trading reported to the TRF grew from 15 percent in October 2008 to 24 percent in October 2009 and 32 percent in October 2010.
• For NYSE Amex- and NYSE Arca-listed issues, the TRF portion at the same times grew from 11 to 23 to 32 percent.
• For Nasdaq-listed issues, the numbers were 17, 24 and 34 percent respectively.
• For small-cap stocks on NYSE, the number was 40 percent in October 2010.

(All of the above is based on Consolidated Tape Association data and NYSE calculations.)

Continuing from our comment letter:  “In addition to concerns about when these increasing levels begin to impact the price discovery process,[1] the increased TRF volume raises concerns about the “toxicity” levels on the public markets as increasing levels of “attractive” flows are skimmed from the public markets.  Based on Rule 605 Realized Spread data for both the NYSE and the TRF over the past few years, this “attractiveness differential” becomes apparent (note that lower/negative values signify adverse profitability for the liquidity provider):

• For liquidity providers on NYSE, the realized spread was 0.45 basis points in 2007; 0.28 in 2008; -0.59 in 2009; and -0.65 year to date in 2010.
• For the TRF, the realized spread was 3.98 basis points in 2007; 3.78 in 2008; 6.66 in 2009; and 4.30 in 2010.

[Realized spread is the difference in the security price from the time a liquidity provider makes a trade compared with the midpoint of the National Best Bid/Offer 5 minutes later.  The above illustrates how liquidity providers on NYSE face higher costs – which discourages the provision of liquidity – compared with markets that skim off attractive order flow.  The data is based on Rule 605 data and NYSE calculations.] 

Our letter concludes:  “As we stated in our comment letter on the Commission’s Concept Release on Market Structure, we strongly encourage the Commission to take a broader review of these issues as part of its ongoing review of equities market structure.”  [Link added].

[1]  See comment letter from Professor Dan Weaver

Footnotes, argh.  But Prof. Weaver’s letter is worth reading as well.  Obviously this blog is not the ideal venue/format to reproduce a comment letter filed with the SEC, but you can see the original, and I hope at least the gist comes across here. 

What are your thoughts on this issue?  As always your comments are welcome in the box below.