Equity Market Structure Wrestles with “Inaccessible Liquidity”

Equity market participants are learning about new stock exchange launches, new order types, and periodic auctions bringing innovation and competition to the equity trading landscape. But concerns about the unintended consequences of retail orders being executed in the off-exchange world seemed to be a huge issue for buy-side traders at the STA 2020 Market Structure Virtual Conference last month 

Citing the concept of “inaccessible liquidity,” asset managers pointed to the surge of retail trading by mom and pop investors whose orders are executed by broker-dealers on private platforms.  

While this phenomenon is not new, some institutional traders are worried that they cannot interact with this burgeoning source of retail liquidity. “I’m concerned about off-exchange liquidity,” said Melissa Hinmon, Director of Equity Trading for Glenmede Investment Management L.P., speaking on the panel U.S. Equity Markets Surveying the Future. 

“I don’t know how you can actually guarantee you are getting true price discovery when you have 25% of the volume in some names that we don’t have access to,” said Hinmon. 

The rise in individual investing in 2020 during lockdowns has led to “historically higher levels of dark trading as stocks are bought and sold on opaque private platforms rather than exchanges,” reported The Wall Street Journal in August. In July, 43.2 % of U.S. stock trading volume took place off-exchange, according to data from Rosenblatt Securities provided to the WSJ.   

Justin Schack, managing director at Rosenblatt Securities, who moderated the exchange panel, noted that overall off-exchange market share has been hitting records for individual securities.  “Fifty-to-sixty percent of the volume in some of the most active stocks is executed off-exchange,” observed Schack. “If asset managers don’t have access to off-exchange volumes that are clearly retail,” Schack asked panelists how they can be sure they are getting the correct price, and how they are responding to these changed circumstances.  

With significant retail order volumes being executed off-exchange, buy side traders expressed concerns about the impact on price discovery on lit exchanges. 

“While there is much chatter about how great the retail experience is with no commissions and executions inside the NBBO, Hinmon pointed out, “There really is no study on how it’s affecting institutional investors – the volume we don’t have access to.” 

According to SEC’s Staff Report on Algorithmic Trading in U.S. Capital Markets, published Aug. 5, 2020, 63% of all shares traded were executed on-exchange, and 37% off-exchange on ATSs and dealer platforms in 2018 where quotes are not publicly displayed, referred to as “dark pools” of liquidity. Of the 37% executed off-exchange in 2018, 27% of NMS share volume was executed by broker-dealer internalization platforms, and about 10% was executed by ATSs, states the SEC’s report. 

The question is whether this trend toward off-exchange trading for retail flow is harmful for price discovery on public exchanges. And what does this mean for algorithmic trading? 

Retail activity has grown from 8% to 25% of share volume, said an electronic trading executive at one of the bulge-bracket firms, who spoke on the Battle for Best Execution panel at the STA virtual event. The electronic trading expert said the firm is doing research on how retail volume is impacting its algos.  “The amount of retail liquidity occurring in certain names is inaccessible.”  

Factoring in the market impact costs for algorithmic trades, the expert noted that algorithms work on average daily volumes, so if brokers don’t have access to all the volumes, it’s a problem for estimating costs and accessing liquidity. When algos were first created, brokers had access to the volume on primary listing exchanges and away exchanges.  Now it’s the opposite.  Certain volume is inaccessible because it’s trading where brokers are internalizing. 

Institutions can eventually reach this liquidity on the back of venues if they incorporate the retail single–dealer platforms of the wholesalers into their strategy, advised the sell-side electronic trading expert. “You probably want to incorporate that into your algorithmic strategy.”

Retail order flow finds its way into the market, said Brian Bulthuis, Head of Quantitative Trading Services at Instinet. “There are ways to trade with that flow on particular single-dealer platforms,” said Bulthuis. “The dealers willingness to provide price improvement to algo orders on those platforms is often informed by retail orders that they have already filled and are holding on their books temporarily, or a prediction that they are going to receive  offsetting retail orders soon,” he said.  

While the internalization of retail orders can impact liquidity available to algorithms, several providers of algorithmic trading emphasized the importance of taking advantage of different order types and various sources of liquidity. 

“I do believe the conversation around internalization, around whether order flow should be more accessible to all market participants is a healthy one to have,” said Joe Wald, Co-Head of Electronic Trading at BMO Capital Markets. But Wald cautioned against focusing on what you can’t control. 

“At the end of the day, the key is to source liquidity for your clients. It’s an incredibly competitive environment for algorithmic trading services providers. We all do the best that we can to manage the liquidity that we have access to,” said Wald. “It’s all about the order types and the liquidity that you can master and stitch together and benefit your clients. There is some liquidity that you have access to, and some that most folks don’t. Whether the inaccessible liquidity is meaningful in terms of benefiting execution quality, ultimately that flow does make its way into the market,” said Wald.  

Innovations: New Order Types, Auctions 

As the STA discussion turned to new exchange launches, new order types and periodic auctions, buy-side firms acknowledged that U.S. equity market structure is becoming more complex.   

Even if there is additional complexity, buy-side firms are open to innovative order types that encourage market makers to enter more displayed liquidity on the exchange’s order book. 

For example, Hinmon noted that IEX had launched its new Discretionary Limit or D-Limit Order, designed to protect displayed limit orders from being picked off by latency arbitrage players.  “People are taking to it going by the volumes,” said Hinmon. “We’re just looking for more complex solutions on the buy side as the market goes more complex,” said the equity trading director.  

 IEX is using artificial intelligence to protect limit orders resting on its order book from the tactics of high-speed traders using latency arbitrage strategies.  

“The D-Limit Order uses machine learning to predict when a price change is about to occur,” wrote John Lothian, Executive Chairman and CEO at John Lothian News. The order type uses IEX’s “crumbling quote indicator” (CQI) to determine when prices are unstable, and the CQI is working to protect traders using the D-Limit or other pegged order types (i.e., D-peg and P-peg),” wrote Lothian. 

While the SEC set a precedent in August by approving the order type, which intentionally delays access to a protected quotation, one panelist suggested this could open the door to similar order types.  

“If you describe it as a slippery slope, then I suspect that us and others are going to look at other solutions that further segment the market, whether it’s through priority or systematic delay or other structures,” said Tal Cohen,  Executive Vice President and Head of North American Markets at Nasdaq. However, Cohen suggested that technology would enable a more elegant solution to either minimize market impact, minimize opportunity cost or achieve more size for institutions. rather than impose a “blunt instrument” as a byproduct on the market. 

Sell-side participants speaking about best execution said the biggest change in the market is innovation and that the conversation between brokers and venues has shifted to execution quality.  

“The market structure is evolving so quickly that we need to have differentiated order types to access at different points in the lifecycle of handling a trade,” said the bulge-bracket firm’s electronic trading executive. It all evolves around algorithms and intents; there is passive liquidity, and conversations are about post-trade auctions and intra-day auctions, said the executive.  

For example, Cboe Global Markets is seeking to launch periodic auctions in the U.S., modeled after its success in Europe, to counter the increase in off-exchange trading. Cboe’s periodic auction will offer an on-exchange alternative for executing block trades and to help attract natural interest, reported Markets Media.  

Sell-side panelists praised the level of innovation that is occurring in equity market structure. 

Referring to the changing environment, BMO Capital’s Wald said, “We are getting three new exchanges, multiple order types, and ATSs that are segmenting orders and allowing brokers to access that segmented flow in different ways.”    

New Exchanges  

In September, Members Exchange (MEMX), Long Term Stock Exchange, and MIAX Pearl Equities from Miami International Holdings – launched their trading platforms, increasing the total number of U.S. exchanges from up to 16. Speaking on the STA’s exchange panel, CEOs of two of the new venues emphasized the benefits of increased competition, newer technology, and lower costs for market data and connectivity. 

“On the trading side, we are introducing fees initially as incentives to get people to connect to our exchange to experience the new technology, but then we will revert to a normal pricing mechanism,” said Jonathan Kellner, CEO of MEMX.  Kellner said MEMX will initially offer market data and connectivity for free to encourage sign ups, but once it starts building volume it will begin charging for data and connectivity.  Beyond lowering costs, MEMX is about improving the quality of interactions in the market, he said. 

Thomas Gallagher, Chairman and CEO of MIAX International Holdings, which owns three options exchanges, said that expanding into equities was necessary to become a global exchange. “Our focus is on bringing another generation of technology to the equities space.”  said Gallagher, who is the CEO and Chairman of MIAX Options and MIAX Pearl. “I can’t wait until the market sees our low-latency deterministic system.  It will probably react with some price changes which is a good thing,” said Gallagher. 

For more insight into how new exchange entrants could impact equity trading, read our blog Exchange Landscape Gearing Up for Expansion in 2020.

But with the new exchanges, each has a set of distinct rules, order types, and fees to keep track of, which adds to complexity, noted Rosenblatt’s Schack. “This is a bit ironic given the complaints – including those arguing in favor of market reforms like the Transaction Fee Pilot – that market structure was too complex, and we needed regulatory fixes to simplify it,” he said.  “But now we don’t have the Transaction Fee Pilot, and we have three new exchanges, order types and data to get back and look at.”  

“It’s not just that we have 16 exchanges, we have 30-plus ATSs [alternative trading systems], a number of new order types, a lot of fragmentation up and down the spectrum,” commented Nasdaq’s Cohen.  Going forward, Cohen suggested that any new order types be measured against how they contribute to price discovery and quality of execution. 

A buy-side trader suggested that the collapse of the Transaction Fee Pilot has pushed forward  Rule 606 (3b) on institutional order routing, mandating transparency into secondary routes to other broker algorithms. It mandates that brokers disclose their order routing data for institutional clients in a standardized format. A study by Greenwich Associates found that 80% of respondents plan to leverage the new 606 look–through report. Over 70% of respondents indicated they plan to request the data on a quarterly basis. 

For an in-depth explanation of Rule 606, read our blog Revised SEC Rule 606 Shines the Light on Order Routing Disclosures.

But the proliferation of order types and execution venues also creates a more complex ecosystem for the buy side to analyze as they make trading decisions.  

“There’s a huge noise factor. For our clients, if they focus on providing best execution for their clients,  we can abstract away some of the micro-level details of how do you handle odd–lots, how do you handle wide spreads, or how do you incorporate alternative forms of  liquidity like single–dealer platforms or CRBs (central risk books),” said Instinet’s Bulthuis. 

As buy-and sell-sides deal with this increasing complexity of new exchanges and order types, it remains to be seen if the retail activity will keep “tilting” toward the off-exchange world.  Amidst this uncertainty, it’s clear that institutions and broker will have new tools, order types, and data at their disposal and more complexity to manage.