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Market Structure

Market Structure. U.S. Equities. 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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Market Structure

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  1. Market Structure U.S. Equities

  2. 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

  3. 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

  4. 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

  5. US Exchanges, March 2012 Source: CFA Institute Market Structure report 2012

  6. 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

  7. 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, GetcoGETMatched, Barclays LX, Deutsche Bank SuperX, UBS PIN, Morgan Stanely MS Pool......etc.

  8. 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)

  9. Internalization • No pre-trade transparency to other market participants • Examples: Proportion of market orders in NYSE stocks routed to OTC market makers (in %) Source: CFA Institute Market Structure report 2012

  10. Internalization “Issue of preferencing” Source: CFA Institute Market Structure report 2012

  11. 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

  12. 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)

  13. Smart order routing example • For institutional clients • In this example, first to dark pools, then to exchanges Portfolio manager Investment bank Sell 15,000 shares of XYZ Sales and trading Routing logic: Dark pools Exchanges Dark pool 1 5,000 shares available Dark pool 2 5,000 shares available Dark pool 3 3,000 shares available 800 shares 700 shares 500 shares Exchange A Bid size: 2,200 Exchange B Bid size: 1,500 Exchange C Bid size: 800

  14. 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

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