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Understanding U.S. Equities Market Structure: Transparency Issues and Trading Mechanisms

The U.S. equities market structure is complex, involving exchanges, dark pools, and internalization, each with differing levels of pre-trade and post-trade transparency. While exchanges provide immediate trade reporting to the consolidated tape, dark pools lack pre-trade transparency, hiding order details to reduce market impact. Internalization occurs when OTC market makers execute retail orders without disclosing them to other market participants, raising concerns about fairness and price discovery. This report discusses the implications of these trading mechanisms and transparency issues within the market.

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Understanding U.S. Equities Market Structure: Transparency Issues and Trading Mechanisms

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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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