Dennis Dick

Doug Clark, managing director of liquidity research for ITG Canada, was recently interviewed on TabbFORUM in a post called “Dark Pools & Private Schools”.  In his interview, Clark questions Canadian regulators for their recent regulation of dark pools.  He compares the restrictions placed on dark pools to prohibiting parents from sending their kids to private school.

But his analogy is flawed.

In his analogy, the parents are the ones choosing to take their kids out of the public school sector, to place them into the private school sector.  But in many cases the retail investor is NOT the one choosing to send their orders to a dark pool. In some cases, they don’t even have a choice.  It is often the broker/dealer controlling the routing, and making that choice for them (usually based on the payments they receive from routing their orders to a specific OTC market maker or dark pool).  Following Mr. Clark’s analogy, this would be equivalent to the education authority taking kids out of public schools and placing them into private schools without the parent having any say, and getting paid to do it!

Secondly, the reason the parent would move their child from a public school system to a private school system is to receive some sort of benefit – better food, better teacher to student ratio, better security, better programs, as Mr. Clark mentions in his interview.  But what is the benefit that the customer is receiving by having their order routed away from the public exchange?  The chance to receive sub-penny price improvement on their order?  These fractions of a cent give little nominal value to the customer, but have a significant effect on deterring displayed liquidity, especially in thinly traded issues.

Consider the following example.

Assume stock XYZ has NBBO:

Bid      Size     Ask      Size

25.50   500    25.70   500

A retail investor places a market order to buy 500 shares of the stock.  The order is routed to an OTC market maker who gives sub-penny price improvement to the order, and executes the buy order at 25.6999.

Instead of paying $12,850 for the stock, the retail investor pays $12,849.95 for the stock, saving a whopping nickel.

But the participant who placed the 25.70 limit order on the exchange, the displayed liquidity provider, is left unfilled.

Imagine if you were that participant that should have received an execution, but did not because your order was stepped in front of at the moment it was about to be executed.  This leaves you with an unquantifiable loss, the loss of the missed trading opportunity.

Now imagine a different scenario:

Assume the same NBBO:

Bid      Size     Ask      Size

25.50   500    25.70   500

A retail investor places a market order to buy 5000 shares of the stock.  The OTC market maker, knowing this order will impact the price significantly, does NOT step in front of the 25.70 order, and allows the market order to route to the displayed market, taking out the 25.70 seller, and trading all the way up to 26.00 to fill the balance of the order.

The 25.70 limit order trader is immediately down 30 cents on the trade.

The routing of retail order flow away from the displayed market has distorted the risk-return matrix of displayed market makers, and they are hesitant to make markets in smaller stocks as a result of the increased adverse selection risk.

In fact, the matrix has become so distorted that our firm, Bright Trading LLC, recommended to our traders that they stop providing liquidity in small and mid cap stocks entirely.  The rationale is simple, if you get filled on your limit order, it is usually because you are on the wrong side of the trade, and the price often blows right through you.

Therefore, there is little point to displaying liquidity in these issues, as the return no longer justifies the risk.  Our traders have learned this the hard way.  The OTC market maker steps in front of your order when it is on the right side of the trade, and allows your order to be filled when it is on the wrong side of the trade.

We believe that the distortion of the risk-return matrix of displayed market makers due to internalization, is the main reason that we have liquidity problems in the small and mid cap space.  It is apparent that the Canadian regulator (and now ASIC) have similar concerns.

To rectify the situation, the Canadian and Australian regulator have mandated that orders routed away from the public exchanges receive meaningful price improvement over the NBBO.  That way at least there is some benefit to the end customer from the routing of their orders away from the public exchange.  It should also help to deter OTC market makers from stepping in front of limit orders, as they now have to assume increased risk (by giving meaningful price improvement) when internalizing a retail market order.

But ASIC may go further.  In their recent report on dark liquidity, not only are they mandating meaningful price improvement, but they are also proposing a trigger to implement a minimum dark order threshold, to apply to securities where there is evidence that dark liquidity has caused degradation in market quality.

These actions by the Canadian and Australian regulator should be applauded as opposed to questioned.  Displayed limit orders are the building blocks of price discovery.  It is imperative that we protect these orders.  The new policy decisions of the Canadian and Australian regulator should help to improve the risk-return matrix of displayed market makers and encourage market participants to display limit orders more aggressively, which should improve market quality in these countries.