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Fragmentation in Focus

By Terry Flanagan

With 13 exchanges and more than 30 active alternative trading systems, it’s no surprise that some market participants see the U.S. equity market as overly fragmented.

Phil Mackintosh, Nasdaq

But there are some common misperceptions about the market and its sources of liquidity, according to Phil Mackintosh, Chief Economist at Nasdaq. Broadly speaking, the market functions well as it’s currently constituted, and exchanges are driving the bus.

“Markets are as liquid as they are today because there are a variety of venues and a variety of incentives that keep trades moving,” Mackintosh told Markets Media. “While this may bring up complaints of market fragmentation, there are many ways of looking at the market and as many ways to trade on these markets.”

More than 7 billion shares change hands in the U.S. stock market each day on average, which sums to about $70 trillion per year, according to data compiled by Nasdaq. Roughly two-thirds of that is traded on exchanges, with the other one-third executed on ATSs. “While a significant segment of the market now trades off-exchange, these venues would be lost without the important price discovery that the lit markets—run by exchanges—provide,” Mackintosh said.

New Player

The debate around fragmentation of liquidity is particularly relevant on the heels of the January announcement that Bank of America Merrill Lynch, Citadel Securities, Morgan Stanley, Virtu Financial and five other large financial firms will launch their own exchange. The new venue, called Members Exchange, will directly compete with incumbent operators Nasdaq, New York Stock Exchange, Cboe Global Markets, and IEX.

MEMX aims to boost competition among exchanges, improve operational transparency, and lower trading costs. But there is also potential downside: institutional traders already have a tough time efficiently trading blocks, and a new venue competing for order flow stands to aggravate that problem.

On a January 30 earnings conference call, Nasdaq CEO Adena Friedman didn’t seem rattled by the startup, noting that it would be at least the sixth time that trading firms have drawn up plans to launch an exchange. “We certainly can’t be surprised by continuation of what has been for over 15 years, a hyper-competitive landscape in the U.S. securities markets,” she said.

Adena Friedman, Nasdaq

A new exchange can be helpful, even to incumbent exchanges, to the extent that it pulls price quotes onto lit markets. “To the extent they bring some of that flow that’s currently internalized into an exchange environment, we then get to compete for that,” Friedman said.

So-called dark pools, which seek to match buyers and sellers of large trades without posting their bids and offers beforehand, have less market influence than is commonly perceived, Mackintosh noted in a Feb. 11 blog post. Such venues account for just one-third of off-exchange volume, or about 12% of total average daily volume.

Exchanges’ lit quotes flow through the Securities Information Processor and onto the market in the form of the National Best Bid and Offer. “No other industry can claim to have the same, market-wide, fair and equal pricing for their customers,” Mackintosh wrote.

Off-exchange venues rarely contribute quotes to the NBBO, Mackintosh’s research noted, though trades must be reported to the SIP, via a Trade Report Facility. Data shows that dark pools comprise about one-third of TRF volume; the rest of the TRF is “other trades” that brokers match, often on a principal basis, before they reach an exchange.

“The U.S. equity market is extremely competitive,” Mackintosh wrote. “Each segment of the market has devised a number of economic incentives to attract order flow to their venues. Rebates were targeted by the recently announced Access Fee Pilot, but they are just one of the many different incentives used across the industry.”

Just last week, Nasdaq, NYSE and Cboe said they would sue the U.S. Securities and Exchange Commission over the pilot plan, which the exchanges say would constrain competition, increase costs to investors and represents regulatory overreach.