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More Innovation Welcomed in US Equities 

Ray Ross, co-head of electronic trading at BMO Capital Markets, is looking forward to continued innovation in US equity markets this year after new venues and order types launched in 2020.

Ross told Markets Media there has been a lot of market microstructure change over the last few years that has allowed the broker to implement trades faster and with lower impact, to the benefit of end-investors.

 Ray Ross, BMO Capital Markets

“We have seen lots of good progress and we are certainly eager to see what is coming next,” he said.

Three exchanges launched in the US in September 2020 – Members Exchange (MEMX), MIAX Pearl Equities and Long Term Stock Exchange (LTSE) – taking the total to 16.

MEMX reported that in April it had a monthly record of 2.2% in average daily market share and 214 million shares traded every day. The exchange added that its market share grew 46% in April and it became the sixth largest U.S. equity exchange. MIAX Pearl Equities said it executed 452 million shares in total in April 2012.

Ross said BMO welcomes new venues and competition in the market.

“MEMX has been somewhat successful but it takes a long time for any venue to gain critical mass,” he added. “The jury is still out and all the new exchanges have plenty of room to grow.”

Another new venue is slated to enter the US equity market this year, subject to regulatory approval. PureStream Trading Technologies is aiming to launch an alternative trading system that will be the first US equity trading platform that allows institutions to trade blocks algorithmically with orders being matched in a stream of liquidity, allowing them to trade large transactions with less market impact. The ATS closed a $14m fundraising in February 2012 with BMO Financial Group amongst the investors.

“We are excited about the launch of PureStream as it is a very different model of matching client interest based on the rate of trading, rather than price, which is very much geared towards block institutional interest and solves a real challenge,” Ross added. “Today there are two ships in the night that each create impact but PureStream allows no-impact trades in an innovative way.”

Order types

In addition to new venues, more new order types are likely in the US equity market this year. The US Securities and Exchange Commission has approved the introduction of periodic auctions in the US by Cboe Global Markets. The exchange has been using the mechanism in Europe where periodic auctions last for very short periods of time during the trading day to help market participants find liquidity quickly with low market impact, while prioritizing size and price.

In Europe Cboe has a separate book dedicated solely to periodic auctions but in US auctions will take place on Cboe BYX Equities Exchange to adhere to Reg NMS rules around displayed orders. In addition, in the US the message identifying when an auction begins will be randomized to help to mitigate any potential adverse selection. Clients can send orders as ‘periodic auction eligible’ to trade against the continuous book provided that an auction has not been initiated, or as ‘periodic auctions only’ to participate only in an auction.

“The concept of running auctions, particularly in less liquid securities with wider spreads, could be an interesting solution,” said Ross. “We are excited to see how it plays out.”

BMO said in its comment letter to the SEC that the broker would like to see periodic auctions start in the US as a midpoint-only order type to reduce complexity and would like to see the mechanism’s impact on the data feed.

“These are nuances and we are generally supportive of the order type,” added Ross.

Consultancy Coalition Greenwich said in a report that Cboe’s proposal for periodic auctions does not just look to improve trading for thinly traded securities but encompasses all NMS stocks and incorporates BYX’s continuous book into the auction process.

“Comments on the proposal were mixed, however, the SEC approved the proposal in an order dated March 26, 2021,” said the report. “The Cboe plans to launch the U.S. version of the periodic auctions in the third quarter, and it will be interesting to see what type of traction it gains in the months to come.”

In October 2020 IEX Exchange fully launched its D-Limit, discretionary limit order type, which protects investors from adverse selection after receiving long-awaited approval from the SEC. The venue’s machine learning signal seeks to predict how the market is going to move in the next fraction of a second. D-Limit then uses the power of the IEX Signal to move an order out of the way if the price is about to become imminently stale i.e. the order avoids being “run over” when the price is unstable

BMO has been using the D-limit order and Ross said it protects their quotes against adverse selection and reduces implementation costs for trading.

“We are able to get higher quality prints, as well as increasing the number of high quality prints, ” he added. “This means we can trade faster and bring more liquidity to the market so it is an important new tool that solves a real problem.”

However Citadel Securities has sued the SEC, asserting that the regulator’s approval was improper and the case is pending. In April 2021, Healthy Markets Association filed an amicus brief in the United States Court of Appeals in support of the SEC, IEX, and investors arguing that the D-Limit order protects investors from predatory trading.

Off-exchange trading

Ross identified another focus for innovation as exchanges compete for order flow that has moved off-exchange due to the increase in retail participation. In the US retail trades are not executed on exchanges but most are sold by brokers to market makers under “payment for order flow” agreements,  allowing the brokers to offer no-commission trading to retail. The market makers internalize the flow and capture the majority of the spread, in return for offering retail investors a slight improvement on the exchange price.

Trade Reporting Facilities (TRFs) run by Nasdaq and NYSE capture trading off-exchange such as in alternative trading systems, internalizers, internal matching by central risk books and single-dealer platforms. Ross added that TRF volume is now larger than any one single exchange and also larger than any exchange family so significant liquidity is absent from exchanges.

“We are going to continue to see innovation and an enhanced focus on retail trading and the use of wholesalers,” he said. “Payment for order flow impacts execution quality, so we need to create more market centres where as many participants, and as many types of participants, can come together to trade.”

Ross argued that market makers serve an important function to stand in when a buyer and seller cannot find one another but in the last few years they have been able to trade in almost every case, even at the expense of other investors.

“We are seeing a lot of innovation in order types and venues that are allowing natural investors to come together without needing a third-party market maker in the middle,” added Ross. “When natural buyers and sellers come together the end-investor gets better quality of execution as  adding a third party only makes transactions more expensive.”

Ross said allowing retail and institutional liquidity to come together could result in meaningful price improvement for retail investors, who will not have to pay the full spread, and also more trading from institutions which would improve liquidity for the entire market.

The US House Committee on Financial Services has held hearings on retail trading and payment for order flow after shares in retailer GameStop rose 1,600% in January. Online broker Robinhood was forced to temporarily suspend trading in GameStop and other “hot” stocks in order to cover its clearing margins which led to allegations of market manipulation and unfair treatment of retail investors, and could lead to new regulations.

Ross said: “For a long time innovation was really just a fee game, but I think the industry has exhausted how many different price points we can have. The fight for order flow is now moving upstream and that is positive.”