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Is The Proposed NYSE Retail Liquidity Program Just A Trojan Horse?

14

October, 2011

On October 12th, NYSE Euronext filed a proposal for its new Retail Liquidity Pilot Program (Read Proposal Here) The program can best be summarized as an “internalization” program for the NYSE. The program will clearly disadvantage the displayed liquidity provider and potentially harm the price discovery process even further. Here is how the NYSE describes it:

“Under the proposed rule change, which is subject to SEC approval, there will be two new classes of market participants on the New York Stock Exchange and NYSE Amex:
Retail Liquidity Providers (RLPs), which would be required to provide potential price improvement for Retail Orders in the form of non-displayed interest that is better than the best protected bid or the best protected offer (PBBO). Similar to our other dedicated liquidity provider programs, RLPs would receive certain economic benefits in exchange for meeting performance obligations”

When we first read about this proposal, we immediately thought it was contradictory to what NYSE has said about internalization and price discovery in the past. So, we went back and dug up a few old NYSE comment letters. In a comment letter to the SEC on its Concept Release dated April 23, 2010, NYSE stated: Read NYSE comment letter here

“When information concerning trading interest is excluded from the public quote stream, the quality of the price discovery process can be affected...Dark pools and other off-exchange trading venues are attracting a significant volume of advantageous marketable order flow away from displayed markets and exchanges, thus increasing the toxicity of order flow on Exchanges. The continued fracturing of liquidity has the potential to further limit order interaction, decrease liquidity, increase short-term volatility, and compromise the quality of the price discovery process.”

In a comment letter dated December 2010 regarding a Direct Edge proposal, NYSE stated: Read comment letter here

“Separately, we reiterate our concerns about the broader growth trend for liquidity that does not participate in the price discovery process, of which flash orders are a component. Over the past four years, there has been a dramatic increase in the level of activity that is reported to the FINRA Trade Reporting Facility (TRF) almost tripling in some cases, with absolute values in excess of 40% in many small-cap names…In addition to concerns about when these increasing levels begin to impact the price discovery process, the increased TRF volume raises concerns about the toxicity levels on the public markets as increasing levels of attractive flows are skimmed from the public markets.””

And then we have the NYSE COO testimony at the SEC Market Structure Roundtable on June 2, 2010: Read testimony here

“We must consider the toxicity levels on exchanges as we continue to filter increasing levels of order flow before accessing public markets, disadvantaging displayed limit orders, the very orders we claim to want to encourage…We should make sure that volume isn’t migrating to the dark for unfair structural reasons or regulatory arbitrage. Existing practices, such as subpenny price improvement should be examined to see whether they violate the spirit if not the specifics of existing regulation.”

Something doesn’t make sense here. We know that the stock transaction business is an extremely competitive business and that exchange margins have been shrinking but why would the NYSE be doing a complete reversal. NYSE has been an outspoken critic of internalization as the title of this article clearly demonstrates  NYSE Vents Over Offboard Trading Are they just giving up now on all of what they have preached in the past few years to try to capture some market share back? Do they honestly think that the SEC will approve a program like this that clearly takes away from the price discovery process?

Or, does the NYSE have an ulterior motive. Could it be that NYSE may actually be hoping that the SEC does not approve this program? Think about that, if they get the SEC to reject this program then they would essentially be getting the SEC to admit that the current broker “internalization” programs are also a problem. Maybe then they could start to get the off-exchange business , which now represents over 1/3 of daily volume, back to the exchanges.

This technique of wanting to get a proposed program not approved would not be unprecedented. Back when Nasdaq proposed “flash” orders in 2009, some suspected that they did this to highlight the practice that a competing exchange was using with the intention of withdrawing the proposal after it received public scrutiny.

Could the NYSE be doing the same here? Is the Retail Liquidity Program really just a “trojan horse” whose true intent is to break up the current broker internalization programs? We hope that this is their intent. And if it is and accomplishes bringing more flow back to the lit exchanges and the public quote then we would be the first to applaud the NYSE. Let’s hope that this is a trojan horse and the SEC rejects this program.

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