Take a look at the following chart closely. It was prepared by Eric Hunsader at Nanex, who shared it with us. We will focus on the moving averages in it (bold blue and red lines) for the purposes of this note.
First, the chart demonstrates (the blue line) that daily volumes in the market have exploded since the implementation of Reg. NMS, from a level of perhaps 3.5 -4.0 billion shares in 2007, to about 9 billion shares during the financial crisis, and back down to the roughly 5 billion shares we see today. You’ve seen that part of the chart before, we’re sure.
Second, it also demonstrates (the red line) that daily volumes in sub-penny trades have also exploded since the implementation of Reg NMS, from about 200 million shares in 2007, to a peak of 1 billion shares around the time of the Flash Crash, and only slightly reverting back to 800 million shares in today’s trading environment.
What’s the point? Simply that all internalization is a much greater portion of market volume today than it ever has been. While market volumes have fallen about 50%, sub-penny volume has only fallen about 20%. Why did the two volumes decouple? What has changed? Why would sub-penny volumes not revert back along with market volumes in general?
We think we know why. HFT market makers, through their relationships with stock exchanges as well as the dark pools, have invented and innovated new ways to touch your orders. Since 2009 market participants have been introduced to all kinds of variations of the Flash Order, which you may remember as being initially introduced by the Direct Edge exchange, and followed shortly thereafter by the other stock exchanges. In addition recently more and more dark pools have increasingly communicated among themselves via variants of flash order types (Ping-For-A-Fill (PFAF), actionable IOIs, conditional orders, and the like). All of the “innovations” introduced in the last three years have resulted in ways for the increasing number of intermediaries to cherry pick through your orders (institutional and retail), and take the other side of the ones that will give them short-term alpha.
If you really want to get dizzy with the chart, then look at the spikes around recent times of stress (Flash Crash, US Debt Downgrade, etc.) Boy, don’t they especially love to internalize your order flow during those periods? The growth in the practice of internalization has not been good for the integrity and fairness of our markets. Having your orders cherry picked through and financially modeled by HFT market makers who then extract short-term alpha has hurt you all.
When defenders of our modern market structure talk about how great competition is, and how great the innovations they bring about are, know that those are not benefits for you. They are benefits for them. This chart is the proof.