Last week , the new CEO of BATS, Chris Concannon, sent a letter to members of the trading community laying out his plan for the exchange.  Chris is a seasoned industry veteran who has worked at the SEC, Nasdaq and Virtu Financial and certainly knows his way around the industry.

Chris spent a considerable amount of space in his letter focusing on how the industry can improve liquidity in thinly traded stocks and announced that BATS will file this proposal with the SEC:

“This month, BATS will file a rule with the SEC proposing to no longer offer trading on the BATS markets in thinly traded stocks that maintain a primary listing on other U.S. stock exchanges (Nasdaq and NYSE). Call it the “BATS Exclusive Listing Proposal…Our proposal is designed to facilitate the concentration of liquidity for these securities at the primary listing market with the goal of improving their trading experience.”

Well, we certainly didn’t see this one coming.  By recommending that the some thinly traded stocks only trade on one venue, BATS is basically admitting that the current fragmented stock market has failed these companies.  We admire BATS for admitting this problem and are thrilled that folks are finally proposing market based solutions to the fragmentation issue that has plagued the market for years now.  While a number of industry participants have already welcomed this proposal, we have some questions on the actual details of the proposal.  Let’s look at some specifics from the BATS letter:

“We believe that concentrating displayed liquidity in thinly traded stocks at a single venue will enable market participants to more efficiently form prices, and that one venue also will be better able to innovate their markets specifically for thinly traded stocks (i.e., tick size, auctions, etc.). Obviously, once a stock achieves certain liquidity and trading characteristics, it will graduate into the competitive world of multiple exchange trading. And most importantly, we are NOT advocating for a trade-at rule as part of this proposal as we believe it would be disruptive to the market.​”

​Question #1 – Can a unilateral rule proposal in a fragmented stock market actually work?

While BATS is making this proposal to the SEC, none of the other 8 stock exchanges (BATS has 4 exchanges) or 40 dark pools need to follow their rules.  BATS states:

“Our filing with the SEC will define the characteristics of the thinly traded stocks that we believe deserve Exclusive Listings, and we hope that other markets will be encouraged by this approach and follow our lead for the benefit of issuers and investors.”

While they hope others will follow, only a SEC rule could force all stock exchanges and market centers to comply.

Question #2 – Without a trade-at component, could other market centers that are not stock exchanges still trade the illiquid stocks that are in the proposal?

In other words, the BATS proposal does not deal with the internalization issue.  While we will wait to see all the details of the proposal, the wording in the BATS letter implies that internalizing market makers will still be able to offer meaningless sub-penny price improvement and step ahead of displayed liquidity.

For example, suppose the market for an illiquid stock is $10.00 bid, offered at $10.20.  An investor looking to buy the stock posts a limit order to buy 500 shares and creates a new bid at $10.05.  The market for the stock is now $10.05 bid, offered at $10.20.  Now suppose a retail investor places a market order to sell 500 shares.  An internalizing market maker can step ahead of the lit bid and buy the stock for $10.05001.  In our example, the investor who tightened the spread and added to price discovery was disadvantaged by the internalizing market maker.  The BATS proposal does nothing to rectify this problem.

Question #3 – Is this proposal an attempt to get regulators to back away from the tick size pilot?

BATS has been a vocal opponent of the trade-at component of the tick size pilot program which could be very difficult and potentially expensive for the stock exchanges to implement.    BATS suggested their plan was easy to implement:

“We view this proposal as a non-disruptive modification to U.S. equity market structure that BATS, other exchanges and the industry at large can implement with very little technical impact to the industry and its many participants.​”

The new BATS proposal could potentially save them and other industry participants significant costs if the tick size pilot was scrapped in favor of their new plan

Question #4 – Why didn’t BATS seek to make the proposal a joint effort with the two listings exchanges, NYSE and NASDAQ?

According to a WSJ interview “the CEO (Concannon) said he hadn’t sought out opinions on the proposal from NYSE President Tom Farley or Nasdaq CEO Robert Greifeld because he wanted the idea to be debated publicly.”  

Seems kind of strange to us.  We think the proposal would have carried a lot more weight had it been a coordinated effort from all the stock exchanges.

While we are very happy to see a major exchange finally admit that there are serious problems with fragmentation, we will reserve final judgement on the BATS proposal until after we have read the entire plan once it’s filed with the SEC.  But upon first glance, we think there are some questions that need to be addressed.