The SDPs Are Coming

Last week, Barclays announced that they will be launching a new single-dealer platform (SDP) known as BARX Book for Equities which will be trading US equities.  While many SDPs already exist in Europe and some market makers operate their own SDPs in the US, the Barclays SDP appears to be the first SDP launched by a bank in the US. According to Barclays:

“BARX Book for Equities represents a new chapter in Barclays’ client liquidity strategy, as it allows more ways for clients to access the firm’s principal liquidity during regular market hours. Clients will be able to access BARX Book through a number of new order types and through the new BARX Book algo strategy.”

We have a number of questions/concerns about this announcement.

What’s an SDP?

An SDP is not an exchange and it is not an ATS. Rather, SDPs have been defined as portals by which traders are granted access to prices from one dealer. They are very common in the FX world and started to appear in equities after the implementation of MiFid II.  You are probably already trading with some SDPs since most market makers operate one in the US. 

Who currently operates SDPs in the US?

As you would expect, the biggest SDPs are run by the big market makers. Here are a few links from some of these market makers describing their SDPs:

Citadel – “Citadel Connect, our innovative Immediate-or-Cancel order (IOC) platform, is one of the fastest growing sources of off-exchange liquidity in the U.S. equities market, providing access to our principal liquidity for 8,000 exchange-listed securities.”

Virtu – “VEQ Link is a single dealer platform offered by Virtu Americas LLC (“VAL”) and is not an alternative trading system as defined in applicable SEC Rules.”

Jane Street  – “Launched in 2014, JX is an efficient, cutting-edge system that allows clients to access our proprietary liquidity.”

IMC – “The IMC Single Dealer Platform (SDP) is an expansion of our equities & ETF market making business and is a way for broker dealers to access our unique liquidity directly.”

HRT -“HRT operates a single dealer platform that provides access to HRT’s unique principal liquidity in US equities and exchange traded funds.”

As you can see, the common theme is the principal liquidity that the SDP provides. 

Are SDPs regulated like exchanges or ATSs?

The short answer is no. According to a 2018 SEC comment letter from Virtu,”the Commission specifically provided for an exemption from the definition of Exchange to exclude automated systems of dealers, i.e. market makers and other dealers, whose systems matched orders as an incidental part of the operation of the system”. In other words, SDPs do not have any special regulations but rather are overseen by FINRA and the SEC just like any other broker. 

How do IOIs work on SDPs?

This depends on the SDP.  For example, Virtu states “We do provide a liquidity filter (aka IOI) indicating VAL’s potential trading interest to customers who integrate this data into their router via FIX message as a source of market data. Unlike institutional IOIs which advertise customer orders, no client order information is ever shared because VAL is always on the other side of the trade. As a result, this liquidity filter is an indication of VAL’s principal trading interest and is used by client routers to make their order routing more efficient.”

Basically, the SDP will indicate when they would like to trade a security. But it’s important to note that these IOIs are not firm. Virtu specifically states “Please note, our trading interest may change following transmission of an IOI; these IOIs are not quotes and VAL does not guarantee an execution.”

Why are banks getting into the SDP market? Are they trying to get a bigger piece of market making pie?

In addition to Barclays, Deutsche Bank indicated last year that they were rolling out their own SDP for US equities. We don’t think banks like Barclays and Deutsche bank are interested in competing in the market making space against firms like Citadel and Virtu.  More likely these banks see the SDPs as lightly regulated vehicles that could help them manage their own overall risk. In other words, these vehicles will be “liquidity providers” when the banks see fit and want to off-load risk but should not be counted on to provide liquidity at all times.

Our concerns

Fragmentation – The trend towards SDPs could further fragment the liquidity in the US equity market. We already have 16 stock exchanges, over 30 ATSs and handful of market maker SDPs, do we really need the banks to further fragment liquidity? Will these new SDPs further reduce visible liquidity? Are these SDPs free riding off of the public quote without contributing to the diversity of the limit order book?

Regulation/Fairness – SDPs are not required to maintain a market and can cease operating their SDP any time they see fit.  They are not covered by Reg ATS or Reg SCI and are limited to normal broker/dealer regulation. This lack of regulation for SDPs raises concerns about what they can and can not do. For example, can they give their better clients a first look at their IOIs? Will clients who have a bigger research budget with a particular SDP receive preferential treatment? Will there be a “liquidity profiling” system (like some ATSs currently have) which distinguishes who they want to interact with?  Will they back away from orders that respond to their IOIs? 

Before an onslaught of new bank SDPs hit the US market, we think the SEC should take a closer look at them and decide whether or not they should fall under Reg ATS or possibly create a new regulation specifically designed to deal with SDPs.  One of the objectives of Section 11A of the Exchange Act was for “an opportunity, consistent with economic efficiency and best execution, for investor orders to meet without the participation of a dealer.” The concept of an SDP does exactly the opposite of this objective.