Discrimination Platforms.

AuthorHaeberle, Kevin S.
PositionWhat Happens in the Dark: An Exploration of Dark Pools and High Frequency Trading
  1. INTRODUCTION II. THE MAIN TRADING PLATFORMS TODAY A. Exchange Trading Platforms B. Off-Exchange Trading Platforms 1. Alternative Trading Systems 2. Internalizing Trading Platforms III. TRANSPARENCY A. Exchange Trading Platforms 1. Transaction Transparency 2. Quote Transparency B. Off-Exchange Trading Platforms 1. Alternative Trading Systems a. Transaction Transparency b. Quote Transparency 2. Internalizing Trading Platforms a. Transaction Transparency b. Quote Transparency I. INTRODUCTION

    Since its emergence over the past ten to fifteen years or so, the new stock market has generated much controversy. (2) During that time, fact-based analysis and coverage of market regulation and practices have often been outnumbered by fiction. The experience to date with respect to the distinction between exchange and off-exchange trading transparency serves as a prime example of the disconnect between description and fact. As with so many aspects of stock trading, when it comes to this one, exchanges are put up on a pedestal, and off-exchange platforms demonized. The former are the model for the ideal of the upright marketplace, the latter a symbol of the underworld of unchecked capitalism. (3) But in reality, exchanges are far less transparent than thought, and off-exchange platforms the opposite.

    This Article debunks much of the transparency distinction, and attempts to shift the regulatory, scholarly, and popular focus toward a clear-cut distinction that has received far less attention. This other distinction relates to trader access. The law allows off-exchange platforms to discriminate among traders, while requiring exchanges to remain open to all. This access distinction, the Article argues, matters for two core concerns of modern securities regulation: investor protection and stock-price accuracy. (4) I therefore conclude by calling for the access distinction to be removed from the transparency-focused blind spot. In particular, I call for additional study by commentators and policymakers, with a focus on the precise nature of the segmentation of the stock market by investor type that is taking place due to the access rules.

    The new stock market is complex, with trading of most individual public stocks occurring across about a dozen exchanges and well over a hundred off-exchange platforms. AT&T stock is no longer predominantly traded on the floor of the New York Stock Exchange. Instead, it is bought and sold through about a dozen electronic exchanges, 50 or so alternative trading systems (ATSs), and an even larger number of internalizing platforms.

    Regulatory distinctions among these various trading platforms add to the complexity. The most widely noted distinction relates to the transparency of exchanges versus the opaqueness of ATSs and internalizing platforms. The latter two--the off-exchange platforms--are said to compose the "dark" part of the American stock market, the former the light one. But as I show, these labels are overbroad, if not wrong altogether.

    All the while, the trader-access distinction has received little attention. Yet, off-exchange platforms have been using their discretion over access to target certain traders and exclude others. Strikingly, internalizing platforms have been able to garner nearly 100% of the orders of individual, retail-level investors seeking to buy and sell stock on demand, while blocking out institutional investors such as investment funds. At the same time, ATSs target index-based institutional investors and often exclude certain high-speed traders. Taken together, the trading attributable to these two types of discrimination platforms adds up to compose almost 40% of all trading volume. (5)

    Unlike the hyped transparency distinction, the access one clearly matters for the traditional ends of securities law. In particular, it raises an investor-protection concern as well as a price-accuracy one.

    With respect to the former, internalizing platforms that target ordinary, individual investors and block out institutional ones essentially execute investor orders at prices that match the best ones contemporaneously quoted on exchanges. However, the exchange environment that generates those quoted prices is very different than the off-exchange one through which those orders are executing. Indeed, the different trading environments at exchanges and off-exchange platforms are traceable to the very targeting and excluding in focus. In short, the diversion of uninformed traders to internalizing platforms results in an exchange trading environment with a higher ratio of informed traders to uninformed ones than it would otherwise have--and that ratio matters for the quality of prices investors receive. For this reason, ordinary investors may be paying too much when buying shares, and receiving too little when selling them.

    The price-accuracy concern is closely related. The altered exchange environment that results from a market in which off-exchange platforms can target and exclude while exchanges must accept all comers matters for fundamental-value traders. As the nomenclature suggest, those traders produce (or pay others to produce) information about firms' fundamental values. They then profit by buying underpriced stocks, and selling overpriced ones. This trading is valuable, as it impounds important information into market prices--prices that, in turn, guide the allocation of scarce resources in capitalist economy. However, as I explain, the exchange trading environment that results from a market in which off-exchange platforms can siphon off certain types of traders makes fundamental value trading less profitable. In the end, those traders' incentive to generate information and impound it into market prices is reduced--likely resulting in a broad reduction to price accuracy across the entire market.

    The remainder of this Article tells the fuller story of transparency and access in the new stock market, step by step. In particular, Part II provides background on each of the main types of trading platforms in the market. Part III then examines the extent to which they differ in terms of trading transparency--upending much conventional wisdom on the nature and scope of the transparency distinction. Next, Part IV surveys the underappreciated distinction relating to the extent to which market participants can access the main types of trading platforms. Finally, Part V thinks about the policy implications of this close look at the market and the regulatory framework that governs it. In so doing, it argues that the access distinction presents the considerable investor-protection and price-accuracy issues introduced above. Ultimately, I conclude that much of the focus on the transparency distinction should be reallocated toward an access one.

  2. THE MAIN TRADING PLATFORMS TODAY

    In the United States today, the overwhelming majority of all stock trading takes place through sophisticated, electronic trading platforms. These platforms generally fall into one of two main types, exchange and off-exchange. In this Part, I provide a quick overview of each.

    1. Exchange Trading Platforms

      Stock exchanges are familiar entities. For many, so too is the requirement that these entities register with the SEC as "national securities exchanges," (6) thereby subjecting them to both increased regulatory burdens and advantages. But despite images of vibrant trading floors of days past, for some time now, exchanges have been little more than electronic trading systems. (7) More specifically, exchanges operate continuous-auction systems in which some traders (liquidity-providing ones) post bid and ask price quotes to electronic limit order books, and other traders (liquidity-taking ones) transact against them. The price quotes are entered in the form of non-marketable limit orders. Those firm quotes sit in the electronic trading system until they are executed against or removed. The predecessor to these systems was a hand-written book in which the orders sat--thus the current term electronic limit order book.

      Importantly, bid quotes posted to exchanges constitute legally binding offers against which any trader can sell stock, and ask ones are similarly firm offers opposite which any trader can buy stock. For this reason, exchange transactions occur whenever a liquidity-taking trader agrees to the price and quantity terms associated with a liquidity-providing trader's bid or ask quote. For example, if the best (lowest) ask quote posted to an exchange for a stock is $10.52, then a trader may buy the stock in return for that price on demand. Likewise, if the best (highest) bid quote for the same stock is $10.48, then a trader may swap shares for that amount immediately with certainty.

      Importantly, exchange trading revolves around much more than just these best asks and bids. Liquidity providers will not hold out legally binding offers for an endless quantity of shares at those prices. Instead, they will post only so many shares at those "inside spread" (9) prices, and then quote successively inferior ones. From the perspective of a liquidity-taking trader, buying a large number of shares through an exchange therefore often means having to pay a series of prices, with some overall average price tag associated with the lot. In the above example, a buyer may pick up, say, 3 00 shares at the best (lowest) ask price $10.52, another 250 at the next best price of $10.53, and so on. Liquidity-taking selling of course involves the mirror image of this situation.

      Inherent in these descriptions and examples is that traders often must pay more than a stock's current market value to purchase it through an exchange, and receive less than that value to sell it through the same. From their perspective, the facilitation of trading activity provided by exchanges is far from free, as in addition to whatever intermediation fee the exchange might charge there is thus a cost associated with the bid-ask spread. This...

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