Direct Edge's ELP Program Causing Market Brouhaha
Competitors criticize Enhanced Liquidity Provider program
May 18, 2009
With its execution volume increasing, Direct Edge's three-year-old program that flashes orders to a private network of broker-dealers before routing them to other quoting markets, is generating calls for regulatory review of the practice as well as the broader notion of dark liquidity.
Direct Edge filed an official application May 7 to convert its two electronic communications networks, EDGX and EDGA, to full-fledged equities exchanges. This was preceded by months of discussion with Securities and Exchange Commission staff to tailor the proposal, which includes the ECNs' Enhanced Liquidity Provider mechanism for flashing to its broker-dealer network, to meet the stricter regulatory requirements for exchanges. Direct Edge's filing indicates approval is likely, arousing criticism from competitors who believe the pre-order routing system may violate regulations.
The ELP program, launched in spring 2006, briefly flashes orders that can't be filled on Direct Edge's ECNs to 25 broker-dealers, giving them the opportunity to execute the orders before they are routed to other quote-displaying markets.
Direct Edge's rapid growth may also be fanning the flames. For April, Direct Edge announced that it handled a record 2.13 billion shares, a 273 percent increase from a year earlier. About 162 million shares were executed in the ELP program, nearly four times the volume from a year ago.
Direct Edge's ELP program, which has prompted at least one other exchange to introduce similar functionality, is one form of dark liquidity, in which orders are matched without displaying both bids and offers. The rapid increase of electronic venues to execute orders in the dark has prompted concern from some market participants.
"The volume of dark liquidity has grown very quickly and could result in a two-tiered market, where some participants are getting information that others aren't," said Joe Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext, adding, "There are a lot of inconsistent practices between the exchanges and (automated trading systems), and we'd expect at some point that the regulators will aim for a more equal playing field."
From a competitive standpoint, the ELP program has enabled Direct Edge to subsidize very aggressive pricing on its ECNs. It does not charge the ELPs for trade executions while charging providers of orders arriving from the ECNs between $0.001 and $0.002 per share--several times the spread of its own displayed market and competitors'. In turn, it has used that revenue to increase its ECNs' liquidity provider rebates that competitors can't match. "We're able to capture premiums in certain parts of our business that help us compete in more commoditized areas," said William O'Brien, CEO of Direct Edge.
Partly as a result, Direct Edge's market share in April leaped to 19 percent and 12.54 percent of handled and matched market share, respectively, up from 13.49 percent and 7.90 percent in January. So far in May, its execution volumes have been at record levels.
That success prompted Nasdaq to seek approval May 6 to offer a similar pre-routing display orders, and BATS Exchange is also weighing the option.
The tiny CBOE Stock Exchange launched in early 2007 with regulatory approval for similar functionality.
Brian Hyndman, senior vice president of transactions services at Nasdaq, said its pre-routing of display orders will be available June 1. Pricing will be determined soon, he said.
