Sub-penny Pricing Undermines Public Markets, Report Asserts
November 19, 2012
A global group of investment professionals Monday raised concerns that the “incentive to display orders in public markets is being undermined” by off-exchange practices, such as sub-penny pricing.
The CFA Institute, based in London, said in a report that brokers’ internal pools of orders now represent roughly 18% of consolidated volume in the United States. More directly, the institute said such internalization – where there is no pre-trade pricing posted -- likely now handles nearly 100% of all retail order flow.
Sub-penny trading, according to the report authored by Rhodri Preece, the director of capital markets policy at the CFA, affects the ability of public markets to form prices by filling retail orders in the dark, before public limit orders come into play.
The sub-penny pricing allows over-the-counter market makers to fill retail orders ahead of displayed orders, by offering price improvements in fractions of a penny, Preece noted.
And the process has now been indirectly endorsed by an operator of lit exchanges. The New York Stock Exchange’s
Retail Liquidity Program, approved in July by the Securities and Exchange Commission, executes retail orders sent to the exchange against undisplayed retail price improvement orders residing within the exchange system.
“The Retail Liquidity Program is akin to internalization in that retail orders will largely not interact with displayed orders within the limit order book of the exchange,’’ the Preece report says.
Dark trading in March accounted for about 31% of consolidated volume in the United States, the CFA Institute said. That amounted by its estimate to growth of 48%, since the start of 2009.
That mirrors the estimate of Tabb Group, the New York consulting firm, that roughly 30% to 33% of market volume is now handled by dark pools and internal pools of orders. At an institutional equities event last week in New York, namesake founder Larry Tabb said the question is whether, should this reach 50%, “do public markets break down?’’
Equity trading in the United States is now “dispersec across” 13 national exchanges, roughly 16 reporting dark pools, one electronic communications network (LavaFlow), approximately 16 reporting dark pools, and “more than 200 broker/dealers who internalize order flow,’’ the CFA Institute said.