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December 2, 2013

Magic Number

How much is too much? Industry officials are starting to worry that the increase in off-board trading will lead to a deterioration in the quality of the U.S. stock market.


Peter Chapman

Is there a magic number?

As the amount of trading done away from the public markets has surged in the past year to record highs, industry officials are starting to worry the trend will lead to deterioration in the quality of the U.S. stock market.

With fewer shares being bid for on the nation's stock exchanges, the validity of the market's best prices could be called into question. In the argot of stock traders, "price discovery" may be compromised.

Joe Gawronski

"We need to look at what is happening," Joe Gawronski, president and chief operation officer at Rosenblatt Securities, told the crowd at the Investment Company Institute's annual market structure conference this year. "Off-exchange trading hit 38 percent in September. That is a big number. It's a dramatic increase since 2008. A record."

In early 2009, off-exchange trading accounted for 21 percent of total volume, according to a report published last year by CFA Institute. Last fall, it stood at 33 percent. As Traders Magazine was going to press, it was 38 percent. Nobody knows for certain what's driving the surge. Nor does the industry agree on whether there exists some magic number that will trigger a deterioration in overall market quality.

"I have to disagree with anybody who says that 30 percent or 40 percent or whatever can't be good," Gregg Berman, an associate director in the Securities and Exchange Commission's Division of Trading and Markets, said at the ICI gathering. "Why can't it be a good number? What's wrong with having 30 percent or 40 percent? We need to know what the actual effect is that people care about, such as price discovery or market quality."

If the number is not 40 percent, then maybe it's 50 percent. At that level, a study conducted by CFA Institute last year concluded, bid-ask spreads start to widen and market quality deteriorates. "If the majority of order flow is filled away from pre-trade transparent markets, investors could withdraw quotes because of the reduced likelihood of those orders being filled," the report noted. "As investors become dis-incentivized from displaying orders, bid-offer spreads are likely to widen."

Most off-board trading is conducted by institutional brokers matching orders in alternative trading systems-such as dark pools-or wholesalers making markets for retail brokers. A lesser amount is traded in ECNs or over the telephone.

There is little difference in the rates of off-exchange trading among small-, mid- and large-capitalization stocks, according to CFA Institute. The group's study did note, however, that dealers internalized a much higher proportion of small caps than mid or large caps. CFA Institute attributed that to the wider spreads of small caps and thus fatter dealer profits. By contrast, the study noted that dark pools matched a smaller percentage of small-cap names than mid or large caps.