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Slicing the Liquidity Pie

Traders Magazine Online News, February 12, 2019

Phil Mackintosh

We recently discussed all the routing choices an algorithm has to make to place an order into the market—picking the right price, time, order type, venue, and order aggression. Today we focus on just one aspect of those choices: the venues the router can send orders to. Let's bust a few myths at the same time.

The U.S. market trades over 7 billion shares a day, adding up to about $70 trillion in notional value each year. But most of the volume trades away from the primary exchange chosen by each issuer, and more than one-third trades “off-exchange,” on an ATS.

The 13 exchanges, and more than 30 active ATSs and significant bilateral trading, as the chart of liquidity below shows. It’s no surprise one of the most common complaints about U.S. market structure is “too much fragmentation.”

Chart 1: The distribution of liquidity in the US market

Source: Nasdaq Economic Research, SIP data, FINRA ATS data (for Oct-Nov 2018)

Three different flow interaction models

Exchanges are regulated under the Securities Exchange Act of 1934. One of the founding principles of exchange operation is they must offer fair and equal access to all participants. Exchanges also tend to be the only venues with published lit quotes that advertise liquidity for everyone to see and trade.

Those lit quotes are important to the whole market. Despite all the different exchange venues, the SIP (Securities Information Processor) combines all quotes and provides an NBBO (National Best Bid and Offer). The NBBO allows everyone to know the best bid and offer regardless of what venue they are posted on, all less than a millisecond (one-thousandth of a second) after the quotes change. No other industry can claim to have the same, market-wide, fair and equal pricing for their customers.

More than one third of trading is off-exchange

Off-exchange volume adds to more than one third of all the liquidity in U.S. markets. That’s more than 2 billion shares a day. However it is not all dark pools, as we discuss below.

It’s rare for an off-exchange venue to contribute quotes to the NBBO, but all the trades done still need to report to the SIP for everyone to see. Because these trades are coming from broker dealers directly, they need to first pass through an official Trade Report Facility (TRF).

TRF trades don’t disclose the venue that handles each trade, but recent reporting enhancements (see “Where did this data come from?” below) require brokers to report aggregated trading to FINRA on a two-week lag. Using this data we are able to see the breakdown of the TRF in more detail—and we see that:

  • Just one-third of off-exchange is Dark Pools (ATSs)

This is one of the common myths of Equity markets. In fact the 30-plus dark pools combined make up around 12% of ADV, and just over one third of the TRF.

For more information on related topics, visit the following channels:

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