Market Structure U.S. Equities

Issue of transparency Exchanges, dark pools, and internalization Differ in pre-trade transparency All have post-trade transparency Exchanges Once trade is executed, it is immediately reported to the consolidated tape, and published Dark pools 15/11/2018

Traditional exchanges Electronic limit order book markets (e.g., NYSE, TSX) Bid and ask prices, size of the orders are posted Buyers and sellers need to “cross” the bid-ask spread for a transaction to take place 15/11/2018

Electronic Communications Networks (ECNs) Example of Alternative Trading Systems (ATSs) Similar to exchanges, but do not provide: Listing services Market surveillance, oversight responsibilities Active in the 1990s, but many have been acquired by exchanges Instinet, now part of NASDAQ Archipelago, now NYSE Arca Today, one major stand-alone ECN left (LavaFlow) < 2% of volume 15/11/2018

US Exchanges, March 2012 Source: CFA Institute Market Structure report 2012 15/11/2018

Dark Pools Registered as ATS for regulatory purposes Lack of pre-trade transparency Orders are not fully displayed to others Different shades of darkness Complete darkness Security, size of order, buy or sell, but no price Orders are matched anonymously Benefits to buyers/sellers of securities Hide information Reduce market impact of the trade 15/11/2018

Dark pools Benefits (cont’d) 16 dark pools in the US as of March 2012 Reduce trading costs - system may cross offsetting customer orders at the midpoint of the nation best bid and offer (NBBO) Can restrict access to certain market participants (e.g., high frequency trading firms)  discriminatory 16 dark pools in the US as of March 2012 Ranking by size: Credit Suisse Crossfinder, Goldman Sachs Sigma X, Knight Link, Getco GETMatched, Barclays LX, Deutsche Bank SuperX, UBS PIN, Morgan Stanely MS Pool......etc. 15/11/2018

Internalization OTC market makers internally execute order flow against their own accounts Account for almost 100% of all retail market order flow (some limit orders may be routed to exchanges) May or may not be related to the retail brokerage firm Large retail brokers have their own OTC market makers Small retail brokers have an order flow agreement with several market makers (who pay the brokers  $0.001 per share) 15/11/2018

Internalization No pre-trade transparency to other market participants Examples: Proportion of market orders in NYSE stocks routed to OTC market makers (in %) Retail Brokerage OTC Market Maker E*Trade Charles Schwab Edward Jones Citigroup Global Markets 5.2 0.1 18.2 Knight capital 8.4 13.4 Citadel 17.1 0.2 30.0 UBS Securities 7.4 99.7 6.1 E*Trade Capital Markets 61.9 32.2 Total 100.0 99.9 Source: CFA Institute Market Structure report 2012 15/11/2018

Internalization “Issue of preferencing” 15/11/2018 Source: CFA Institute Market Structure report 2012 15/11/2018

Transparency Exchanges Dark pools Internalization Pre-trade transparent In the US, account for 2/3 of volume Dark pools Not pre-trade transparent In the US, account for 8-13% of volume Internalization In the US, accounts for 18% of volume Issues: fairness - incentive to provide quotes, speed of price discovery due to fragmentation 15/11/2018

Post-trade transparency Exchanges, dark pools, and internalization Differ in pre-trade transparency All have post-trade transparency Exchanges Once a trade is executed, it is immediately reported to the consolidated tape, and published (real time) Off exchange trades Trades are reported to a Trade Reporting Facility (TRF) through FINRA in the US, IIROC in Canada (within 30 sec) 15/11/2018

Smart order routing example Portfolio manager Investment bank For institutional clients In this example, first to dark pools, then to exchanges Sell 15,000 shares of XYZ Sales and trading Routing logic: Dark pools Exchanges Dark pool 1 5,000 shares available Dark pool 2 5,000 shares available Dark pool 3 3,000 shares available 800 shares 700 shares 500 shares Exchange A Bid size: 2,200 Exchange B Bid size: 1,500 Exchange C Bid size: 800 15/11/2018

Final note According to Regulation ATS, introduced in 1998, if an ATS executes > 5% of the trading volume of a stock, then must provide pre-trade transparency But according to the SEC, this threshold has not been met 15/11/2018