A Long-Term Trend
A high level of transparency is one of the great strengths of U.S. equity markets. Transparency in our markets is heavily dependent on the use of displayed bid and offer prices by exchanges. Only exchanges are required to provide this level of transparency, and only exchanges now do so. But the proportion of market activity occurring on exchanges and resulting from displayed prices, also called “lit trading,” has been steadily eroding for many years. This trend accelerated in 2020, as a wave of new retail investors, whose orders are typically handled off-exchange, entered the market. In 2012, non-exchange market centers accounted for about 31% of overall share volume. In the first three quarters of this year, that percentage was nearly 44%, and for many stocks, on a daily basis, it consistently exceeds 50%.
As one prominent money manager recently put it, we live “in a trading environment that has increasingly gone dark.”
Why It Matters: The Need for a Public Square
The overall level of exchange trading matters because of the unique role exchanges play. Unlike other venues, exchanges are required to be accessible to everyone, on terms that are fair and meet strict regulatory standards. Because of that distinction, they have the potential to draw together the deepest and most diverse possible pool of participants, whose orders can interact with each other. In this respect, exchanges have the ability to serve as a type of public square for the markets, and they have the potential (as yet unrealized) to level the playing field for the benefit of all investors. Other venues provide important benefits, but they are not designed to achieve that purpose.
What You See Is What You Get
Lit trading, or pre-trade transparency, matters because market participants rely on it for a wealth of real-time information – not just the “best” bids and offers, but also data on the depth and intensity of buy and sell interest and the direction and volatility of prices. Traders rely on this process of price discovery to make trading decisions, value positions, calculate index values, set trading risk limits, and more.
Transparency is also critically important to investors. Professional traders have ways of locating non-displayed orders that offer prices better than those quoted, but investors’ understanding of the market is limited to what they can see. Also, the best quoted prices – the “national best bid and offer” – set the boundaries for the prices investors can expect to receive. For example, when the best displayed offer price for AMC is $55.20, a retail investor who wants to buy AMC will look to that price as the outer limit of what she should pay. She may also consider the best bid price. If it is $55.00, the twenty-cent spread between the best bid and offer will inform her and her broker about how much price improvement she should expect to obtain. At a 20-cent spread, she might be willing to pay $55.19. If the spread is instead one dollar, the same one cent “price improvement” looks much less appealing.
It stands to reason that if more participants contribute more displayed orders, the calculation of the best bid-offer prices and spreads can improve. Our AMC investor might instead see a “better best offer” of $55.15 and a narrower bid-offer spread. More important, she would benefit from the difference whether her order is sent to an exchange or anywhere else, because her broker would be required to use the better price in meeting its obligation to deliver “best execution” for her order. The same potential benefit would apply to all stocks and all investors, big and small, wherever they trade.
Where is the Tipping Point?
It is easy enough to see that less lit trading could have ripple effects that undermine the efficiency of the price discovery process and other aspects of market quality, and various academic studies have looked at this linkage. One study by the CFA Institute in 2014 (when the overall proportion of dark volume was much lower than today) concluded that dark trading at lower levels can be beneficial, but that these benefits disappear and the effects can become negative at the point when non-displayed volume exceeds around 43% of the total. It is worth noting that in recent years, some measures of market quality – the spreads between the best bid and offer prices and the size of displayed shares available at those prices – have clearly worsened.
There is no simple answer to the question of when the erosion of lit trading may start to seriously harm price discovery and market efficiency, and the impact might not be clear until after the tipping point has been reached. But we are living that experiment today, and even if the tail is not yet wagging the dog, it is clear that the equity markets have grown a very muscular tail.
What Are the Causes?
The causes for the trend are no doubt complicated, but feedback from institutional investors and many of their brokers coalesces around two themes, which are related: lit trading is generally toxic, and it’s too expensive.
A Tale of Makers and Takers
Healthy lit trading requires substantial participation by a diverse set of firms trading for themselves and for investors that “make liquidity” by sending displayed orders, and also that “take liquidity” by sending orders to execute trades with the makers (many firms do both). Displayed trading is sometimes said to be toxic because makers disproportionately lose money to takers. This occurs because some takers are able to use the most sophisticated and fastest technology and market data to time their lit trades in moments when prices are moving in their favor and against the displayed quote. The losses from these “latency arbitrage strategies” are systematic and result in a well-documented “liquidity tax” on displayed orders. In fact, it is precisely this toxicity that has driven many institutional investors to seek out dark trading venues where they are less exposed to such strategies.
To incentivize makers, the largest exchanges pay rebates to brokers when their displayed quotes execute. But those payments don’t reduce the toxicity, they just seek to compensate for it. They also greatly increase market complexity, with literally hundreds of pricing combinations that can change each month. And because rebates are paid under a tier system tied to the total market volume traded by each firm, the compensation is heavily skewed in favor of a relatively small number of firms that can qualify for the highest value tiers. As a result, the number and diversity of firms willing to send displayed orders is constricted.
At the same time, taking liquidity is usually costly because the biggest exchanges charge high fees (the highest rate allowed by the SEC) to trade with displayed quotes. The high take fees are needed to subsidize the maker rebates, which inhibits competition to lower the fees. The profits from latency arbitrage strategies can easily outweigh those costs, but that doesn’t help the majority of firms that don’t use those strategies. As a result, the orders to take liquidity tend to be more toxic, which limits who is willing to post displayed quotes and reinforces the use of rebates to attract them.
And There are Other Costs
In addition to these costs tied to individual trades, most exchanges (not IEX Exchange) impose unreasonably high charges for proprietary market data and technology that brokers and traders need to efficiently access exchange systems and manage the risks inherent in extremely fast computer-based trading. Those exchanges have a built-in competitive advantage over other vendors in selling these products, because they are the source of the data and control the access. As IEX has detailed, as these costs have increased, the number of exchange member firms has declined, further reducing the firms that are available to send displayed orders. Exchanges have relied on these subscription fees to maintain their profit margins, even as the proportion of displayed liquidity available in the markets has declined.
What Can Be Done?
Increasing the level of lit trading depends on changing the incentives that have driven it away. That requires action by both regulators and exchanges to reduce toxicity and other costs.
Action by the SEC
Action by the SEC is needed to interrupt the self-reinforcing price dynamics that inhibit lit trading. The SEC should renew its efforts to take on the maker-taker pricing system to correct the distortions it causes. If rebates are removed or slashed, competitive forces will substantially reduce take fees. With lower take fees, the number and type of firms taking displayed quotes can expand. And if displayed orders can interact with more “non-toxic” taking orders, the economics for displaying will also improve, encouraging new sources of displayed orders.
The SEC can also help by keeping up its constructive efforts during the last few years to blunt rising costs of exchange market data. These include rejecting fee increases that are not clearly explained and justified, as well as acting to promote competition for the sale of market data.
But regulatory action won’t be enough. Exchanges need the flexibility to find new ways of encouraging healthy displayed liquidity, and they need to use that flexibility. IEX Exchange’s development efforts during the last two years have been focused on doing just that. Last Fall, we introduced our D-Limit order type, which helps protect displayed orders by automatically repricing them in those moments market prices are unstable and IEX’s technology detects they are at high risk of losing to latency arbitrage strategies. IEX has published extensive data showing the positive impact of this new order type in increasing both the amount and quality of displayed trading on IEX, for both makers and takers.
IEX is also changing its program geared to retail orders to provide better opportunities to retail investors while increasing transparency. Retail orders, by their nature, are viewed as non-toxic, and for that reason many participants are willing to trade with them at improved prices. The IEX program, just launched, now allows anyone to post “Retail Liquidity Provider,” or RLP, orders available to trade with incoming retail orders at the midpoint of the best displayed bid and offer prices. Midpoint prices are generally viewed as representing the optimal amount of price improvement for both buyer and seller. An important feature of the program is that IEX disseminates to the market a transparency indicator showing when there are RLP orders for at least 100 shares of a given stock. This feature can help retail investors and their brokers identify better price opportunities, and it provides new pre-trade transparency about orders that are willing to trade at the midpoint. As the SEC said in approving the changes, this additional transparency will provide information that brokers can be expected to use in assessing the best prices that are available for their customers.
Away from IEX, one of the Cboe exchanges is introducing a program for intra-day periodic auctions, similar to the auctions that some markets conduct at the beginning and close of the trading day. This option could help investors find liquidity in less-liquid and harder-to-trade stocks, and it will provide a new way for orders to interact that adds to transparency because the exchange will disseminate real-time price information about orders in each auction.
Units of Display
Changes to the units that affect how orders and prices are displayed would help at the margins. For example, the public consolidated data feeds show a best bid or offer only when there are orders available at that price totaling at least one “round lot,” which is almost always defined as 100 shares. The round lot concept is also used to determine which quotes are “protected,” meaning trades can’t occur off-exchange at worse prices than those displayed.
The 100-share round lot convention made sense at one time, much less so today when there are many high-priced stocks and a high percentage of quotes and trades occurring in amounts less than 100 shares. Last year, the SEC mandated that markets move to four new round lot categories, using smaller round lot sizes for higher-priced shares. It also required wider disclosure of “odd-lot” quotes, which today are sent only to subscribers of data feeds sold by individual markets. Both of these enhancements will improve transparency in a way that better reflects modern market conditions, but they are not due to be completed for several years. The exchanges can and should initiate action on their own to accelerate these overdue changes to the price information markets must disclose.
Another idea now being promoted is to give exchanges more flexibility by reducing the minimum price increment, or “tick,” used for displayed quotes, which is now set at one cent for most stocks. One proposal, to reduce the tick size to one-hundredth of a cent – makes little sense. Increasing the number of price points to that extent would create a lot more complexity and drive firms to compete even more on speed of quoting rather than improved prices. And any change to tick sizes would not do much to bolster lit trading because it would do nothing to address the fundamental problems of toxicity and cost that have driven participants away from public markets.
Seeking the Right Balance
Healthy capital markets need to offer plenty of alternative venues where orders can trade. They also need to offer the opportunity and incentive for orders from all types of investors, traders, and brokers to come together, with a high level of transparency that benefits all participants. Perhaps there is no perfect balance between these two objectives, but there is clear evidence that the pendulum has moved dangerously away from the second one. The reasons for that are structural and embedded, and the problem will not fix itself. Finding a better balance will require concerted effort and commitment to preserve the public square and turn up the lights.
 CFA Institute, “Dark Pools, Internalization, and Equity Market Quality” (October 2012), at 14 (“CFA Study”).
 NYSE TAQ Data.
 Letter from Joseph Scafidi and Carlos Oliveira, Brandes Investment Partners, L.P., to Vanessa Countryman, Secretary, SEC (February 28, 2020) (commenting in support of IEX Exchange's D-Limit order type).
 See, e.g., Hatheway, Kwan, and Zheng, “An Empirical Analysis of Market Segmentation on U.S. Equity Markets,” Journal of Quantitative and Financial Analysis (2017).
 CFA Study, at 56-59.
 See, e.g., Wall Street Journal, “Buying or Selling Stocks? It Isn’t Always Easy” (January 2, 2020).
 See, e.g., Budish, Aquilina, and O’Neill, “Quantifying the High-Frequency Trading ‘Arms Race’” (June 2021), avail. at https://faculty.chicagobooth.edu/eric.budish/research/Quantifying-HFT-Races.pdf.
 IEX Exchange, “IEX is ‘All In’ on Pricing Transparency” (February 14, 2019).
 IEX Exchange, “The Rising Tide of Broker Costs, and the Shrinking Pool of Competitors” (June 8, 2021).
 IEX Exchange, “D-Limit: One Year In” (October 4, 2021).
 See Securities Exchange Act Release No. 92398 (July 13, 2021), 86 FR 38166 (July 19, 2021).