Horses for courses?

Exchanges are beginning to explore a different kind of diversification, involving the segmentation of liquidity into a subset of markets that would be subject to different rules and practices.

So what’s brought the idea of order flow segmentation into the spotlight? 

US stock exchanges have led the way, with recent plans to split up their markets into different services with specific rules that cater for a subset of market participants.

NYSE was the first to do so, filing a plan with the Securities and Exchange Commission that specifically targeted retail order flow. The Big Board’s retail liquidity program finally went live on 1 August after a protracted approval process and enables retail brokers to trade against market making firms that will benefit from cost reductions for providing liquidity.

The practice essentially disintermediates market making firms such as Knight Capital, Citadel, UBS and Citi that have competed for retail business by executing flow at the national best bid and offer or better, often via internalisation.

BATS followed NYSE soon after with similar initiative called the Retail Price Improvement on its BYX Exchange. Speaking to, BATS Global Markets CEO Joe Ratterman suggested that the separation of flow on exchanges would not stop there.

“There is more than retail and 'not retail' when you look at the market,” said Ratterman. “There is retail professional, retail long-term investor, retail active trader, institutional long-term investors, institutional short-term, institutional high frequency, and so on…”

To what extent has the market tried to distinguish between different types of participants before? 

In Europe, Equiduct, a regulated exchange majority-owned by Citadel, targeted retail flow with a model that lets retail brokers forge bilateral relationships with market makers that have an obligation to trade at the consolidated best price calculated across multiple trading venues.

The other classic example is dark pools – initially conceived as a way for brokers to trade a large block of stock on behalf of long-only asset management clients while minimising market impact. A number of models have evolved since dark pools have emerged across the globe – ranging from Liquidnet, a buy-side only crossing network, to sell-side operated venues that offer a more discretionary approach to matching orders in the pursuit of beset execution.

A number of recent initiatives by dark pools in Europe – including by Nasdaq OMX and Turquoise, the multilateral trading facility majority owned by the London Stock Exchange – have attempted to limit participation through the functionality and pricing they offer.

Surely further segmentation of order flow just creates more fragmentation in a market where liquidity is already too dispersed? 

NYSE argues that its plan simply brings a type of flow that was previously traded off-exchange onto public markets, thereby improving price formation. In short, institutions would not have interacted with this flow anyway.

If the trend of segmentation order flow continues, the ‘ecosystem’ of diverse types of liquidity that trading venues crave could be a thing of the past. If market participants don't have a range of flow to interact with, the ability to find matches for orders could diminish further 

On the other hand, many of the buy-side trading desks that now express a preference for dark pools have long complained their needs have been ignored by exchanges in pursuit of high-frequency flow. Exchanges competing for institutional flow might be a welcome change.

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