Retail trading practices in the US are undermining displayed market quality, with a new study suggesting brokers who serve retail flow should offer a greater degree of price improvement.
The new research from the CFA Institute, an association for investment professionals, delved into the impact of dark pools and broker internalisation on market quality.
It found that while broker internalisation can offer benefits to institutional investors – such as a narrowing of spreads and general improvement in market quality – there is a danger the practice could go too far.
In particular, the study focused on the way retail orders are traded in the US. Brokers that serve retail investors currently rely on relationships with market making firms, which aggregate retail flow and trade it against the liquidity they hold internally, typically at a price better than the national best bid or offer (NBBO) displayed on exchanges. Orders are only sent to public markets once all other options have been exhausted.
“There is a danger of market quality deteriorating if internalisation goes too far,” Rhodri Preece, director of capital markets policy at the CFA Institute and author of the report, told theTRADEnews.com. “For US retail flow, brokers only need to beat the NBBO by a fraction of a penny – we don't think this is ‘meaningful’ enough to deprive those market participants posting limit orders on lit markets from retail order flow.”
Preece said the same criticisms could also be made for retail trading initiatives launched by NYSE Euronext and BATS Exchange in recent months. The new schemes essentially emulate the internalisation performed by brokers, by creating a separate segment on the exchange that matches orders between retail brokers and market makers at a better price than the NBBO.
“Too much internalisation will disincentivise institutional investors from posting limit orders on exchanges because of fears that lit markets will only include flow that is more informed, or ‘toxic’,” said Preece. "We think retail liquidity programmes contribute to this and could reduce the willingness of traditional investors to post limit orders, which are the building blocks of price discovery. We think markets best serve investors if they are heterogeneous liquidity pools that include a diverse range of flow.”
The study, titled ‘Dark pools, internalisation and equity market quality’, looked at the market quality of 450 US stocks, including spreads, top-of-book depth and off exchange volumes. The CFA Institute believes the study is the only one to have disaggregated data from Nasdaq OMX’s trade reporting facility for off-exchange trades, which enabled it to better categorise OTC trades.