How Reg ATS Destroyed Buy-Side Price Discovery and Block Liquidity

By Kevin Foley, AQUA

Originally published on TABB Forum 

There’s plenty of demand for block liquidity. The problem is supply. Reg ATS, which was intended to broaden market transparency, instead eviscerated it, in the process leaving price discovery behind. And without price discovery, there’s no economic incentive for liquidity suppliers.

Natural block liquidity is increasingly harder to come by. Traders tells us they would prefer a market in which they could access the larger orders only other naturals can trade, away from the reaches of high-frequency trading. Larger trades reduce information leakage, adverse price movement and cost.

People are often surprised when I argue there’s no shortage of demand among buy-side traders to trade in larger size, but it’s true. I can’t tell you how often I hear the complaint, “I want to trade blocks; it’s everybody else who doesn’t.” Otherwise, they would be trading blocks, right?

Well, no. When traders are all saying they want to trade blocks but can’t, the problem isn’t one of demand. There’s plenty of demand for block liquidity. The problem is supply.

So what happened to the supply of natural block liquidity? No big secret. Look no further than the incredible rise of indexing and ETFs over the past decade. As much as 30% or more of the outstanding float in most US equities is in the hands of indexers, closet-indexers, indexed mutual funds, ETFs, smart betas and the like. What does this group have in common? They don’t trade anymore. They used to, but not anymore. They are investors who concluded their returns were being eaten up by fees and commissions. They decided they were tired of paying for the privilege of providing their liquidity to the market.

After the indexers left, much of what remained of natural block liquidity was lost to algorithmic trading. Traditionally, buy-side traders endeavored to supply liquidity to each other. But it’s hard for naturals to find each other when they’re both masquerading as something else. Buy-side traders use algos to hide their intentions from the HFT firms. It’s an open question whether these algos are in fact fooling the likes of Tradebot and Virtu. But they do a good job of concealing the buy-side traders from each other.

If demand is undiminished and supply has fallen off, Econ 101 says price should be the mechanism that restores market equilibrium. Just as unsatisfied demand for a stock will produce higher stock prices, we would expect unsatisfied demand for a stock’s liquidity to produce thicker prices – wider markets for larger sizes. Wider markets would provide an incentive for new suppliers of liquidity to enter the market, earning profits while satisfying demand and restoring equilibrium.

Why isn’t this happening? 

Reg ATS is the reason why. Following on the heels of the 1997 Order Handling Rules implementation, the SEC’s Reg ATS ended the practice of limited public display of order information. Prior to that, Instinet’s popular “I-Only” feature (for “institutions only”) dominated institutional trading in Nasdaq stocks. Large orders could be displayed at various price points to other buy-side firms and not be visible to anyone else. With Reg ATS, the SEC essentially said, if the buy side wants to show orders to each other, they have to show them to everybody else too. Retail investors, that’s who regulators had in mind. But in practice, it includes the likes of Tradebot and Virtu, too.

And because buy-side traders understandably didn’t want to show their hands to HFT firms, they turned away from displaying orders. This fear of signaling drove buy-side trading into the dark. And let’s be honest about the results – there is no pre-trade transparency anymore. Not in quantities or lengths of time that have any meaning to institutional investors. The bids and offers you see are a fleeting picture of small orders already executed or canceled, vanishing even before they reach your retinas.

During that timeframe, the broker-sponsored ATS rose to prominence to control costs, and also because a successful crossing pool could raise a broker’s prestige. But that doesn’t explain why broker-sponsored ATSs are all dark. Undoubtedly, brokers would broadcast at least some ATS market data to their buy-side clients if they could, just as Instinet once did. Reg ATS is the reason they don’t. It’s not permitted. Reg ATS was intended to broaden market transparency but instead eviscerated it.

In the process, price discovery was left behind. Trading in the dark can only succeed at or close to the midpoint. Try any other price and you get nothing but near-misses. That’s why the midpoint became the price of choice when pre-trade transparency ended.

And here’s the problem with the midpoint: It provides no incentive for new suppliers of liquidity to enter the market. 

It’s as simple as that. No transparency, no price discovery. And no price discovery, no new supply. Why should anyone go out of their way to supply liquidity at the midpoint? Never gonna happen. It’s not for lack of demand that block trades are harder to come by. Without price discovery, there’s no economic incentive for suppliers to fulfill their function.

It doesn’t have to be that way. That’s why our mission at Aqua is to restore price discovery. Price discovery provides the incentive for new supply of block liquidity to enter the market. At Aqua we deploy Reg ATS-compliant technology with a little ingenuity to facilitate a buy-side-only display at price points that create an incentive to display.

And there are two great potential sources of block liquidity out there waiting for a reason to come back – the indexers and the algorithms. Price discovery provides the framework for these two big former suppliers of liquidity to return on terms that are attractive to them.