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WFE Focus February 2011
Off-exchange trading and market quality in a fragmented market structure
Daniel G. Weaver
Associate Director,
Whitcomb Center for Research in Financial Services
Department of Finance
Rutgers Business School

Introduction
A recent article in Traders Magazine states that the amount of “internalization” in US markets has increased from 20% to 30% in the past year. ?  As pointed out in the Traders Magazine article, the definition of internalization has expanded to include dark pool and upstairs trades and is also known as off-exchange reporting. In addition, a recent Wall Street Journal article reports that markets are becoming increasingly fragmented, with NYSE market share declining to 37% from 70% two years earlier. ?  The question then is, given the increased fragmentation in US markets, what impact has the increase in off-exchange reporting had on market quality - if any? This study seeks to provide answers to that question.

Internalization has traditionally been considered part of a broader category of order routing (or non-routing) called preferencing. A broker can decide to either trade a customer order from (for) the broker’s inventory or send it to a pre-designated market maker for execution against that market maker’s inventory. Dutta and Madhavan (1997) and Kandel and Marx (1997) both cite preferencing as an institutional feature of NASDAQ in the 1990s that led to higher execution costs for investors. Chordia and Subrahmanyam (1995) and Easley, Keifer, and O’Hara (1996) develop theoretical models that show that dealers have an incentive to internalize uninformed orders. This discrimination in order routing, leads to wider spreads in the overall market to compensate for the increased percentage of informed traders in the non- internalized order flow. Chakravarty and Sarkar (2002) develop a model that suggests that internalization diminishes market quality by reducing market depth and price informativeness.

The empirical studies of internalization have shown that its impact on market quality has been at best benign [Battalio, Greene, and Jennings (1997); Hansch, Naik, and Viswanathan (1999); and Kam, Panchapagesan, and Weaver (2003)] or at worst harmful to market quality [Battalio, Greene, and Jennings (1998); Chung, Chuwonganant, and McCormick (2004); Grammig and Theissen (2005); Chung, Chuwonganant, and McCormick (2006)]

Until recently, the trend among exchanges has been to enact rules to reduce or prevent internalization. This has been especially true in Europe. The Paris Bourse enacted rules to require members to send all orders to the exchange for execution. The Italian equivalent of the SEC, CONSOB, required that all stock orders be sent to Borsa Italiana for execution. Grammig and Theissen (2005) report that in 2002 Deutsche Börse created Xetra Best which allowed members to internalize orders, but required that the internalized orders receive price improvement. The above attempts to limit internalization were ended by the European Union’s full implementation of the Markets in Financial Instruments Directive (MiFID) in 2007. ?  MiFID eliminates so-called concentration rules and creates systematic internalizers who are not allowed to offer price improvement to retail customers in the most liquid shares, but must publish quotes.

There have been two notable events related to internalization of order flow in North America. In the United States, the NYSE repealed its Rule 390 in 2000. The rule, similar to the Paris Bourse, required members to route orders in listed stocks to an exchange. ?   The effect was to allow firms to internalize orders at their firm. Kam, Panchapagesan, and Weaver (2003) conclude that following the rule’s repeal, NYSE specialists narrowed quoted spreads (perhaps to make internalization less profitable) but that effective spreads did not change. ? 

The mid 1990s saw an increase in electronic order management systems in Canada. Concerned about the impact on market quality the Toronto Stock Exchange (TSX) convened a special committee that published a report in 1997 (see Toronto Stock Exchange Special Committee Report, 1997.) As a result of that report the TSX issued what was to become known as the Price Improvement Rule in 1998. That rule, similar to the Deutsche Börse rule, requires all orders of 5,000 shares or less to receive price improvement to be internalized. Larrymore and Murphy (2009) find that following the passage of the rule market quality significantly improved.

Given the above studies, we would expect the recent increase in off-exchange reporting in the US to negatively impact market quality. This paper examines the relationship between off-exchange reporting and market quality. We find, consistent with reports in the popular press, that low-priced stocks are most likely to be internalized. We then examine the impact on market quality. The methodology used is to regress the degree of off-exchange reporting for a stock on various measures of market quality, while controlling for other known relationships. We examine the relationship both overall and for each market segment: AMEX; NASDAQ; and NYSE.

Except for a few exceptions, we find strong support for the existence of a negative relationship between the degree of off-exchange reporting and market quality. In particular, for all three market segments off-exchange reporting is associated with wider percentage spreads for that firm. After controlling for variables known to be associated with spreads we find this result for quoted, effective, and realized spreads. The impact of off-exchange reporting on spread width is measurable. For example a NYSE listed stock with 40 percent of its volume reported through a TRF will on average have a dollar effective spread that is $0.028 wider than a similar stock with no TRF reporting. We show that this results in investors paying $10,272,693 more per stock per year due to off-exchange reporting.

Turning to price impact, the extant literature suggests that off-exchange reporting reduces depth in the market. A reduction in available depth, both at the inside and away, increases the probability of orders “walking through the book” or taking the liquidity at subsequent price levels. If this is the case then we should find that increased levels of off-exchange reporting are associated with increased price impact and volatility. That is exactly what we find. For all but AMEX stocks the percentage of share volume associated with off-exchange reporting is directly related with price impact. In other words, as the percentage of off-exchange reporting increases, average trades will have an increasing impact on prices. Finally, for all market segments, higher levels of off-exchange reporting are associated with higher levels of return volatility. We conclude that increased off-exchange reporting is associated with a degradation of market quality for all market segments in the United States.

Conclusion
Equity markets in the United States are becoming increasing fragmented at the same time that we are witnessing a dramatic rise in off-exchange reporting (internalization) of customer order flow.

Theoretical studies of internalization assume that order flow from uninformed traders is internalized or purchased by dealers. The internalizing of uninformed order flow by discriminating dealers reduces the number of uninformed orders for the non-discriminating dealers to spread their informed loses over. The result of this is a market wide increase in spread. These theoretical studies also suggest that internalization diminishes market quality by reducing market depth and price informativeness.

Internalization has been examined empirically by a number of authors. While some papers find no relationship between internalization and market quality, others find that internalization reduces market quality. For example, studies have found that quoted, effective, and realized spreads are directly related to the level of internalization in a stock. Others have found reduced market depth and increased volatility associated with higher levels of internalization. In summary, theoretical and empirical studies of internalizations impact on market quality show that at best internalization is benign and at worse it is associated with a decline in market quality.

Given the results of previous studies, we would expect the recent increase in off-exchange reporting in the US to negatively impact market quality. Using the percentage of share volume reported through a Trade Reporting Facility (TRF), this paper examines the relationship between off-exchange reporting and market quality. The main methodology used is to regress the degree of off-exchange reporting for a stock on various measures of market quality, while controlling for other known relationships. We examine the relationship both overall and for each market segment: AMEX; NASDAQ; and NYSE.

Except for a few exceptions, we find strong support for the existence of a negative relationship between the degree of off-exchange reporting and market quality. In particular, for all three market segments off-exchange reporting is associated with wider percentage spreads for that firm. After controlling for variables known to be associated with spreads we find this result for quoted, effective, and realized spreads. The impact of off-exchange reporting on spread width is measurable. For example an AMEX listed stock with 40 percent of its volume reported through a TRF will on average has a dollar spread that is $0.04363 wider than a similar stock with no TRF reporting. We show that this results in investors paying $1,729,250 more per year per stock due to off-exchange reporting.

For all but AMEX stocks the percentage of share volume associated with off-exchange reporting is directly related with price impact. In other words, as the percentage of off-exchange reporting increases, average trades will have an increasing impact on prices. Finally, for all market segments, higher levels of off-exchange reporting are associated with higher levels of return volatility. We conclude that increased off-exchange reporting is associated with a degradation of market quality for all market segments in the United States.

For the complete study please contact Daniel Weaver.

About Daniel G. Weaver

Daniel G. Weaver holds degrees in English literature (BA, Seton Hall University) and finance (MBA, Ph.D. Rutgers University).

Dan's research and teaching focus is on security design, security market structure, and e-commerce. He has over 30 published articles. He has published in the Journal of Finance, Journal of Financial Economics, Journal of Financial Markets, and Journal of Financial and Quantitative Analysis, among others. Recent papers include an examination of the value of specialists, the impact of anonymity on the quotation of NASDAQ market makers, the impact of the public disclosure of limit order books on liquidity, potential visibility gains as a reason for listing, and the impact of tick size on market quality. He has served as a consultant to the American Stock Exchange, New York Stock Exchange, Stockholm Stock Exchange, Toronto Stock Exchange, and the Securities Industry Association.

Dan has been widely quoted in newspapers across the United States including the Wall Street Journal, New York Times, Washington Post, USA Today, Associated Press, Barron's, Securities Week, Traders, and the Los Angeles Times. He has appeared on CNN, CNBC, PBS, NPR, and local radio and television. He has testified before the U.S. Securities and Exchange Commission as well as U.S. Congress on market structure issues.

See D'Antona (2010.)
See Patterson (2010.)
Davies (2008) provides a good overview of MiFID.
At the time of the repeal of 390 there were multiple exchanges trading the same stocks in the US. In France there was only the Paris Bourse.
Quoted spreads can narrow and effective spreads remain unchanged if the amount of price improvement declines. This is exactly what Kam, Panchapagesan, and Weaver (2003) found.
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