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WFE Focus April 2011
Peter Clifford
Deputy Secretary General,

The US equity option market is seen in many parts of the world as a model in market structure where investors benefit from intense competition between exchanges, but with little of the added costs and weaker investor protection that is linked to fragmentation.

Gary Katz, President and CEO of the International Securities Exchange, sees one of the main reasons for the dynamic growth of the options markets is the fact that all trades must be executed on exchanges, and no off-exchange internalization is permitted.

Internalization is the practice by intermediaries to withhold not only large orders from institutional clients who do not want their orders exposed to the market, but also small orders from retail investors that could be filled in the public market.

As stated in ‘The case for protecting the options markets from internalization’ the internalization in the US stock market is a contributing factor that has caused traditional liquidity providers to leave the market. ‘Because internalization allows the good order flow to be traded before it reaches an exchange’ there is very little interest for a market maker to provide liquidity in times of high volatility such as the flash crash.

Internalization ‘harms the overall competitive dynamic of the market place by discouraging market makers from providing narrow, continuous quotes on the exchange.’

The US options market structure is the strength behind its exceptional liquidity, growing at 44% CAGR over the past five years. This has not developed by accident. It is result of vigilance and coordinated effort by exchanges to defend the liquidity of the market and safeguards for investors. Now rules in the Canadian stock markets may also help to protect investors’ liquidity.

In the Canadian cash markets, regulatory scrutiny of internalization could lead to clearer rules around the ways that orders can be executed away from transparent markets, and better defined thresholds for internalized order. These changes will need to carefully monitor the dark pools that are often owned and operated by intermediaries.

Deanna Dobrowsky, Director of Regulatory Affairs, at TMX Group, notes that ‘dark pools came to market without benefit of any public comment and were permitted to operate without publicly available rule sets’.

As this edition came to press, the US SEC announced its fines following an investigation of dark pool which seems to prove her point.

But exchanges are not waiting for regulators to fix the problem. October 2011 also saw the announcement from NYSE Euronext of the Retail Liquidity Pilot Program which provides incentives to the retail investors and intermediaries that service retail order flow providers.

Tightening the oversight on internalization, enforcing the rules in dark pools and bringing liquidity back to the central markets are battles that are just beginning.


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