BATs and Direct Edge Market Share

Taking On the Duopoly

Peter Chapman

December 05, 2006 - Market share is the name of the game in stock trading and for much of the past two years the industry has focused intently on the New York Stock Exchange's. Traders watched as the passage of Regulation NMS led to a flurry of deals intended to revive moribund regional exchanges eager to compete against the Big Board. The industry took note as Nasdaq built up its listed book by intercepting orders in NYSE names on their way to the primary market. Dire predictions that the Big Board would bleed flow are largely starting to come true. In the past year or so, the New York has shed about 10 percentage points, mostly to Nasdaq, from the 80 percent share level it maintained for decades.

And the implementation of Reg NMS, slated to begin next February, is expected to put more pressure on those numbers.

But while it looked as if open hunting season had been declared on the New York Stock Exchange, the same could not be said of trading in Nasdaq securities.

Ever since Nasdaq bought the INET and Brut ECNs two years ago, trading in Nasdaq names has been dominated by Nasdaq itself and NYSE Arca.

Last year, about 95 percent of all Nasdaq shares matched on a public book were done by Nasdaq and NYSE Arca, according to Traders Magazine's estimates.

Four remaining ECNs accounted for the balance. All were at least three years old, and none were making much headway against the dominant market centers. Two sold out last year and one long ago changed its business strategy. The market was in effect a duopoly.

That is beginning to change. Two new ECNs, BATS Trading and Direct Edge ECN, a unit of Knight Capital Group, are using a combination of aggressive pricing, fast technology and innovative order types to chip away at the status quo.

Their impact so far is incremental rather than dramatic. But it can be seen in recent statistics. In the third quarter, the amount of Nasdaq flow matched by the two giants dropped to about 90 percent of all matched volume. Nasdaq does about 63 percent and NYSE Arca does about 27 percent.

These figures do not include the number of shares traded internally by Nasdaq market makers and in broker-dealers' "dark pools." Roughly one-third of all Nasdaq shares are traded internally, never touching a public limit order book.

>>Touched Volume

Taken together, BATS and Direct Edge are matching about 75 million shares per day on average, or 5 percent of the total. The numbers are much higher if one looks at all shares touched. That includes both the volume that enters their systems and trades as well as that which fails to trade and is routed out. Combined, touched volume is about 130 million shares. "Our business strategy is to get to critical mass, as fast as possible," Dave Cummings, BATS' chief executive office says. "When you have the economies of scale, you can offer aggressive pricing to subscribers and still turn a small profit."

For Cummings, critical mass starts at around 200 million shares. That's both routed and matched. The exec says it's possible BATS could reach that level by the end of the year.

BATS has been touching about 50 million shares a day in recent months. How much of that is matched and how much is routed out is unknown. The ECN is privately held and not obligated to disclose that information.

Cummings does say the match rate varies depending on which broker-dealer is using the system. On one day in September, the match rate did reach 68 percent, according to Cummings.

BATS has found support recently for his upstart shop with some of the bigger order-sending firms. Lehman Brothers, Morgan Stanley, Credit Suisse and Lime Brokerage have all invested in BATS, providing it with necessary capital, Cummings says.

The exec won't disclose the size of his war chest, but other sources put it at about $30 million. BATS was originally capitalized at about $8 million. It has 72 customers.

"We like the technology and the access to multiple markets," says Michael Richter, Lime's chief financial officer and executive vice president for new business development. "It's an attractive competitive alternative to Nasdaq and the NYSE."

Of the two newcomers, Knight's Direct Edge is the clear volume leader. It has matched, on average, 50 million shares per day in recent months. That's double the amount it was doing in this year's first quarter.

Its status as a unit of one of the Street's largest market-making firms has not hurt it, sources contend. They believe much of Direct Edge's volume originates from Knight.

Still, others say the connection to Knight has hampered the ECN's growth and its ability to sign up customers. Nasdaq market makers don't want to support a competitor. Also traders are leery about trading against orders that might come from Knight's well-informed trading desk.

Bill Karsh, Direct Edge's chief executive, bristles at the slights. "We are independent," he says. "We have a separate management team. Everything is walled off. No one gets to see what goes on within the ECN."

The exec adds that the orders posted on the ECN are not Knight's proprietary market-maker volume. They come from Knight's wide and diverse customer base, including 112 direct subscribers to the ECN, 1,200 institutional accounts and hundreds of broker-dealers.

"We represent quite a large pool of market participants," Karsh says.

Whatever the case, BATS and Direct Edge are up while Nasdaq and NYSE Arca are down. If the duopolists are worried, however, they're not showing it in their pricing. Despite a spate of aggressive price changes this year from the ECNs, Nasdaq and NYSE Arca have not budged.

The last move on the Nasdaq pricing front from one of the two majors came from Nasdaq late last year. That's when it increased the fee to remove liquidity from its books as well as the volume hurdles necessary to be eligible for discounts.

In Nasdaq's wake, there have been moves by the ECNs to either decrease their "take" charges, increase their rebates or decrease their outbound routing fees.

The most aggressive move-which ultimately failed-came from BATS in March. The ECN cut its take fee, the charge for removing liquidity, from 26 cents per hundred shares to an unheard-of 15 cents. Simultaneously, BATS lowered its rebate for adding liquidity from 25 cents to 14 cents. It kept its outbound routing charge unchanged at 30 cents.

The move did not sit well with BATS' liquidity providers. They turned up their noses at 14 cents and sent their business elsewhere. Liquidity on BATS dried up. The ECN restored pricing to "normal" levels in the second quarter.

"It was an interesting experiment," Cummings says. "But we found that everyone wanted to remove [liquidity] and no one wanted to add. That is not a recipe for a two-sided match."

National Stock Exchange

BATS' problems were compounded by its move to the National Stock Exchange. In May, the ECN left Nasdaq where it had been publishing its quotes and receiving some of its orders.

As a member of the NSX, BATS' quotes shared shelf space with INET's. In other words, the NSX consolidated quote for Nasdaq securities

CINN - was to a large extent an amalgamation of INET and BATS quotes.

Most traders assumed the CINN quotes represented orders on INET, as it was one of the largest ECNs. So they sent their orders to INET and never considered BATS.

To get traders' attention, BATS set its outbound routing charge to that of its take charge, or 27 cents per hundred shares.

(An outbound routing fee is the levy ECNs and exchanges charge traders to send their orders to other venues if no match can be found on their own systems.)

Because BATS' routing rate was cheaper than INET's take charge of 30 cents, it acted as an incentive for traders to route to BATS first.

Traders saved money whether they filled on BATS or INET. If the fill happened in BATS, they paid a 27-cent take charge. If the fill happened on INET, they only paid BATS' 27-cent route fee.

If the order did route out, BATS took a loss likely equal to the difference between the industry standard 30-cent take charge and the 27-cent route fee it charged its customers.

This willingness to take losses astounded many in the industry. Even competitor Marty Kaye, the chief executive officer of Track ECN, seems appreciative. "I give him credit," Kaye says of Cummings. "He had his back to the wall."

The move got the BATS train rolling. Cummings has watched his touched volume jump from an average of 7 million shares per day in July to 53 million in September.

Knight Move

BATS was not the first ECN to embrace the loss-making routing strategy this year. Direct Edge began offering outbound routing in May at 27 cents per hundred shares for large customers trading under its EDGX market participant identifier.

Smaller customers quoting on EDGX got a break too. Their charge dropped to 29 cents. By August, all EDGX quoters were eligible for the 27-cent charge. Today they pay just 25 cents.

(Direct Edge, like other ECNs, maintains two MPIDs: EDGX, for quoting on Nasdaq, and EDGA, for quoting on the NASD's Alternative Display Facility.)

Direct Edge's move goosed its volume. "The ECN may have experienced slower-than-desired volume growth prior to the implementation of outbound routing and other introductions to the platform," Tom Joyce, Knight's chief executive, told analysts this summer. "But with many of these technology enhancements behind us, we are conducting more intense client outreach."

Eventually, Track decided to take the plunge as well. In September, it lowered its outbound route fee to 27 cents per hundred shares from 30 cents. Last month, it cut it again to 26 cents.

"It forces people to notice what you are doing," Kaye says. "We've seen some increase in outbound traffic as a result of lowering the price." However, the exec notes that most of Track's 20 million to 30 million shares per day match internally.

So far neither Nasdaq nor NYSE Arca have opted to compete head-on with the ECNs by tweaking their pricing models. Their take and routing charges are still higher while their rebates are lower. (See sidebar for details.)

Still, Nasdaq, at least, is taking steps that could make life difficult for its rivals in the short run.

At presstime, Nasdaq was in the process of merging its three trading platforms-SuperMontage, Brut and INET-into one. In effect, that means Nasdaq will jettison much of SuperMontage and Brut and adopt INET as its core trading platform.

In doing so, it will make a critical change to the services it provides the ECNs that quote and accept orders on its facility. At presstime, three of the four active ECNs did a significant portion of their business on Nasdaq's platform.

Those are DirectEdge, via its EDGX identifier; Track via its TRAC identifier; and Bloomberg Tradebook.

By adopting INET as its central matching engine, Nasdaq will eliminate the all-important order delivery service it offers ECNs and require them to take automatic executions against their quotes.

Slowdown

The move will speed up trading on Nasdaq's platform, Nasdaq executives maintain. "Order delivery makes your market slow down to the most inferior participant, the order delivery participant," Chris Concannon, executive vice president for transaction services, said at an industry conference earlier this year.

"That is something we experience every day at the open and close," he said. "We see a substantial slow down in our order delivery process. We are encumbered by having third parties affect our speed and execution. It is more efficient to have auto-ex all the time."

However, the switch would subject the ECNs to the risk that two incoming orders might trade against a single quote on their books. ECNs operating on Nasdaq's platform receive their orders via Nasdaq's order delivery facility and their own proprietary connections. Those customers linking directly to the ECNs receive automatic executions.

The ECNs have always maintained that such a double liability is unacceptable. And earlier this year, the five "independent" ECNs complained to the Securities and Exchange Commission about Nasdaq's policy change, but the regulator ruled against them.

Alternative Displays

At presstime, Nasdaq was in the process of consolidating trading in 20 stocks onto its INET platform. Most of the ECNs are in the process of leaving Nasdaq to quote on the NASD's ADF.

Some, if not all, are planning to join BATS on the NSX. This summer, Knight, Citigroup, which owns the OnTrade ECN, and Bloomberg invested in the NSX. Its system is not yet ready to accept the ECNs though, so the only alternative to Nasdaq at this time is the ADF.

The ADF is a quote facility and not a trading platform. For that reason it does not receive high marks from market participants. "It's not much of an alternative when people can't hit your quote," Track's Kaye says.

He adds that Track has stepped up its campaign to convince traders to connect directly to Track.

Like OnTrade and DirectEdge, Track maintains a second MPID on the ADF, called DATA. Track's clients can decide whether they want to post their quotes on the TRAC MPID (Nasdaq) or on DATA.

Last month, Track increased the rebate it offers to traders posting on DATA to 29 cents per hundred shares from 27 cents. That's the highest payout in the industry. The increase was done to encourage more posting under the DATA identifier.

Despite an aggressive push to shift business to DATA, the company is clearly concerned about its future business. It receives most of its order flow via Nasdaq's order delivery service.

"Management cannot determine how this move will affect revenues in the long-term," the company said recently in a statement, regarding its decision to leave Nasdaq, "but it will likely result in potentially significant short-term declines in revenue."

Singlebook

Direct Edge is less worried. As Nasdaq was launching trading in 20 securities on its "Singlebook" platform, Direct Edge was shifting trading in those same securities under its EDGX acronym to the ADF.

As Nasdaq gradually transitions to Singlebook, Direct Edge intends to follow in lockstep, according to Karsh. Thus the ECN will now operate two MPIDs on the ADF.

Karsh says most order flow comes onto the Direct Edge platform via direct connections anyway; not via Nasdaq. "We would not go someplace if we believed there would be a problem," he says of the move to the ADF.

Trading under EDGX gives a trader access to DirectEdge's unique order types and lets him route out if he chooses. Trading under EDGA (ADF) does neither. Yet on a recent day, most of Direct Edge's volume was traded under the EDGA moniker.

That's despite the fact that what distinguishes Direct Edge from plain-vanilla ECNs is special functionality only available under EDGX.

In a unique twist, Direct Edge has chosen to marry the displayed liquidity of an ECN with the non-displayed liquidity resident inside certain brokerage houses.

Traders routing orders to EDGX have the option of trading against two types of hidden liquidity: that residing in one of the industry's "dark pools" and that on broker-dealers' internal books. If the trader chooses, his order will sweep all available liquidity displayed on EDGX and then check for any undisplayed liquidity. Karsh will not name the dark pools with which Direct Edge interacts but says they are alternative trading systems (ATSs) in the mold of Investment Technology Group's POSIT.

He says that an order routed to EDGX that opts to check the dark pools may get a fill at the midpoint of the market's best bid and offer. Many blind crossing systems such as POSIT cross their orders at the midpoint of the market's best bid and offer.

The other form of nondisplayed liquidity available via EDGX is what Direct Edge calls "enhanced" liquidity or that of "other market participants."

When Direct Edge gets an order willing to interact with this flow, it sends an indication of interest out to several players. That creates a "race" situation where the first to respond wins the trade.

Knight Equity Markets, L.P. is one of the "other market participants," Karsh says. It's the only name he will disclose. The exec notes that by opting to trade with either of the two classes of hidden liquidity suppliers, traders could potentially reduce market impact and/or receive price improvement.

Market Impact

If the stratagem is successful, the trader's order does not route to another venue to trade against more displayed liquidity. That reduces the trader's risk that prices might move against him as his order continually soaks up displayed liquidity.

"The inside market will not change," Karsh says. "The client doesn't have to move the market to a higher level to get his order completed. This order type provides the least market impact. It's a tremendous differentiating point between the other ECNs and ourselves."

Not everyone is enamored of trading with hidden liquidity. "Our customers generally prefer to trade against displayed liquidity," Lime's Richter says.

To encourage traders to look for a match with its hidden liquidity suppliers, Direct Edge recently altered its pricing. Using one particular order type, traders who execute against hidden flow will only pay 10 cents per hundred shares. That compares with charges of 28 cents or 30 cents (based on the size of the client) to take displayed liquidity off of EDGX.

There is a catch. Any unfilled portion posts on Direct Edge's book. It does not route out to another market center. Direct Edge suggests traders use this scheme when the EDGX quote is at the inside.

Direct Edge's pricing model seeks to encourage those traders who do want their non-executed orders routed out to tap into hidden liquidity as well. The ECN charges an extremely low outbound routing fee of 25 cents per hundred shares as long as the trader opts to explore the dark liquidity. If he chooses not to, his routing fee is 29 cents.

Such pricing strategies are central to the efforts of ECNs to win market share. They understand that traders are grateful for alternatives to the Nasdaq-NYSE Arca duopoly but are still price- sensitive.

"ECNs are doing what it takes to grab share in the over-the-counter space," Cummings says.

It's the ECNs versus the duopolists

BATS and Direct Edge are betting that aggressive pricing will win the day when

it comes to Nasdaq trading. So far neither of the duopolists have blinked. Their take and routing charges are still higher while their rebates are lower.

Nasdaq, for instance, charges all but its largest customers 30 cents per hundred shares to take and route when trading Nasdaq-listed names. It pays just 20 cents to all but the largest liquidity suppliers.

NYSE Arca does not discriminate among users, but offers similar pricing. For Nasdaq securities, its take fee is 30 cents per hundred shares. Its outbound route fee is 40 cents. Its rebate is 20 cents.

By contrast the ECNs are much more aggressive. BATS charges 26 cents to take and route. It pays a 24-cent rebate. That gives BATS a meager two-cent spread, or profit margin. Nasdaq and NYSE Arca reap 10-cent spreads.

DirectEdge is more generous with liquidity providers than BATS, but stingier with liquidity takers. Traders quoting under its EDGX (Nasdaq) MPID pay 30 cents per hundred shares to take liquidity and receive rebates of 25 cents. Traders quoting on the ADF pay 30 cents and receive 26 cents.

As with BATS, DirectEdge has decided it can live with tighter spreads than either Nasdaq or NYSE Arca. It earns between four and five cents for trades done on its system.

EDGX PRICING

Adding Remove Routing-out
EDGX Tape A $(0.0025) $0.0026 $0.0029
EDGX Tape B $(0.0025) $0.0026 $0.0029
EDGX Tape C $(0.0025) $0.0026 $0.0029
EDGA FREE FREE $0.0029
EDGX < $1.00 FREE 0.2% of Dollar Value 0.3% of Dollar Value

1) EDGX is awesome for marketable orders on Nasdaq (and from what I understand from the experiences of other knowledgeable traders, they are great for marketable NYSE orders, as well).

When you send a marketable order to EDGX, the order goes through four steps:
a) Checks for liquidity on the in-house EDGX book (the book is very thin, and you won't get many fills => You are charged 0.28 cps to remove liquidity from the EDGX book); likely <2% of marketable incoming orders filled here, if not filled:

b) The order is routed to their 'dark book' liquidity providers. These dark books are simultaneously given the order, and if any chooses to fill it, you get a quick fill (Cost is 0.25 cps to remove liquidity from the dark books). Note that the dark books only have 50 milliseconds to respond or the order before it 'times out'. Roughly 30% of incoming marketable orders are filled by the dark books => a very good source of liquidity, IMO. If not filled here:

c) The order is routed to the 'market' for a fill. In other words, the order goes to INET, ARCA, or whatever market is shown at a matching price to your order.

d) If no matching order is found in the market, then the order is posted on the EDGX book.

Note that the above sequence is what happens for a EDGX 'ROUT' order. You have other order handling options to bypass the darkbooks altogether ('ROUX' orders) or only send to EDGX book and dark books ('ROUZ' order), etc.

To answer your initial question. How does EDGX make money charging only 0.25 cps to remove liquidity? => A couple of factors help them to do this.

First, for any orders that are filled on their own ECN, the charge clients 0.28 cps to remove liqidity (0.30 cps if your firm does less than 200k shares per month, which is likely very few firms) while paying a rebate of 0.25 cps. So for these orders (filled within the ECN) they make a spread of 0.03 cps.

The order executed on the darkbooks generate the most revenue for them. They charge you 0.25 cps to remove liquidity, while paying zero rebates to the darkbook firms that are adding the liquidity.

For those orders routed externally to the other markets (INET/ARCA/etc), the situation is not as bad as it seems. Since EDGX is owned by Knight Trimark, they do HUGE volumes on all the ECN's. As a result, they get favorable super-volume rates on the ECN's that aren't typically available to the rest of us. In other words, they are not paying 0.30 cps to remove liquidity. I believe they pay 0.28 cps, and so incur a small loss on those externally routed, non-darkbook executions.

I hope this helps. For what it's worth, I've executed over 150k shares with EDGX in the past 3 days, and the fills have been better than any other route (INET, ARCA, SOES, etc) for marketable orders. I would not use them for non-marketable limit orders, since as has been pointed out, they will typically not get a fill until after INET/ARCA/etc has already filled a similar order. But, for marketable orders, I highly recommend them.