Lightspeed, a direct-access brokerage firm whose clients include hedge funds and sophisticated day traders, is turning to alternative trading system operator PDQ Enterprises to put a modern twist on an old-school way of finding liquidity. For traders who aren’t solely driven by a need to execute at warp speeds, PDQ’s ATS provides an electronic throwback of sorts to the open exchange auction-style that once was the primary way many traders tracked down a market for their orders.
In November, Chicago-based PDQ rolled out an electronic version of the old auction market, the first such platform of its kind. When a customer places an order through the PDQ ATS, according to the firm, it pauses that order for a fraction of a second while it sends out a signal to let high-frequency and other algorithmic traders know that there’s interest in a particular stock. In turn, those liquidity providers respond with their markets for that order, which PDQ then aggregates for its customers. The firm says this setup gives Lightspeed and other clients a deeper reservoir of quotes with which to interact.
“This is a mechanism that used to be performed in the days on the floor when there was a specialist in the crowd,” PDQ chief executive Keith Ross explains. “If a broker had a significant order, he would walk into the crowd, ask what the market was, and different participants would shout out their interest.” But in today’s marketplace, he explains, if a trader is trying to transact more than a couple hundred shares of a particular stock, it’s increasingly difficult to discover the market unless the security happens to be one of the top 10 or 20 most-liquid names.
“Our process is unique, and it allows for the ability to create an auction market for each order,” Ross says. “We force the algorithmic guys to compete and fill the order.” Ross notes that the model ultimately enables liquidity seekers — in this case, Lightspeed’s clients — to actually trade with a collection of algorithmic and high-frequency providers all at once, rather than being forced to track them down sequentially.
PDQ reports that it posts about 125 million shares of marketable activity per day, with 25 million to 30 million shares a day resulting in actual trades.
Meanwhile, as the amount of volume that’s being traded off-exchange continues to climb, Lightspeed’s deal to give its clients access to PDQ’s venue was a natural fit, according to Stephen Ehrlich, Lightspeed’s CEO. “The marketplace is changing, and in the current market structure you’re seeing quite a bit more volume getting executed through ATSs and dark pools rather than on exchanges,” he says, adding that while Lightspeed historically provided access to exchanges and dark pools, it’s now looking to extend its reach to platforms such as PDQ’s. “The depth of quotes and depth of liquidity on the lit markets is not what it was six months ago, so people want to try to access liquidity through the use of different platforms.”
The Off-Exchange Imperative
Just two years ago, Ehrlich says, his active traders showed very little interest in off-exchange trading. But today there’s a growing consensus throughout the industry that liquidity is increasingly headed off of the displayed markets, and a growing number of traders are now looking to gain access to dark pools and ATSs. According to most estimates, about 30 percent of all the liquidity that’s traded in the U.S. occurs in the dark. And Advanced Trading previously reported that among smaller stocks, that figure is actually closer to 50 percent.
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“It’s that demand from the buy side to be able to manage their order in a way where they think they can reduce the impact of the marketplace and get a better execution — that’s why dark volumes are growing,” PDQ’s Ross says. “People are concerned that at some point the displayed market is not going to be the best indication of where the markets are.”
Another crucial feature of dark pools and platforms such as PDQ’s is that they can help traders execute block trades, Lightspeed’s Ehrlich adds. “We have clients that trade larger blocks, and this will definitely help them get access and get a price that they’re comfortable with,” he says, noting that such trades could never occur on an exchange these days. “You would never have it completely lit to the market because you don’t want to show your hand and maybe affect pricing one way or another.”
PDQ’s Ross adds, “It sounds almost trite — Economics 101 — but if the people who have significant trades to get done are comfortable that they’re getting the best result by being in the dark, that’s why the dark is growing. There’s no other mysterious, Big Brother collusion happening. It’s just a function of, ‘How can I accomplish my goal of executing this trade with as little impact as possible?’ And the dark is becoming more sophisticated. There’s more opportunity, and tools like PDQ can help create the contra side.”
And though exchanges will survive and always play a crucial role in the marketplace, Ehrlich suggests, the declining volumes they’re experiencing already show that they’ll need to adapt. “There’s a lot of liquidity that needs to be on the lit markets, and I think people want to trade where there are quotes that they can access on a timely basis,” Ehrlich comments. “But I do think [off-exchange trading] is a real challenge to the exchanges, and that’s why you’re seeing the retail liquidity program presented by NYSE and the other exchanges contemplating [similar programs].”
In July, the Securities and Exchange Commission approved the New York Stock Exchange’s bid to launch a dark pool aimed at retail investors. The venue reportedly would provide retail investors with access to cheaper prices than those available to institutional investors.
As for PDQ, Ross says the firm’s ATS is in direct competition for order flow with dark pools, but he contends that the PDQ ATS offers a more efficient way of matching buyers and sellers than typical dark pool offerings. “Let’s suppose I wanted to sell 5,000 shares of IBM — if I go to a traditional dark pool, the only way that’s going to happen is if there’s a resting bid at the dark pool for the contra side of my position,” he explains. “If the buyer in IBM was there five minutes ago but is not there now, even though I’d like to hit his bid, his bid isn’t current, and we end up being ships passing in the night.”
But the PDQ system, Ross says, can request markets from algorithms for that order, and they'll respond virtually instantaneously. And in similar fashion to a dark pool, placing a large order on PDQ won’t move the market against a trader, he adds.
"We can aggregate those responses, and if 10 of our providers each do 500 shares, we could fill your whole 5,000-share order," Ross says. "Now, instead of missing the bid from the other dark player, you're getting a fill, getting your order done, and hopefully with a little less aggravation and a little cost savings."