'Direct Edge's ELP Program Causing Market Brouhaha'; 'Private Exchanges Looking to Turn Back Clock'

By: Ray Pellecchia

File Under: NYSE, NYSE Amex, NYSE Arca

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Securities Industry News reports, "Direct Edge's ELP Program Causing Market Brouhaha; Competitors criticize Enhanced Liquidity Provider program." Excerpts:

With its execution volume increasing, Direct Edge's three-year-old program that flashes orders to a private network of broker-dealers before routing them to other quoting markets, is generating calls for regulatory review of the practice as well as the broader notion of dark liquidity.

Direct Edge filed an official application May 7 to convert its two electronic communications networks, EDGX and EDGA, to full-fledged equities exchanges. This was preceded by months of discussion with Securities and Exchange Commission staff to tailor the proposal, which includes the ECNs' Enhanced Liquidity Provider mechanism for flashing to its broker-dealer network, to meet the stricter regulatory requirements for exchanges. Direct Edge's filing indicates approval is likely, arousing criticism from competitors who believe the pre-order routing system may violate regulations.

The ELP program, launched in spring 2006, briefly flashes orders that can't be filled on Direct Edge's ECNs to 25 broker-dealers, giving them the opportunity to execute the orders before they are routed to other quote-displaying markets.

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"The volume of dark liquidity has grown very quickly and could result in a two-tiered market, where some participants are getting information that others aren't," said Joe Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext, adding, "There are a lot of inconsistent practices between the exchanges and (automated trading systems), and we'd expect at some point that the regulators will aim for a more equal playing field."

But it's not just competitors (including NYSE Euronext) questioning this practice:

Flashing orders to a select group, even if the group is not limited by the market center's rules, runs contrary to other regulations, though, said Jamie Selway, managing director at White Cap Trading and former chief economist at Archipelago, one of the pioneering ECNs.

"In terms of Reg ATS, this practically violates the first principle -- that a large marketplace can display an order to one participant, but if it displays it to multiple participants it should be in a public quote," he said.

On a somewhat related note, Reuters reports, "Private exchanges looking to turn back the clock." Excerpts:

A new era in stock exchanges may be on the horizon -- and it looks something like the past, when a small handful of owners ran important capital markets.

...

Executives at the Reuters Exchanges and Trading Summit this week raised the specter of a partial return to a system in which key marketplaces are run by a small group of powerful players.

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New Jersey-based Direct Edge, which aims to be a formal exchange later this year, is owned by Goldman Sachs (GS.N), Knight Capital Group Inc (NITE.O), hedge fund giant Citadel, and options mart International Securities Exchange.

Kansas City-based BATS, which is already in Europe and is now eyeing options markets, is owned by several big investment banks including Citigroup (C.N), Credit Suisse Group (CSGN.VX), JPMorgan Chase & Co (JPM.N), Morgan Stanley (MS.N) and Deutsche Bank AG (DBKGn.DE).

"What that exchange then looks like is what I would call a 'semi-mutualized exchange,'" said Duncan Niederauer, CEO of NYSE Euronext, which has more than 30 percent market share.

"It starts to look like the old NYSE member-ownership model, which I think we all concluded was not a great outcome and actually was fraught with conflict."

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"I think the SEC will ultimately re-look at some of these regulations," he said of dealers funneling orders to their exchange arms.

More to come on this, I'm sure.