Retail order flow now totally dark

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The conventional wisdom as of late has been that retail order flow goes mainly to the big wholesalers who internalize as much as they can before sending the remaining flow to the exchanges, where it is traded against by savvy high-frequency traders.

This exhaust flow was indeed thought to be the bread-and-butter of the HFT crowd. But a new report suggests that retail order flow is 100 percent internalized. One big issue here is obviously sub-penny pricing, which continues to proliferate off the exchanges. The reality is that ATS-like trading services all allow sub-penny pricing, which has allowed them to garner the entire retail market to the chagrin of the main exchanges. It's no wonder that the NYSE is so gung-ho about its nascent Retail Liquidity Program.

Other exchanges are jumping in as well. BATS has just received approval from the SEC to run a one-year pilot program that will allow it to experiment with individual investors' trade execution at increments of a tenth of a cent. The idea is that such special pricing is good for individual investors, as it will lower costs. Certainly, it will allow for more competition, as the exchanges are better able to compete with internalized dark pool services.

One implication is that order flow from individual investors is slowly but surely being carved out as a separate class by regulators, distinct from institutional other orders. This makes sense, as the SEC has historically taken retail orders as something of a special concern when it comes to market structure. That said, there's an argument to be made for widening spreads in other areas.

I noted recently that the SEC also is considering a move to force spreads wider for small-cap stocks that have trouble increasingly attracting liquidity. All this could get really confusing quickly. Are we moving toward a market structure that will allow retail investors to trade at sub-penny increments for all stocks, while institutions pay souped-up costs for all stocks, but especially for small-cap stocks?

What's needed is a clear articulation of the theory of what's going on now and the intended effect on market fragmentation. Ultimately, it has to make sense at an intuitive level. -Jim