As we approach the Regulation NMS implementation deadline, brokers and exchanges are faced with the challenge of utilizing technology in order to become compliant while adapting to the evolving marketplace. Topping the list is replacing the primary interexchange routing mechanism for listed shares - the Intermarket Trading System (ITS) - which has outlived its usefulness and cannot accommodate the modern increase in market trades.
The SEC is removing the mandate for ITS and encouraging the markets to find, create and use private linkages. Over these new connections will unfold a new paradigm for routing and protecting customer orders and quotations - a paradigm that the markets expect to be heavily enforced.
But the new market landscape must be taken into consideration. It is not made up solely of exchanges; there is a continued proliferation of alternative trading systems (ATSs), including new Electronic Communication Networks (ECNs) as well as crossing networks and other dark book variants. Together, these venues will continue to cloud the visibility in the market, a phenomenon traders are familiar with today.
The emerging problem is one with which traders are just beginning to struggle - the fragmentation of dark liquidity. As these dark pools grow both in number and importance, we'll continue to see new tools and approaches to bringing together the dark liquidity of the markets. (For more on dark liquidity, see related article, page 15.)
A Need for Private Linkages
When considering a trade routing alternative for the post-Reg NMS world, we must keep in mind that it will be much more common for order routers to post orders at the regional exchanges, simply because that is where the order will have the best opportunity to be the sole order at the market center at the National Best Bid and Offer (NBBO). The order will become protected immediately - avoiding the price-time priority queue of the NYSE or Nasdaq. This will garner added market data revenue for the regionals, which also is encouraged by other changes in NMS. This new importance of the regionals is driving their ownership stakes and helping to shape the new market structure landscape. This landscape will be a web more tangled than any that market participants have been required to navigate to date. It will include the SRO market centers, with the regional exchanges gaining share from the big two - NYSE and Nasdaq. It also will include the publicly quoting ECNs, those that represent their quote in the Consolidated Quotation System through the Alternative Display Facility or a Self Regulatory Organization (or that just as likely merge with a regional exchange), and the intermarket routing by the dark book participants that currently do not have to worry about routing outside of their nonquoting books (see Exhibit 1, previous page).
All of these market participants will need to have connections to each other. Since there no longer will be a central ITS routing network to which they all can connect, each of these market centers will need to look for alternatives via private market linkages. The solution to the exchanges' connectivity problem must be robust, offering the speed and capacity to get to the required venues and clear the protected quotes. Beyond that, these private linkages will help untangle much of the new landscape web. With a single connection to the right routing hub, a market center will be able to get to all of the other venues it needs. Contrasting this with the eight to 12 direct connections the market centers would build themselves makes it evident that there is a clear demand for an ITS replacement.