Roughly five weeks after it decided to pull the public display of its prices for the five largest exchange-traded fund instruments it trades, the Island electronic communications network has experienced a precipitous drop in its ETF market share. Specifically, after it stopped displaying prices for its top five ETF contracts on Sept. 23, Island took a significant hit in trading of the QQQ and DIA -- extremely popular ETFs which track the Nasdaq-100 index and the Dow Jones industrial average, respectively.
While acknowledging that the ECN has lost some ETF market share since Sept. 23, an Island spokesperson declines to provide specific numbers. However, according to statistics compiled by the American Stock Exchange -- the home market for QQQs and DIAs and Island's chief ETF rival -- Island's market share in the QQQ fell from 36.9 percent in the in first three weeks of September to 23.6 percent in the 9/23 - 10/11 time period. What's more, during those same periods, Island's slice of the DIA piedropped from 36.2 percent to 17.4 percent. Meanwhile, the Amex's QQQ market share has increased slightly -- rising from 17.2 percent to 19.6 percent -- while its DIA share has held steady in the 28 to 30 percent range.
The Island/Amex rivalry has evolved into a feud over the last year, mainly because Island has consistently refused to post its ETF quotes in the National Consolidated Quote System -- the market data platform that displays the best bids and offers for listed stocks to everyone participating in the Intermarket Trading System. But Island has complained that the ITS -- an outdated dealing platform that electronically links together the New York Stock Exchange, Amex, Nasdaq Stock Market and six other regional equity exchanges -- moves way too slowly to meet the needs of its ETF traders.
Island's major complaint about ITS centers around the system's trade-through rule, which states that every ITS member cannot trade a stock at an inferior price if there is a better price available at an away market. In other words, for example, if a stock is being traded at Island and the Amex is offering a better price for that same stock, the order must be sent to the Amex, in accordance with the trade-through rule. But Island contends that the rule could greatly inhibit the speed of its ETF executions, because the market on the receiving end of an ITS order has a maximum of 30 seconds to respond.
The Securities and Exchange Commission, recognizing the speed at which the largest ETFs trade, actually tried to eradicate Island's concerns about the trade-through rule by issuing an exemption to the rule on Aug. 28. The so-called de minimis trade-through rule exemption -- which applies only to the three largest ETFs -- enables firms to trade-through another market's price for a specific ETF, as long as the transaction is no more than three cents away from the best bid or offer displayed in the NCQS. In other words, for example, if Island had a bid of 29.96 for the QQQ and the Amex had a bid of 29.99, Island could trade through the Amex's price.
But the SEC followed up its de minimis exemption ruling by requiring ECNs to represent the best quotes for their most popularly traded ETFs in the NCQS. The ruling, which took effect on Sept. 23, stated that any ECN that held more than five percent of the volume in any ETF for four of the last six months had to display its prices for those instruments in the NCQS. However, there was one caveat in that ruling: an ECN did not have to post on NCQS if it did not display its prices to its subscribers on any other venue.
Island subsequently decided to take advantage of that loophole by eliminating the posting of ETF quotes on its order book -- prices that were previously available not only to Island subscribers, but anyone who tapped into the ECN's book via Island's Web site. Island explained its decision it a Sept. 19 letter it sent to its subscribers, in which it states that could not simultaneously meet the ITS' trade-through requirements while maintaining the speed and efficiency of its ETF executions.
An Island spokesman says that the SEC's de minimis exemption for the trade-through rule was a "significant step" in the right direction, but did not solve the "fundamental challenge" of "integrating electronic markets into the national market system." Island, he says, asked for a six-cent de minimis exemption after the SEC proposed a three-cent exemption. However, the spokesman says the exemption, regardless of its size, is not a "long-term solution" to the challenges ITS pose to ECNs.
Island, he says, is working with the commission to forge a compromise that would enable the ECN to participate in ITS and post its quotes on the NCQS. Starting Sept. 23, the spokesman notes, Island pulled quotes from its order book for the following five ETF instruments: QQQ, DIA, SPY, SMH and MKH. The decision to abolish the public display of quotes for those instruments was a very difficult one, he says, because Island prides itself on providing a completely transparent market to its subscribers.
But the spokesman says that since a significant portion of the liquidity on Island has always been represented as either non-displayed or reserve size, ETF traders that want to measure the liquidity on Island for, say, the QQQ or DIA, do not necessarily have to see a price for those instruments. Rather, they can use a pre-scanning mechanism that identifies liquidity within a few milliseconds, he says. "Traders who are trading ETFs are running computer-generated models that are doing precisely that: scanning the Island book based in the algorithm contained in the model. So they don't need to actually physically see the book," says the spokesman, while noting that Island does not charge for unexecuted orders.
Still, the spokesman acknowledges that Island has lost some QQQ market share since Sept. 23, and believes that it is "exceedingly important" to find a long-term solution to the ITS dilemma so that it can restore its transparency.
However, Brett Redfearn, senior vice president of business strategy and equity order flow at the Amex, says that he is puzzled by Island's decision to pull its ETF quotes -- especially after the SEC tried to appease the ECN via its de minimis trade-through exemption. "The SEC realized that quote updates and quote changes (for the largest ETFs) are extremely fast. So they created this three-cent de minimis exemption ... in part to try to accommodate Island," he says. " Everybody (then) assumed that Island would work to try to integrate its quote .... (But) instead of complying, Island made the decision to basically not quote at all. Even with this compromise, they still decided that they would go dark."
Island has experienced tremendous growth since it began actively trading ETFs in 2000. In fact, last fall, it actually surpassed the Amex in trading of the QQQ -- the most popular ETF -- and has held the largest market share for that instrument ever since. But now, lacking the transparency it had before Sept. 23, it looks as if Island may have trouble holding onto its spot as the ETF kingpin.
Redfearn says that Island has been ignoring SEC rules requiring the ECN to post its ETF quotes in the consolidated quote system for months. Island's flaunting of the rules, he says, has created an "unlevel playing field" in ETF trading. While Island can offer its subscribers speedy executions via ignoring the trade-through rule, Redfearn says, markets like Amex must obey the rule -- sometimes sacrificing execution speed in a quest for price improvement. "We want to give people the best execution, (in the) fastest way that we can. But if there is a better market posted on the Boston Stock Exchange, we will take the time to try to execute that order at the Boston Stock Exchange. It takes more time, but that's the rule. And if we ignored all of the quotes at all of the away markets, we would be faster as well," he says.
But a source close to Island says the reason the ECN rose to the top of the ETF ranks was because it could offer its subscribers something that its predecessors could not: extremely fast and efficient executions. This source says that while Island's ETF market share has declined in the past month, the more important issue is that the falloff in Island trading has also caused a precipitous decrease in the overall ETF volume. WS&T Week could not obtain data on overall ETF volume by press time.