These Market Makers May Collect Data on Trades and Create Information Leakage, Argues New Report

BestEx Research’s Hitesh Mittal says institutional investors should consider the potential hidden costs of single dealer platforms such as Virtu and Citadel.

Illustration by II

Illustration by II

When brokers for institutional investors choose to route trades to market makers categorized as single dealer platforms they may not be getting the best prices for their clients, according to a new report from BestEx Research, a trading firm and institutional broker that does not route trades through the single dealer platforms, or SDPs.

Two of the best known examples of SDPs are Virtu Financial and Citadel Securities. Both declined to comment on the report.

SDPs are able to take significant amounts of data about traders and their trading patterns to use for future use because they aren’t subject to Securities and Exchange Commission regulations that prevent alternative venues — such as dark pools registered as alternative trading systems, and exchanges from doing so, said Hitesh Mittal, the report’s author and BestEx CEO and founder.

“To the extent there is information leakage, there is a risk of getting worse prices,” Mittal told Institutional Investor. “These side effects are not well known.”

On the face of it, SDPs appear to be less expensive. In his paper, Mittal explained that they “compete with market makers on exchanges by offering liquidity at the same execution price. But while exchanges may charge up to $.0030 per share to take the order, SDPs provide liquidity for ‘free’ (and may even offer a rebate), hence providing an opportunity to reduce costs for algorithmic execution brokers.”

But it’s the brokers, not their institutional investor clients, who get those benefits. In fact, the brokers, who are paid a fixed commission from their institutional investor clients, have a conflict of interest because it’s more profitable for them to use the cheaper SDP, argued Mittal.

Mittal said his paper, which is designed to dispel myths about SDPs, has caused a bit of a stir in the industry. “It’s tough to be one of the only firms talking about these issues because these are well entrenched businesses,” he told II.

He explained in the report how the SDPs “receive much more information in their order flow than is typical for a liquidity provider” on an exchange or alternative trading system. “Although SDPs have attempted to brand themselves as dark pools,” he said, “there are critical differences between SDPs and traditional dark pools registered as Alternative Trading Systems with the SEC.”

The main difference involves what he calls “leakage” of information obtained by the STP—which allows it to reconstruct a counterparty’s trading patterns.

Here’s how the systems differ.

“When sending a marketable order to an exchange or ATS, the order is anonymous to the counterparty trading against it,” Mittal said in the report. “Since a liquidity provider at an exchange or ATS does not have information about the identity of its counterparty, they have no ability to reconstruct the counterparty’s trading patterns. Contrarily, an SDP trading against an arriving market order has complete information about the identity of the algorithmic broker in real time and information about the ‘segment’ of flow an order belongs to.”

Even if a trade order is broken up into slices, the STP has the ability to learn the entire order, according to Mittal.

In general, information leakage is a big issue because once people find out there is a big order behind a trade, the price of the stock being purchased moves up and “you end up buying the rest of the order at a much higher price,” he explained.

Mittal said that a dark pool or exchange only finds out about the order only after the trade occurs, rather than prior to the trade. Nor do they receive any information about the residual quantity of the market order left unfilled after the order.

But the SDP market makers “have the opportunity for a ‘last look,’ allowing them to check current quotes at exchanges before providing a fill,” he said, That gives them “a significant advantage over market makers providing liquidity at exchanges. And if they decide not to trade against the order or to fill only part of the order, they have information about the residuals that are likely to appear on exchanges soon after.”

“More importantly, since they also know who is sending the order (and the segment [retail or institutional] that this order flow belongs to), they can establish order patterns from corresponding brokers in real time and historically. Although frequently advertised as dark pools, there is little ‘darkness’ in an SDP,” claimed Mittal.

The SDPs “aren’t doing anything illegal,” he stressed. They are allowed to use this information to make markets or even to trade for their own account, he said.

Mittal noted that the single dealer platforms have so far escaped regulation, but he believes SEC Chairman Gary Gensler is concerned about the type of “information asymmetry” that they represent. Mittal, who previously worked at AQR and ITG (now part of Virtu), was on a panel about best execution practices at an SEC investor advisory committee meeting last June.

“These entities have now become very big, but there is no transparency,” Mittal said. “Pension funds don’t even know how these SDPs operate.”

His report concluded that “institutional investors should be aware of the differences in the way SDPs operate compared to traditional dark pools in order to best evaluate whether to and how to interact with SDPs in their execution algorithms.”

“Know that you’re taking this medicine and it may have side effects,” he told II. “It doesn’t mean you’re going to die.”