These market makers can collect transaction data and create information leaks, says new report

According to a new report from BestEx Research, a trading company and institutional broker that does not route trades through single dealer platforms, or SDPs.

Two of the best known examples of SDP 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, as they are not subject to Securities and Exchange Commission regulations that prevent alternative venues – such as dark pools registered as alternative trading systems and exchanges in doing so, said Hitesh Mittal, author of the report and CEO and founder of BestEx.

“To the extent that there is information leakage, there is a risk of lowering prices,” Mittal said. Institutional investor. “These side effects are not well known.”

At first glance, SDPs appear to be cheaper. In his article, Mittal explained that they “compete with market makers on exchanges by offering liquidity at the same execution price. But while exchanges can charge up to $0.0030 per share to take the order, SDPs provide liquidity “for free” (and may even offer a discount), thus providing an opportunity to reduce costs for algorithmic execution brokers.

But it is brokers, not their institutional investor clients, who enjoy these benefits. In fact, brokers, who receive a fixed commission from their institutional investor clients, have a conflict of interest because it is more profitable for them to use the cheaper SDP, Mittal argued.

Mittal said his article, designed to dispel myths about SDPs, caused a stir in the industry. “It’s hard to be one of the only companies talking about these issues because they’re entrenched companies,” he said. II.

He explained in the report how SDPs “receive significantly 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 portray 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 concerns what he calls a “leakage” of information obtained by the STP, which allows him to reconstruct the trading patterns of a counterparty.

Here’s how the systems differ.

“When sending a tradeable order to an exchange or ATS, the order is anonymous to the counterparty trading against it,” Mittal said in the report. “Because a liquidity provider at an exchange or ATS does not have information about the identity of its counterparty, it does not have the ability to reconstruct the trading patterns of the counterparty. On the contrary, an SDP trading against an incoming market order has complete information about the identity of the real-time algorithmic broker and information about the flow “segment” an order belongs to.

Even if a commercial order is split into slices, the STP has the ability to learn the entire order, according to Mittal.

In general, information leakage is a big problem because once people find out there’s a big order behind a trade, the price of the stock bought goes up and “you end up buying the rest of the order at a much higher price. he explained.

Mittal said a dark pool or exchange only discovers the order after the trade, rather than before the trade. They also do not receive information about the residual quantity of the market order left open after the order.

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

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

The SDPs are “not doing anything illegal,” he stressed. They are allowed to use this information to make deals or even to trade on their own account, he said.

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

“These entities have now become very large, but there is no transparency,” Mittal said. “The pension funds don’t even know how these SDPs work.”

Its report concluded that “institutional investors should be aware of the differences in how SDPs work compared to traditional dark pools in order to better assess whether and how to interact with SDPs in their execution algorithms.”

“Be aware that you are taking this drug and it may have side effects,” he said. II. “It doesn’t mean you’re going to die.”

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