3 Pie Charts that Show Fragmentation in the U.S. Market

We’ve done a few blogs this year looking at the increase in off-exchange trading, and fragmentation of what is on-exchange, even as on-exchange share continues to shrink.

Today, we update one of our favorite charts, which looks at how orders route, where trades actually get done and what economic incentives each part of the market structure pies use to attract customers. 

You could say the U.S. equity market is really more like three interconnected markets, with a lot of retail, mutual funds and arbitrage traders mostly separated from each other – resulting in less “accessible” liquidity, available to each, than top-line volume numbers suggest.

The U.S. market works more like three separate markets

The chart below shows the most recent market shares of each pie in the U.S. market structure. The circles are sized relative to their contribution to market-wide volumes traded. When we first made this chart nearly five years ago, 65% of total market volume was executed on-exchange. As more volume has moved away from lit markets, the economics of trading have changed, too.

As we detail below, the market rules, trading economics, and how orders are handed by brokers, means each pie actually works quite differently to the others.

Chart 1: Order flow and market share in the U.S. stock market

The rules for each part are quite different 

The rules and conventions for trading across each of the three pies are quite different, too.

1. Mostly Retail Pie

We say this is “mostly retail” because it includes all sorts of bilaterally agreed trades. That includes trades between Single Dealer Platforms, other brokers, as well as blocks agreed between investors. However, based on work we (and others) have done looking at retail trading growth, retail seems to be the largest part of this pie, but we acknowledge that it’s not the only activity driving the growth of off-exchange.

Orders from retail brokers are usually sent to wholesalers. Because retail orders are small, and typically fairly random, it’s easier to profit from filling a retail spread crossing order than an arbitrage spread crossing order. 

As a result, retail typically gets filled before reaching exchanges, usually with sub-decimal prices that are better than the limit orders dark pools and exchanges are required to use. 

This results in an economic incentive, called price improvement, to trade more with this pie. Sometimes, wholesalers will also pay for order flow that is particularly profitable to trade with.

2. Dark Pools Pie

Investment banks typically handle mutual fund customer trades and build algorithms to slice their large orders up to minimize their impact. They also usually run their own dark pools to cross those customer orders away from exchanges. 

Unlike how retail trade, dark pools need to trade “on tick” (or, frequently, at midpoint). They do this using the NBBO from exchanges.

This not only helps brokers avoid exchange fees, but it also earns them trading and SIP data revenues. 

In addition, the ability to segment also means some customers can have better spread capture, which means they are willing to pay higher fees to trade.

However, both these pies are, by their nature, not transparent. Rather than set prices, they use NBBO prices. In addition, their fees can be very different, and trades are sometimes free or bundled with other services. Even where trades are occurring is anonymous on the SIP (Although FINRA does report aggregate market share with a two-to-four-week lag).

3. Exchanges Pie

Once liquidity is exhausted in either of the broker run pools above, orders will fall into the “public” markets. 

Just like dark pools, exchanges need to trade on tick (or at midpoint). However, unlike dark pools, exchanges are fair access markets, meaning they can’t discriminate on who can trade on their venue or segment customers into tiers based on profitability to other traders. Although things like speed bumps and fees and rebates do affect trading economics, which is why some venues receive orders.

Something a lot of pundits seem to forget is that Exchanges are also important to the whole ecosystem for other reasons. Exchanges publish their best prices, which are then used throughout the industry to protect investors from bad fills. Some also list and provide needed services for public companies that want access to public markets.

Table 1: The rules for trading in each pie are quite different

The U.S. has a very fragmented, and segmented, market

What the data shows is not only that the U.S. stock market is extremely fragmented, but it is also segmented at the point of order arrival. 

This affects the economics of providing “positive externalities” like bringing more IPOs to market and providing prices to protect investors. It transfers the economics of trading and spread capture from those providing the NBBO to those trading first in segmented venues. It reduces the actual liquidity that is accessible to everyone. It’s also hard for retail and Institutional investors to trade directly with each other.

Not only is the U.S. market structure complicated. It’s far from a level playing field.