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Liquidity comes from individuals, institutions and brokers making independent trading decisions based upon where the most profitable and advantageous places are to trade. Most think of price when thinking of liquidity. But price can be subjective. How long it takes to execute, how definitive the execution is and the probability that the price will change before execution also are key factors. Latency, speed, accessibility and tradability (the ability to hit a listed price) -- in addition to price -- are critical to liquidity formation.
While these factors are table stakes, they mostly are technology-dependent, meaning they are acquirable. The real question is: How does a new venue get the best price to show up at its doorstep? Most believe that you form a bulge-bracket broker consortium and brokers will just move their flow. But it's not that easy.
Broker liquidity is comprised of three main flows: customer, proprietary and market making -- none are easily ported to a new venue. Customer flow is regulated by best execution and cannot be ported unless it is to a location where best execution is achievable. To accomplish portability, best execution must be guaranteed. While proprietary flow is determined by the firm, a proprietary trader is compensated for implementing ideas, not supporting a trading venue. So unless a venue already has liquidity, proprietary flow also is hard to port.
That leaves market-maker flow. Can market makers prime the liquidity pump where prop and customer flow can't? Well, we are getting warm. If any flow could prime a broker's consortium partner, it would be market-maker flow. However, market makers want to execute, too, and getting a market maker to quote in a venue with little flow can be challenging for a trader looking to facilitate customer business, manage risk and generate profit.
So if traditional broker flow is difficult to port to a new venue, will traditional exchanges always win over start-ups? How can new venues attract liquidity?
All is not lost for the de novo exchange. New business models and innovative market structures can be incredibly successful.
Economics plays a factor in tipping the balance of power. Rebate models have had tremendous success in shifting liquidity ground rules. Incentives can entice new, lower-cost market makers to seed venues with liquidity. In the U.S., venues such as BATS have leveraged new pricing structures to get rebate traders to electronically populate the book with very competitive limit orders. Since BATS (and other similarly structured venues) rebates firms for their liquidity, traders can actually lose money on each trade, but as long as the rebate is greater than the loss, the firm profits. Once the book is populated with well-priced limit orders, then traditional brokers can route orders to this new venue, and market share increases.
Developing innovative market structures also can tip the balance of power, as DirectEdge has demonstrated. Through different pricing models, DirectEdge has attracted significant retail order flow. Typically less-informed and more nondirectional than institutional flow, retail order flow tends to be more prized and valuable to institutions, which will pay a premium for access to that retail flow. DirectEdge has developed two liquidity pools to leverage this model: EDGA and EDGX. EDGA is free, and EDGX has a traditional 1 mill spread rebate structure. The key to DirectEdge, however, is the EDGA flow, which attracts price-sensitive retail flow and displays it to other liquidity pools (including EDGX); when that retail flow is taken, DirectEdge charges a 26 mill routing fee, which is how the financial market generates revenue.
Both the rebate and distinctive order-flow models change the way investors think and react to order flow, which in turn disrupts the status quo and catalyzes change. So while the general rule of thumb about liquidity begetting liquidity may actually be true, just because you have liquidity today doesn't mean that it won't be gone tomorrow.
