US Equity Market Structure (2): The Playing Field and Referees – Exchanges and Other Trading Venues

This is the second post of a series on US Equity Market Structure (a total of 6).

I didn't write any of these posts; while I was learning the fundamentals about investment, I came across this series on Interactive Brokers' IBKRCampus. If you are interested you can go to their site here.

（Disclosure: I'm using Interactive Brokers for my personal investing, but I'm not paid by them to write about it.)

This series is mostly platform-agnostic, meaning that you don't have to be on Interactive Brokers to find this series useful. Enjoy.

Thanks for coming back for lesson two in our course on equity market structure. In our last lesson, we talked about the US equity market's rulebook and the regulators—the laws, regulations, and regulators that govern the broad structures for trading. Today, we're talking about the exchanges and other trading venues.

These entities, which are for-profit in the U.S., play two roles: trading venues act as the playing field and referees for trading. They have rules and technology that set up the basic boundaries for how they will match buyers and sellers. Their playing fields must be set up within the confines of the Exchange Act, but beyond that, they have some leeway with how trading works on their particular exchange.

For instance, IEX is known for its "speed bump"—a coil of cable that delays all messages coming in and out of the exchange by 350 microseconds. Trading venues are also responsible for monitoring trading on their venue for, among other things, potentially manipulative activity.

So, where are these entities that have so much power over how trading happens?

Stock Exchanges: Three Exchange Families Plus IEX

Stock exchanges are the main places where trading gets done. As of the recording of this lesson, there are 13 stock exchanges in the US, but that number makes it sound more complicated than it is. There are actually only four stock exchange operators currently in the market.

The New York Stock Exchange (NYSE) was the first US equities exchange. It still exists today and is often called "NYSE Classic" as shorthand. It’s the exchange that lists companies like GE and DuPont. However, NYSE also owns four other stock exchanges: NYSE Arca, which mainly lists ETFs, and three smaller exchanges with less than 1% market share: NYSE Chicago (the former Chicago Stock Exchange), NYSE American (the former American Stock Exchange), and NYSE National (the former Cincinnati Stock Exchange).

Next, there's Nasdaq, which was founded in the 1970s as the first fully electronic stock market and became an exchange in 2006, ahead of Regulation NMS, which we discussed in the previous lesson. Nasdaq's main exchange, just called Nasdaq, currently handles the most trading of any exchange and lists companies like Microsoft and Apple. Nasdaq also owns Nasdaq BX (the former Boston Stock Exchange) and Nasdaq PSX (the former Philadelphia Stock Exchange).

Then there’s Cboe Global Markets, the company that bought Bats Global Markets. Bats was founded in 2005 and started two exchanges. In 2014, it merged with Direct Edge, which also had two exchanges. Those four exchanges, which are now part of Cboe, are called Cboe BYX, Cboe BZX, Cboe EDGA, and Cboe EDGX.

Finally, there's the Investors Exchange (IEX). IEX became an exchange in 2016 and is most well-known for the speed bump mentioned previously, which is designed to help the exchange ensure it has the most up-to-date prices from around the market before executing trades. IEX has also introduced other technology and business practices that are designed to level the playing field for all participants.

All the stock exchanges have applied for and received permission from the SEC to be what is called nationally registered stock exchanges. In this capacity, they are considered self-regulatory organizations (SROs) that have significant power to enforce the rules of their exchanges, acting as referees. However, with that power comes a large amount of scrutiny and regulatory oversight, aimed at ensuring that the exchanges operate with a high degree of integrity, security, and precision.

In addition to these exchanges, there are a number of other companies that may be launching exchanges in the near future, including the Long-Term Stock Exchange, the Members Exchange, and MIAX, which is known for operating multiple options exchanges. It’s a constantly evolving landscape and one that you can follow in the news regularly.

Alternative Trading Systems (ATS) – AKA Dark Pools

In addition to the stock exchanges, trading also occurs on Alternative Trading Systems (ATSs), often referred to as dark pools. These venues have the same fundamental rules but exhibit some critical differences. ATSs are more lightly regulated marketplaces for trading, often run by large banks. For instance, two of the largest dark pools are run by UBS and Morgan Stanley. However, some ATSs are run independently, such as Liquidnet.

ATSs are called dark pools because, in many cases, they only offer non-displayed trading, meaning buyers and sellers don’t publicly post or advertise the prices at which they would be willing to trade. Instead, they submit their orders to the dark pool and wait for another order to match with them. Non-displayed trading is also available on exchanges but tends to be more prevalent on ATSs.

Starting soon, dark pools will have to disclose the rules of how trading works on their venues publicly via a form called ATS-N. This is important because the way dark pools operate is more flexible than exchanges. For example, they can charge more for trading than exchanges. Additionally, after trades occur on dark pools, they are only reported publicly as occurring off-exchange and are not attributed to the specific dark pool where they occurred.

Internalization

Finally, trades can also be executed inside large brokerages, for example, by matching or internalizing two customers’ orders. Large banks often work with a lot of clients across various departments. If they receive one order to buy and one order to sell the same stock, they can match those orders internally rather than sending them to an exchange or dark pool. Brokers prefer this because they get two orders filled immediately without sharing any information with the broader market, and they don’t have to pay another entity to execute the trade.

Additionally, some brokers send orders to market-making firms (also known as wholesalers) who trade against the orders for their own accounts. This process is also referred to as internalization.

In the next lesson, we’ll talk about what is actually traded in the US equity markets: stocks.