Connecting to the Stock Market (Choosing a DMA Partner)

Alright, so you’re starting a broker-dealer. First question is what kind of customers will you serve, and you probably already decided. In other words, will you be a retail broker serving individuals (like Schwab, E-Trade, Fidelity, TD Ameritrade, Interactive Brokers, or Robinhood, etc.); or an institutional broker serving mutual funds and hedge funds (like JPMorgan, Bank of America, Morgan Stanley, UBS, Credit Suisse, Goldman Sachs, etc.)? Technically, you can serve both groups, but most firms choose one or the other. Our broker-dealer subsidiary, Proof Services, serves institutional investors.

Next you need to tap into this complicated mess of a stock market, but before that you must understand where stocks actually trade. The US stock market is very fragmented. There are 16 stock exchanges and about 30 dark pools, and each public equity trades on all of them. And these are completely distinct from the 5-10 major wholesalers (e.g. Citadel, Virtu, Two Sigma, etc.) who gobble up orders from retail brokers before they hit the open market. If you connect to any one of these places, your firm would be able to trade every stock, but there are major differences between them and good reasons to connect to multiple, if not all of them. And even once you’ve decided which venues you want to connect to, there are different methods of connecting and different fees associated with those different methods. To make informed decisions for your use case it helps to understand: what are the different venues and ways to connect to them, and how are they designed to serve the needs of different kinds of participants?

So let’s dive deeper!

Trading Venues

The three types of players in the trading venue space are exchanges, dark pools, and wholesalers:

Exchanges

Exchanges are the major, heavily regulated institutions that list securities, run the opening and closing auctions, and collect and distribute public quotations, in addition to facilitating continuous market trading. Exchanges represent about 50–55% of market volume these days (down from 65% pre-pandemic). There are 3 large families: NYSE, Nasdaq, and Cboe who collectively operate 12 exchanges that trade nearly 95% of all exchange volume. And there are 4 independent small exchanges: IEX (our alma mater), MEMX, LTSE, and MIAX that make up the balance.

Dark Pools

In addition to exchanges, there are alternative trading systems (ATSs), most of which are colloquially called dark pools. These are less regulated mini-exchanges that don’t quote and account for about 10% of the market. The largest dark pools are operated by UBS and Credit Suisse, but they are each pretty small compared to the major exchanges.

Wholesalers

Finally there are wholesalers, mostly a subset of proprietary trading firms. Wholesalers are market makers who trade again individual retail investor orders that they receive from a retail broker, and then they offload accumulated risk in the open market (i.e. on exchanges and dark pools). In this way, a wholesaler serves as a bridge between retail investors and the wider market where institutional orders are traded. The largest wholesalers are Citadel and Virtu, and both of these companies also happen to operate decently sized institutional broker-dealer businesses too. Virtu even runs a couple ATSs. There’s actually a lot of overlap between all of these lines of business, and it’s quite complicated to untangle.

Connecting to the Stock Market

There are long standing regulations, similar to the three-tier system in the liquor world, that dictate that only broker-dealers may trade on exchanges. For this reason, neither retail nor institutional investors can bypass brokers and trade directly on exchanges. Even for brokers, however, acquiring direct access to exchanges can be onerous and costly.

Retail brokers are typically not well-served by connecting directly to exchanges. This is because retail and institutional investor orders (typically) mix anonymously on exchanges, and market makers are more cautious in their pricing on exchanges to cushion them from potential losses when trading against a large, well-informed institutional order. When a retail broker reaches an agreement with a wholesaler instead, the wholesaler can tailor its spreads to the source of the orders, better serving the particular needs of retail investors (at least in theory).

As a result, most retail brokers take the approach of facing off with wholesalers via a payment for order flow (PFOF) arrangement, and most startups begin by just having their clearing firm manage this piece. In this case, the clearing firm provides a 1-stop custody, clearing, and execution solution. While there is nothing precluding retail brokers from obtaining exchange memberships and sending customer orders directly to the exchanges, very few actually do this (other than in the narrow use case of posting passive orders on a super-high retail rebate exchange like EDGX).

Institutional brokers, however, serve larger customers whose needs are met by trading on exchanges and dark pools. Accordingly, institutional brokers generally connect to many such venues. Proof’s broker-dealer subsidiary, for example, could obtain memberships everywhere and connect directly to all the dark pools, but there are two major obstacles to going down this path:

1. Exchange membership and connectivity can be quite expensive, particularly for their low latency offerings. The ballpark is $5–10k per family upfront to apply for membership, and anywhere from thousands to hundreds of thousands to connect per month (1, 2, 3, 4), and this doesn’t even include networking costs and operational overhead;
2. Exchange tiers, which are probably even more important:

Exchange pricing tiers

Exchange transaction pricing is crazy complicated. Exchanges by law are required to offer “fair access” to all broker-dealers, and their transaction fees are capped at 30 cents per hundred shares. This means every broker in good regulatory standing must be allowed to connect, and all of them must be subject to the same exact fee schedule. But exchanges, being the evil (brilliant?) for-profit titans of industry that they are, have developed an immense web of fees, rebates, order types, and tiers that technically are available to everyone, but in effect allow them to offer dramatically different terms to their various participants.

You can think of the tiers as frequent flier programs, where large firms are in the ultra platinum tier and little firms are in the bronze tier, where they kick you in the shins as you get on and off the plane. Technically anyone can qualify for a good tier if you do enough business, but when huge players like Goldman Sachs, UBS, and Credit Suisse are not qualifying for the very best tiers, that tells you there is some serious price discrimination going on. As a result, there is really no chance for a small institutional broker-dealer to have a good experience trading directly on the major exchanges. Fortunately, there is another (confusingly named) option: Direct Market Access, or DMA.

Direct Market Access

DMA is where a smaller broker (or even an investor) generates exchange orders, but sends them via a larger broker to take advantage of the larger broker’s connectivity and tiers. There are major benefits, and a few downsides, to taking this approach:

Pros

• Much better exchange transaction pricing, depending on the DMA provider’s tiers.
• No exchange membership/connectivity fees.
• Much easier operationally, since you only manage one connection but can still access the full gamut of exchanges and exchange order types (as long as the DMA provider supports passing them through, which most do).
• Access to most if not all major dark pools.
• Access to the DMA provider’s other services.

Cons

• You (usually) have to pay the DMA provider.
• It’s an extra hop, which means additional latency and another potential point of failure. The DMA provider is also required to perform 15c3–5 risk checks on your order flow, which means a bit of extra latency, but some folks might consider this a positive tradeoff.
• Possible data privacy concerns, although you can certainly negotiate on this front before signing an agreement.
• Your volume doesn’t count toward your own exchange tiers (because it counts for the DMA provider), but c’mon you weren’t going to hit the good tiers anyway.

Pricing

DMA pricing is almost always cost plus, as in all the exchange fees and rebates get passed through, and the DMA provider just tacks on a tiny additional fee.

The major DMA providers are all broker-dealers who have large trading businesses of their own. There is a great deal of competition among them and the basic offering is pretty commoditized. All of them already have this connectivity and functionality anyway for their own business, and they really compete for customer business because the additional flow helps them hit and maintain their exchange tiers. It’s gotten to the point where if you trade a fair amount of volume, you can probably find a good DMA provider who will offer you the service for free for this reason alone. Wild!

In our case, Proof Services is tiny because it is brand new, so it can’t command free pricing, but we were still pleasantly surprised by the quotes we got when we evaluated potential partners. After narrowing our initial options, we went well down the evaluation path with 4 firms: MS, UBS, CS, RBC (where I also used to work). I think any of these four could have been great.

Factors to consider when choosing a DMA partner

• Exchange tiers: this is probably the single most important factor. Our impression of the firms we deeply evaluated was that MS had the best tiers, and RBC had the worst, with CS and UBS in between.
• Cost: based on the quotes we got, the market seems to be quite competitive and in a pretty narrow band of cost plus 0.5 to 2 mils per share, often starting at the higher end, and scaling down to the lower end with more order flow. Some of our initial quotes came in above this range, but in those cases there was wiggle room, and it didn’t take much if any pushing on my part.
• Available venues/order types (especially dark pools): there were some differences in terms of which dark pools each provider was connected to, and these did play a role in our evaluation. Additionally, many DMA providers have their own dark pools, which means a few things: 1) you might get a particularly good experience trading in theirs (although not necessarily); 2) they might have friendly reciprocal relationships with competitor dark pools; or 3) they might have contentious relationships with certain dark pools leading to subpar access (e.g. your orders only interact with “toxic” counterparties), or even no access.
• Latency: most of the firms we considered offered two options: a higher latency option (still <1ms) where you have one connection/normalized spec, and they convert your messages to the individual exchanges’ specs; and a lower latency option (single digit microsecond, if not better) where they’re a basically a straight passthrough with a thin layer of risk checks. In the latter case, you write messages to the individual exchanges’ specs.
• Level of service: in our experience so far, there has been a good correlation between the level of service we receive during the partner evaluation process and our ultimate experience working with them. A couple of the firms we evaluated were extremely responsive, transparent, and thoughtful during this phase, and that wound up playing a large role in our decision. In general though, broker-dealers are amazing at sales (like, too good, to the point where it makes you suspicious). So you know, keep your guard up.

Our decision: Credit Suisse!

This was a tough one, particularly because MS has slightly better tiers, but we just had an outstanding experience dealing with CS during the evaluation process, and that tipped the scales in the end. Since partnering with them, I’ve given CS multiple shout outs in this blog because they really have been excellent. From the beginning, they seemed to genuinely believe in Proof’s vision and potential, or at least they think we have a good enough shot at success to be worth the effort, and they have treated us like a meaningful long-term partner and not just the small fry that we currently are. Now that we are several months into the relationship, through the onboarding process into live trading, this is one decision that we feel particularly good about.