The Value of Inverted Exchanges

Cboe’s Equities Execution Consulting team frequently analyzes the global equities markets through an unbiased lens to provide valuable insights to all market participants. Most recently, the team analyzed how the use of inverted exchanges has evolved over time to determine their continued value in the broader equities marketplace.

The U.S. equity market structure landscape has changed substantially over the last decade. In particular, in the last three years there have been large shifts in volume and a restructuring of where that order flow is directed, as well as the noticeable rise and fall of inverted exchange market share. Inverted exchanges play an important role in U.S. equity market structure and participants should be mindful when deciding where to route their orders, primarily to retain faster fill times for orders at the National Best Bid or Offer (NBBO).

The Inverted Exchange Evolution

As we detailed in a previous post, inverted exchanges operate on a model that is the opposite of a maker-taker exchange. Inverted exchanges charge participants for adding liquidity while paying those who remove it, rather than offering a credit for adding liquidity and charging a fee for removing liquidity. This model incentivizes those liquidity providers who prioritize faster fills. Cboe Global Markets^TM operates two inverted exchanges: Cboe BYX^TM Equities Exchange and Cboe EDGA^TM Equities Exchange. These two markets, along with NASDAQ BX and NYSE National, comprise  the U.S. inverted exchanges.  Inverted markets offer an economical model for liquidity removers, particularly for brokers who may have cost-plus or direct market access clients.

These markets reached a peak of more than 10% market share in October 2017 but that share has considerably decreased since the rise of retail trading at the beginning of 2020. From 2010 until 2020, inverted exchanges held around 8-10% of equity market volume, however that has declined to just under 4% in the past two years. Cboe’s markets have remained the leaders in inverted market share, as illustrated in the chart below.

Figure 1 (Source: Cboe)

Figure 2 (Source: Cboe)

Changes in Market Share

In terms of overall U.S. landscape, the decline in inverted exchange market share has coincided with the increase in Trade Reporting Facility (TRF) volumes around the beginning of the COVID-19 pandemic. Though all four inverted exchanges saw significant volume increases at the start of 2020, the inverted exchanges’ market share did not grow to the same degree as other exchanges and the TRF.

Figure 3 (Source: Cboe)

As a whole, inverted markets averaged 15 billion shares per month in the years leading up to this paradigm shift. The initial volume spike in March 2020 led to a record month for inverted exchanges, with just under 25 billion shares traded. Since then,  volume has tapered off to around 10 billion shares traded per month, collectively.

Figure 4 (Source: Cboe)

Daily Market Share Changes

Despite this reduced footprint, inverted exchanges still retain plenty of notable benefits and advantages.

It is imperative to look at the different periods throughout the day when evaluating market share. While inverted exchanges may only average 4% market share overall, their market share increases toward the later part of the trading day, as demonstrated in the chart below. Inverted exchange market share climbed to  approximately 6% market share in the last hour of the regular trading session in June 2022. Additionally, of the volume executed in the last half hour of each trading session in June 2022, 48% was large-cap stocks, 26% in mid-cap and 25% in small-cap. Exchange Traded Funds (ETFs) only represent 1% of share volume traded during this period.

Figure 5 (Source: Cboe, Bloomberg)

Average trade size in inverted markets has decreased since 2019, which is consistent with their loss of market share. At the beginning of 2019, the highest inverted average trade size was 135 on Cboe BYX and the lowest was 110 on NASDAQ BX. By June 2022, Cboe BYX still had the largest average trade size of the inverted exchanges, at an average of 100 shares, while NASDAQ BX had the lowest, with an average trade side of 54 shares. In contrast, the majority of maker-taker exchanges have not experienced a similar drop in average trade sizes.

Figure 6 (Source: Cboe)

A Need for Speed

Inverted exchanges are one of the first exchanges to execute orders at the NBBO because they give credit to liquidity removers. To examine this more closely, we analyzed the time to first fill of all four Cboe exchanges when they are at the NBBO.  Between Cboe’s maker-taker exchanges, BZX and EDGX, and its inverted exchanges, BYX and EDGA, EDGA had both the lowest time to first fill, and fastest time to full fill. In June 2022, the average time to first fill on EDGA was 6.30 at the NBBO, compared to 9.32 seconds on BYX.

For  orders that received a full fill in June 2022, EDGA’s time to full fill was 6.13 seconds,  2.5 times faster than EDGX, which came in at 15.62 seconds. BYX reached full fill in comes in at 9.05 seconds compared to 9.47 seconds on BZX. Among Cboe exchanges, inverted exchanges are the fastest to full fill.

Figure 7 (Source: Cboe)

Since displayed quotes on inverted exchanges receive a faster fill when at the NBBO and are fully filled more quickly, they make a great alternative liquidity source for those routing blind immediate or cancel (IOC) orders to off-exchange platforms, which could be an Alternative Trading System (ATS) or an Enhanced Liquidity Provider/Single Dealer Platform. Part of the rise in TRF market share can be attributed to the diversion of this order flow, yet there is potential for better execution quality on-exchange thanks to several recent product additions to Cboe’s exchanges, such as Quote Depletion Protection (QDP) and Periodic Auctions.

QDP is an optional instruction on Midpoint Discretionary Orders (MDO) that disables the discretionary range of the order for a period of time, if the quote indicates that price movement may result in more aggressive executions. QDP’s signal is accurate the majority of the time and helps provide several basis points of price protection for MDO orders.

Periodic Auctions are currently exclusive to Cboe BYX during regular trading hours, facilitating on-exchange liquidity by providing price-forming auctions throughout the day. Two new order types have been created: Periodic Auction Only and Periodic Auction Eligible. Periodic Auction Only orders only execute in periodic auctions, eligible when matched with a contra side periodic auction order. Alternatively, Periodic Auction Eligible orders can still trade in the continuous book, but will lock in and trade only against auctions upon initiation for the duration of the auction. Periodic Auctions serve to help attract buyers and sellers in symbols with wider spreads or less liquidity in an equal and fair manner for all participants.

Inverted exchanges may not capture the market share they did several years ago, but they remain relevant in today’s U.S. equity markets because unique pricing structure attracts a different variety of liquidity. They are an ideal market center for passive orders with high participation rates or for marketable orders that include fees into the overall performance.

Innovation and choice enhance the investor experience, especially when it comes to how and where to route orders. We encourage our members and their clients to review empirical evidence when using execution platforms and are proud to continuously provide unbiased analyses to help inform your decisions.

For more information on these and other products, please contact your Cboe representative.

The information provided is for general education and information purposes only. No statement provided should be construed as a recommendation to buy or sell a security, future, financial instrument, investment fund, or other investment product (collectively, a “financial product”), or to provide investment advice. Cboe®, Cboe Global Markets®, BYX®, EDGA® are registered trademarks of Cboe Global Markets, Inc. and its subsidiaries. Past performance of an index or financial product is not indicative of future results. © 2022 Cboe Exchange, Inc. All Rights Reserved.