Jaffray Woodriff


    This article was originally published at the Transparent Simplicity blog, and is reproduced here with the author’s permission.

    The problems detailed below of order types, rebates, and failed regulations are symptomatic of the deeper, more systemic problem with the regulation of equity markets:undue and dangerous complexity.  Ever increasing regulatory and market microstructure complexity endangers market participants and society at large.  It is absolutely essential for the long-term health of our financial system that policymakers reduce complexity. 

    Regulators seem to think that the rules need to be complex because the financial system is complex, but that couldn’t be further from the truth. Rules governing the stock exchanges need to be as simple as possible so that robustness is built into the system.  High-frequency traders (HFTs), regulators, and exchanges are all responsible for this complexity, which is manifested most significantly in the following unfortunate properties of our stock market:

    1. Order type proliferation and confusion
    2. Destination proliferation (numerous of each: lit exchanges, dark pools, internalization)
    3. Rebate distortions and complexity

     The equity markets’ complexity has led to a burgeoning fragility.  In contrast to the opaque and complex equities market, the futures market is several orders of magnitude simpler and more robust.  There are fewer futures market venues and there are no rebates which over-complicate the markets while distorting price discovery.   Futures market microstructure should be the model and standard for reforming our equities markets.

     Recent SEC penalty

    The SEC has recently been paying more attention to the advantages HFTs have over all other market participants.  In October 2012, the SEC imposed a bold $5 million penaltyagainst the New York Stock Exchange for providing delayed quotes to different traders.  One SEC staff member described the penalty in this way: “The NYSE chose ground-shipping for sending market data to the consolidated feed but used next-day air for its paying customers.” 

    The SEC Is Lagging on Regulation

                    However, the SEC in general has lagged in their understanding of regulations and their consequences in the new world of super-low latency trading.  The SEC’s Division of Risk, Strategy, and Financial Innovation was created to oversee HFT regulation and is currently headed by a physicist and former hedge fund manager named Gregg Berman.   Despite his academic qualifications, Berman has been extremely deferential to HFT.  For instance, no formal application for a new order type has been denied to the various stock exchanges.  Berman’s division in general has been overly cozy with HFTs.  In an October Reuters article, Berman explained his reluctance to regulate HFT more aggressively:

    “I’ve heard many suggestions for how we might slow down the markets. But I think some ideas have ignored the fact that we have markets in which investors demand the ability to trade on an immediate and continuous basis, not at discrete intervals. . . . It’s like saying ‘let’s use the rules of train travel, in which every train is on a specific track, to try to dictate how cars should behave, even though cars can drive between the lanes and on the shoulder.'”

    Berman has been strongly criticized for this approach to HFTs.  In October 2010, Reuters reported that HFT firms see Berman as very favorable to them.  Also see this Firedoglake post titled “Official Report on Flash Crash: Nothing to See Here.”

    In August 2012, the SEC announced that Berman is directing a new Data Analysis Group that is looking for staff.  Trader Magazine reported that part of the reason for the group was that the “SEC learned it was unprepared to sift through the mountains of market data in the current high-speed, rapid-trading marketplace of today.  That was evident when it had difficulty understanding what happened in the market on May 6, 2010-the day of the ‘flash crash.’” 

    Finally, the SEC recently announced its decision to pay a New Jersey trading firm named Tradeworx $2.5 million for real-time data for the Data Analysis Group.  Tradeworx’s founder Manoj Narang has been an extremely staunch defender of HFT and a harsh critic of efforts to limit quote traffic.  TradeWorx has designed a proprietary software system called Market Information Data Analytics System (MIDAS) for the SEC, to be released by the end of 2012.  SEC’s retention of Tradeworx is another example of the SEC’s too-close relationship with HFTs.  As the New York Times reported, a recent Senate hearing featured testimony from a former HFT that the arrangement was “reminiscent of the fox guarding the hen house.”

     Reg NMS, Rules 610 and 611

    Another example of problematic regulation is the extensive regulatory arbitrage around Regulation National Market System (Reg NMS), which the SEC adopted in 2005 to link together the multiple markets where securities are traded.  In 2007, Rule 610 was implemented to require fair and non-discriminatory access to quotations; establish a limit on access fees; and require each exchange to establish rules to prohibit members from locking markets through quotes.  Please see Locked Markets, Priority and Why HFTs Have an Advantage: Part I by former HFT trader and SEC whistleblower Haim Bodek.

    In plain English, Rule 610 was supposed to stop HFTs from locking up markets through “scalping.”  Scalping occurs when an HFT buys a large quantity of a stock at the bid price and then sells as the ask price within a tight time period, without the bid or ask prices moving.  This had the effect of locking a market to an outside participant.

    Rule 610 was well-intentioned, but created an environment where HFTs send and cancel large numbers of unexecuted transactions to make their orders “stick” at the best price at the top of a queue.  After Rule 610, HFTs launched new “spam and cancel” strategies that repeatedly attempted to get to the front of order queues in new ways, often enabled by the exchanges themselves.

    For example, one new order feature is to “price slide” the order.  After an order, exchanges slightly “slide back” or modify the price to offer a purportedly “convenient” and “sensible” price.  When these orders are “slid back,” they lose their placement in the queue.  HFTs therefore learn that there are other orders ahead in better queue positions and cancel their “slid orders” and re-place with new orders.  However, the orders placed by traditional investors, such as pension funds, typically slide without being canceled, therefore losing ultimate placement in the queue to the HFTs.  Many institutional traders have no idea that their orders are being “slid away” from the top of the book. 

    Some exchanges also give HFTs specialized order confirmation information that enables them to detect when their orders are being “slid,” so they can quickly cancel the price-slid order.  These “opt out” options reject orders that might have otherwise been placed in a disadvantaged queue position, giving another hidden advantage to HFTs over institutional traders. 

    Rule 610 also enabled a new wave of “Hide and Light” strategies offered by the exchanges and exploited by HFTs.  “Hide and light” order types gave a superior queue position by automatically “lighting” a hidden order when the order would no longer lock the market, transforming an HFT’s previously hidden order into a “protected quotation” when it is most advantageous.  See Bodek’s Locked Markets, Priority and Why HFTs Have an Advantage: Part II.  The “Hide and Light” strategies further disadvantage institutional investors, who cannot take advantage of the “special relationship between Rule 610, the processing of the Security Information Processor (SIP) feed, exchange order matching engine practices, and the special order types themselves.” 

    Finally, Rule 611 of Reg NMS, also known as the Order Protection Rule, has also enabled HFTs to gain an unfair advantage over institutional investors.  Rule 611 was intended to create a single, unified national bid and offer by prohibiting exchanges from executing trades that can be filled at better prices at away markets.  The SEC created Intermarket Sweep Orders (ISOs) as an exemption to Rule 611.  Using ISO types such as the “Immediate-or-Cancel” (IOC) version, which instructs an exchange either to immediately execute an order at a specific price or to cancel it, HFTs defeat institutional investors using slow SIP data feeds.  For more information on this very complex issue, see Haim Bodek’s Why HFTs Have an Advantage, Part 3: Intermarket Sweep Orders.

    Problems such as these should be fixed with an overhaul of Rule 610 and Rule 611 by the SEC.

    Odd Lots 

    Another example is the SEC’s refusal to require odd lots to be reported to the consolidated tape.  Odd lots are trades under 100 shares.   As Trader Magazine has reported, a 2011 Cornell University report contained disturbing findings of additional unregulated opacity in our markets. 

    The report finds that odd lots increased from 2.25% of total volume at the beginning of 2008, to as high as 20% today—a change attributable to HFTs’ algorithms.  In the words of one co-author of the study: “Part of what’s happening is algos have now changed how you trade, and so it’s not that uncommon to have an order chopped up into lots of little pieces.”

    Some of the increased traffic is caused by HFTs using single share trades—which are considered odd lots—to ping a stock’s price and potential hidden orders.  But even though odd lots are under 100 shares, they can still be large trades.  Google trades at over $600 a share, so a trade of $60,000 of Google stock is still an odd lot.  34% of all trades in Google are odd lots, and all of these trades go unreported.

    Rebates and Order Types

    A final example is the enormous and unnecessary complexity surrounding rebate and fee schedules.  It should be noted that QIM receives a significant amount in rebates which partially offsets various equity execution costs.  Despite this, rebates have a highly distortive effect on the equity markets, and we believe they should be banned.  The discriminatory order type and queue system is further enabled by the complex rebate and fee landscape on our stock exchanges.  All US stock exchanges currently employ complicated systems of fees and rebates that provide further incentive and opportunity for HFTs to disadvantage all other traders with respect to queue priority. 

    These systems are not public or transparent, meaning that some exchanges are affording unfair advantages to certain traders, either because they pay for them, because they are confidentially informed about how to get their orders higher in the queue, or because they have collusive relationships with the exchanges themselves.  In addition, the sheer enormity of the complexity itself enables a large asymmetry of information that HFTs exploit every second of the trading day. Please see this Wall Street Journal article titled For Superfast Stock Traders, a Way to Jump Ahead in Line for more information.

    The vast number of order types also contributes to extreme complexity.  See this SEC listing of “common order types,” which is modest and minimal, and coincidentally or not, very similar to the list of available order types on a typical futures exchange.  Then compare it with this exhaustive, complex, and extremely opaque list of order types provided by the exchange Direct Edge.  There is clearly a gap between industry and government.

    As Themis Trading argues, the new order types are perks sold to them by the exchanges – including colocation, data feeds, and dubious order types – to make sure that they maximize the number of free shots at a risk free rebate. This means they want to bid and be first in line, and only when they are assured that there are other buyers deep behind them, and collect rebates.  If they are successful and buy stock and collect a rebate, they can turn around and instantly sell that stock at the same price to the person behind them, still making a profitThis is not liquidity provision.  They game ways to be at the top of the book in stocks that already have the liquidity that serves as a backstop.” 

    Policy Recommendations

    1)      The SEC and CFTC, led by Congress, should undertake a holistic effort to reduce undue complexity in our regulatory system.  This effort would fit well within your regulatory “pay go” proposals and would be akin to the Paperwork Reduction Act of 1995.  The government should aspire to make the equities market meet the simplicity and transparency of the futures market.

    2)      Rules 610 and 611 should be overhauled to address the perverse incentives they have created and the ways in which exchanges are working to give HFTs unfair advantages over all other market participants.

    3)      As Themis Trading recently suggestedthe SEC should institute a moratorium on the approval of new order types; disclose its “yardstick and methodology” for approving complex order types; and overhaul the self-regulatory organization (SRO) rulemaking process.  We actually take this much further and urge that most order types be de-authorized.

    4)      The SEC should hire only top-flight personnel who will subject HFTs and the exchanges to the highest level of scrutiny.  This would counter the perception that the SEC itself is seriously behind industry when it comes to crucial issues like discriminatory order types. 

    5)      Monitoring and data systems like the MIDAS system should cover off-exchange trading, including dark pools and, to every extent possible, internalization.  This will enable the transparency and complete information that all market participants need and that fair regulation requires.

    6)      We should seriously consider outlawing rebates altogether.  The current rebates for stocks especially with share prices between $1 and $20 are extremely distorting to the price-finding mechanism of a properly functioning market.

    7)      The SEC should require odd lots to be reported to the consolidated tape.

    About the author

    Jaffray Woodriff has 25 years of experience developing proprietary quantitative models to predict price movements for a wide variety of markets. The success of these models is due to his lifelong work of inventing and employing mathematical formulas to create better approaches to quantitative prediction. He co-founded Quantitative Investment Management in 2003. Presently, Mr. Woodriff guides all aspects of QIM’s business and is responsible for the innovation and improvement of the models and techniques that underlie the firm’s predictions, risk management and trading.

    The opinions and writing contained in this article are of the author alone and do not necessarily represent those of HFTReview.com.

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