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September 1, 2008

The Senator Taps Twice

In the most infamous IOI of recent times, Senator Larry Craig of Idaho tapped his foot in the men's room of the Minneapolis airport, looking for a trading partner of sorts. The IOI, or "indication of interest," backfired miserably, resulting in the esteemed lawmaker's arrest for lewd conduct and a subsequent decision not to run for re-election this November.

The senator learned the hard way that IOIs are a two-edged sword, and that blindly indicating interest in something that's best kept discreet is not always an optimal strategy.

Traders have already overwhelmingly absorbed this lesson. IOIs on Wall Street refer to electronic messages that inform select recipients about your orders, in the hope of finding the other side. In poker, revealing your "hole" cards to other players, even if done selectively, will not help you grow your pile of chips. Yet an IOI represents the trading version of doing just that -- it is the ultimate "tell," and exactly what you don't want to be doing with your sensitive orders. As a consequence, volume in algorithmic systems that don't IOI or leak order information has been spiking over the past few years.

But lately, growing even faster than the algorithmic volume are rumors of inappropriate electronic IOI-ing, the sudden burst of sellside chatter on the topic rivaling the media explosion that occurred when Senator Craig's IOI was first exposed. So what is all the recent fuss regarding electronic indications really about?

There are several different kinds of messages that make up the alphabet soup being stirred by electronic trading desks: IOIs, IOLs ("indications of liquidity"), "Blind IOCs" and "Targeted IOCs". IOCs, or immediate or cancel orders, have been around for many years and are a staple weapon in the smart order routing arsenal. As its name implies, an IOC is an order that is either executed at the moment of arrival, or else cancelled. A Targeted IOC is sent in response to a displayed quote or in response to someone else's IOI. It is not a shot in the dark; a Targeted IOC represents a decision to hit or take a known bid or offer.

The other type of IOC is the "Blind IOC", sent out to probe a trading destination to see if it has dark liquidity available. Blind IOCs are enormously useful when searching for dark orders at or within the bid/offer spread and are a crucial component of achieving best execution. They are a fast and efficient way to probe for a dark offer at 27 cents, prior to taking a displayed offer at 28 cents. As opposed to the Targeted IOC, which has very high fill rates, a Blind IOC has a very low fill rate, typically less than 1 percent.

So for a Blind IOC to be a safe and effective trading tool, and not a fountain of information leakage, it has to be completely confidential, meaning no active market participant ever gets access to the IOC order history.

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