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March 7, 2008

Traders Say Price Discovery Is Endangered

By James Ramage

The market's price-discovery process is at risk due to the impact of a major exception to the Securities and Exchange Commission's Regulation NMS. That's the concern of some trading officials who contend intermarket sweep orders (ISOs) are not doing what they're supposed to.

Rather than take out displayed quotes, ISOs frequently take out hidden ones.

"That goes into the whole hierarchy of the price-time priority debate: You have to satisfy price first and then [arrival time]," said Will Geyer, president of JonesTrading. "And now you're introducing this other component, which is: How do we hierarchically interact with the hidden liquidity, and is that fulfilling the objective of what this initiative [intended to do]?"

The initiative in question, namely Reg NMS's Rule 611, was designed by the SEC to protect displayed quotes-though not hidden ones-against trade-throughs.

ISOs were intended to be used by traders to take out a market center's best-priced electronically accessible quotes when a trader was simultaneously trying to trade at an inferior price elsewhere. The exception was meant to allow traders to access large chunks of liquidity at prices inferior to the market's best while still providing incentives for other traders to post limit orders.

Brokers who print blocks for customers away from the inside, for example, use this order type.

Many ISOs are not trading against the displayed and protected limit orders, though. En route to trade against the top-of-book limit orders, they are intercepted by hidden orders that are actually priced better. Nasdaq, for instance, claims that between 18 and 20 percent of the trades done on its system involve a hidden order. Often, the hidden order is priced better than the displayed quote that was the original target of the ISO user.

And as long as ISOs that target a market's best bid or offer can take the undisplayed liquidity inside the market's quote, some argue, traders could grow less inclined to risk exposing their orders.

One buyside trader who declined to be identified said the ISO exception's capacity to leave protected orders unexecuted goes against what Rule 611 was intended to achieve. If more traders think twice about displaying their orders, he added, there could be price-discovery issues.

"That's a problem for the market," the buyside trader said. "The fact that these orders are not going to come in and improve the prices-we're going to see less true pricing."

Both Geyer and the buyside trader said they understood the perspective of the ISO user on the other side, too. The trader sending the ISO gets a price-improved fill against the hidden order. Some market participants argue that that trader should get the benefit because he's initiating the order and taking the liquidity, and is willing to pay the spread to do so.

"The real conundrum is if you're the one shipping the ISO," the buyside trader said. "You're getting a better price than the BBO from these undisplayed orders, so you're ending up in a better position because of them. It's hard to say they're bad. It's just that they're doing something that wasn't intended."

Dan Gray, market structure counsel within the SEC's Division of Trading and Markets, answered questions regarding the ISO exception during the Security Traders Association of Chicago midwinter meeting in January. Gray, not speaking on behalf of the SEC, acknowledged that the market's best displayed quote may not get taken out by an incoming ISO, but declined to pass judgment on the case.

Sources knowledgeable about the SEC's intentions when drafting Reg NMS tell Traders Magazine the regulator knew interceptions by hidden orders could occur, but saw no way to prevent them.

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