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December 5, 2008

ARCA Adds Depth-of-Book Routing

By Peter Chapman

NYSE Arca, trying to improve the quality of the fills on those orders it routes out, no longer limits its routing to competitors' top-of-book prices.

Under Regulation NMS rules, Arca need only try to match those orders it can't fill on its own book with the best single quote on any or all of its competitors' books. It can safely ignore a competitor's second-best price even if it is better than another exchange's best price.

But in the wake of trading mishaps that caused the cancellations of thousands of trades on Sept. 18 and 19, Arca has decided to pay for its competitors' depth-of-book feeds and match its outbound orders against second- and third-tier prices.

This, Arca hopes, will go a long way toward preventing fills at prices that are too far away from the market's best prevailing prices.

That is what happened in September after the Securities and Exchange Commission temporarily banned short selling in 799 financial stocks. A lack of liquidity, a surge of volatility and the blazing-fast trading speeds of the electronic markets resulted in tens of thousands of trades occurring at "clearly erroneous" prices.

Arca itself busted 30,000 trades on Sept. 19.

By routing to more price points, Arca's new procedure is expected to slow the trajectory of an outbound order, giving the market with the best prices an opportunity to refresh those prices before the order hops to another exchange or ECN.

"The situation we had on September 18th and 19th is probably not an aberration," Paul Adcock, an NYSE Euronext executive vice president responsible for Arca operations, said. "We can expect events like this to occur in the future, so we are making modifications to our systems to improve the situation for our customers. By trying to hit more price points, we can give more time for backfilling of quotes."

Arca has integrated depth-of-book data from most of the market centers and now hits 23 price levels, versus nine or 10 before. The exchange still plans to add Bloomberg Tradebook's data, as well as a flash quote from the CBOE Stock Exchange.

"What causes erroneous trades is not waiting," Adcock explained. "You just keep trading and trading. So when you are adding 23 to 24 points of interest versus nine, you have a better shot at slowing the pace and providing a better execution experience."

In taking out more price points on competitor books, NYSE Arca will incur certain costs. Adcock reports the percentage of orders it receives that eventually get routed out has increased by 10 to 12 percent.

That means fewer fills on NYSE Arca's book as orders are less likely to return to NYSE Arca after zipping through competitors' top-of-book prices.

The initiative also means NYSE Arca's servers must be able to accept much more data. At one point recently, Adcock says, NYSE Arca was processing 375,000 quotes per second. Previously, the norm was 50,000 to 70,000.

Arca is not the only market center to go beyond the dictates of Reg NMS. Citi this year incorporated its Lava Trading ColorBook routing capabilities into its LavaFlow ECN services. The technology, originally part of Citi's brokerage services, has checked depth-of-book pricing before routing for many years.

Other major brokers also check depth-of-book data as part of their routing services.

No other market centers do, although they take other steps to prevent their outbound orders from coming to a bad end. Both Nasdaq and Direct Edge ECN, for instance, "oversize" their orders. That means they will send orders out in quantities that exceed displayed amounts quoted at other venues. This gives the order the opportunity to interact with hidden liquidity, if any, at the top-of-book price.

Nasdaq also reports it routes serially rather than spraying "to ensure the best price." Routing serially means routing to one price level at a time and exhausting all liquidity at that price level and then moving to the next one. The spray method would spray multiple price levels simultaneously and potentially get fills at inferior prices.

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