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November 1, 2012

Exec Says Change Locked Cross Rule

By By Peter Chapman

Also in this article

  • Exec Says Change Locked Cross Rule
  • Page 2

Recent public criticism over the swelling number of exchange order types can be partly addressed by changing a key part of Regulation NMS, a top brokerage compliance official argues. Specifically, he claims changing the locked and crossed markets rule will go a long way toward reducing the number of order types.

"We have a locked markets rule that was made for a different era," Jerry O'Connell, chief compliance officer at Susquehanna International Group, said last month at the annual market structure conference hosted by the Securities Industry and Financial Markets Association.

Exchange order types, which number in the thousands, have come under fire in recent weeks at a series of hearings and conferences held in New York and Washington. Most industry officials appear to agree there are too many order types and that their numbers add undue complexity to the marketplace. [See companion story on Page 22.]

O'Connell argued that the locked and crossed markets rule, implemented in 2007, has led exchanges to create many of these order types. Because some of their customers want to quote at prices that would otherwise lock the market, exchanges have had to devise ways for them to do so without breaking rules.

The result has been the deployment of order types with such names as "Price to Comply," "Hide Not Slide," "BATS Only Post Only" and "Post-No-Preference Blind." The common denominator is that all the order types allow traders to "book" hidden quotes that would otherwise lock the national best bid and offer if displayed. Professional traders such as market makers and arbitrageurs are the most common users of these order types.

A locked market occurs when the displayed bid equals the displayed offer. A crossed market occurs when the displayed bid is greater than the displayed offer. Most industry professionals maintain that locked and crossed markets are signs of inefficient markets. The SEC outlawed them with Reg NMS, stating that a trader who locks the market unfairly elbows aside the original price-setter.

Still, during the Reg NMS debates, some professional traders opposed the locked and crossed markets rule, including Tradebot, Tower Research and Hudson River Trading. At the time, the market for Nasdaq stocks had no such rule. During a one-week period in March 2004, Nasdaq reported over a half million locked and crossed markets per day, on average.

Professional traders often prefer to quote at a price that would lock the market rather than simply execute against the original quote. The tactic increases their profits and ensures they maintain their standing in the exchange's queue.

Because spreads in most stocks are only a penny wide and access fees can reach three-tenths of a cent, they can increase their profits by supplying liquidity. If their order is then traded against, they avoid paying an access fee and receive a rebate as well.

And, by hiding and waiting for their number to come up, they avoid having their order shipped to another exchange. That lets them hold their place in the queue.

O'Connell argues the locked and crossed markets rule doesn't take into account these practices. Before Reg NMS, it was understood that an order for an NYSE-listed stock that would otherwise lock the market would simply fill against the prevailing quote, he explained.