Who Ever Said Cede Priority?

In my last post, I wrote about D-Peg’s post-trade performance, showing how D-Peg trades (usually at the midpoint) on average outperform near-side displayed trades on Nasdaq.

But performance isn’t only measured after the trade has happened. In this installment, we’ll go into the details of how D-Peg performs at the moment of the trade itself. In particular, we examine the fact that D-Peg cedes priority to displayed orders at the NBB or NBO, as well as non-displayed orders booked at more aggressive prices (like a traditional Midpoint Peg).

At first blush, this seems like a weakness of D-Peg. Why would you want to cede priority? Don’t you want to get done? Well, not necessarily. Not if you have the IEX Signal.

Priority Basics
Backing up a bit, it’s important to know that most exchanges run a price-time priority matching process. This means that they rank limit orders first by price then by time on a FIFO basis. If multiple orders have the same resting price, they will be matched in order based on time, starting with the order that was received by the exchange first.

This is easy enough to understand for limit orders. However, pegged orders are priced derivatively, that is, based on other existing orders in the market. That nuance makes it less obvious where they should be placed in the limit order book (i.e., booked).

Typically (including on IEX) midpoint pegged orders are booked at the NBBO midpoint and have priority over all displayed limit orders, because they have a more aggressive price. For example, if the NBBO for a stock is $50.10 by $50.11, an order to buy at the NBBO midpoint would be booked at $50.105[1] and have priority over all orders at the NBB of $50.10.

In contrast, a D-Peg order to buy at the same moment would be booked at $50.09, behind all orders booked at the NBB. When the IEX Signal (i.e., the Crumbling Quote Indicator or CQI) predicts that the price is not about to change (i.e., the Signal is “off”), the D-Peg can exercise discretion to trade up to the price of an incoming order, up to the NBBO midpoint. But, because it is booked at $50.09, it would be executed after displayed orders or non-displayed orders booked more aggressively on price.

Should you Prioritize Priority?
As noted above, ceding priority seems to be a disadvantage of D-Peg. However, while priority has obvious advantages, D-Peg’s more conservative booked price has its own potential rewards.

Using the same NBBO of $50.10 by $50.11, assume IEX has 100 shares to buy at the NBB of $50.10. Now, consider what would happen when an order to sell 100 shares at $50.10 is sent to IEX in two scenarios (assuming the IEX Signal does not predict that the price is about to change):

a) IEX has a Midpoint Peg order to buy 1,000 shares on the book

b) IEX has a D-Peg order to buy 1,000 shares on the book

In scenario a), the incoming order trades against the Midpoint Peg at $50.105, ahead of the resting order on IEX’s bid. This example demonstrates that Midpoint Peg orders potentially hold up the quote at $50.10. If that seller is trying to clear out the NBB, they would have to keep sending sell orders to exhaust the Midpoint Peg before clearing the IEX bid at $50.10.

Now consider scenario b). In this situation, the sell order would trade with the displayed bid on IEX’s book at $50.10, clearing out the IEX quote. While the D-Peg order missed the fill, it can potentially reprice to a lower (better) bid for future trades if the NBB changes. This functionality — ceding priority to the displayed limit order book when an incoming order is priced aggressively — is a key feature of D-Peg.

Now think about a third scenario. In this scenario, the resting order is also a D-Peg, but the incoming order oversizes IEX’s quote. The D-Peg would trade at $50.10 against the oversized quantity, keeping ½ spread of price improvement (PI) and not leaking information about the order type they were using.[2] There’s no hint to the outside world that there was a D-Peg order resting on IEX.

This scenario demonstrates how, when the limit price of a dark order overlaps with that of a contra, the exchange’s rules can dictate which party keeps the PI. On IEX, the PI goes to the resting D-Peg order.

The PI Payoff
So D-Peg’s functionality means there is a potential for PI. But how often does that happen? How often does ceding priority pay off?

In October 2019, 8.2% of resting D-Peg volume was price improved in a stable market, meaning these D-Peg orders traded at the near-side while the IEX Signal predicted that the price was not about to change.

And that PI was meaningful — the price didn’t typically move into them immediately. The 1-second markouts totaled a positive $1.2 million notionally, or an average of 71 mils per share. And 3 minutes after the trade, the PI fills improved slightly with positive markouts of 79 mils per share on average. That is genuine spread capture.

Ultimately, the key differences between a Midpoint Peg and a D-Peg on IEX come down to their different booked prices, their priority vs. displayed orders, and of course the IEX Signal. There are times a client may want the higher priority of a Midpoint Peg, or its higher fill rates, and there are times where urgency is lower and performance is paramount. At IEX, we provide you with both sets of tools, allowing brokers and investors to decide situationally which fits their specific needs and priorities.

In our final installment, we’ll look at the performance impact of an aspect of D-Peg functionality we only touch on above: the ability for D-Peg orders to avoid trading when the IEX Signal predicts that the price is about to change in their favor, and then step up to trade when the Signal predicts that it has stabilized.

[1] Midpoint Peg orders can book at a sub-penny price even though limit orders are not permitted to be entered in or displayed at sub-penny prices. Regulation NMS prevents the entry of orders in increments less than $0.01 for stocks with a price greater than or equal to $1.00.

[2] Dark trades at the near side could come from non-displayed limit orders, primary peg orders, reserve orders, and D-Peg orders.