The Senator Taps Twice

Why IOI has become a four-letter word

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.

Most exchanges, ECNs and ATSs do not leak IOC information as policy, and sending a lot of Blind IOCs to these destinations is typically a sign of good execution. Where Blind IOCs get shady is if they’re sent to electronic market-making (EMM) shops that, like the specialist of old, are also active market participants and may be able to use the information against you.

So why would anyone Blind IOC an EMM? Behind the migration of volume to electronic market-makers lies a steady increase in “taking liquidity” fees. As volume has moved off the NYSE floor and into the high-rebate/high-take-fee models of Nasdaq, Arca and BATS, the cost of hitting bids and taking offers has increased more than three-fold. That has given electronic market-making firms an interesting business opportunity. The market-makers offer traders a chance to “ping” them with IOCs before going to the major destinations. If the EMM fills the order, the trade is free, saving the trader as much as 30 mils per share. But the true cost is not in cents, it’s in the form of information leakage. For traders that are moving small quantities relative to the volume, the EMMs offer a great deal. But for traders that are moving large positions that require confidentiality, it can be a penny-wise and pound-foolish way to trade.

Even worse than the Blind IOC on the information-leakage scale may be the new IOLs, the trading equivalent of the senator’s foot-tapping in the bathroom stall. Traditional IOIs for large orders have been sent around Wall Street for years, risking front-running in an attempt to line up huge block trades. But in their new incarnation, IOIs are streamed out to smart order routers slice by slice, typically representing interest in a few hundred or a few thousand shares, often cancelled within fractions of a second.

To differentiate these streaming electronic IOIs from the traditional ones, they are sometimes referred to as IOLs, or “indications of liquidity.” IOLs are often used to save technology costs. By broadcasting their book to their trading partners all day, the trading destination then receives only a few thousand Targeted IOCs throughout the day, instead of getting barraged with millions of Blind IOCs. But while this does reduce technology infrastructure costs, it comes at a cost: Essentially, you get to play in the poker tournament for a smaller buy-in, but at the cost of having to play with your cards face up.

Since the decision to send IOLs and Blind IOCs to EMMs typically occurs far behind the scenes at the smart order routing level within broker-dealers, the regulators would be wise to force brokers to issue written policies spelling out how they use these leaky message types. While their use can make sense for traders that don’t have market-moving quantities and whose primary concern is cost, i.e., retail clients, for most institutional clients these message types should be avoided like foot-tappers in Minneapolis.

As the handcuffs were being fastened behind Senator Craig’s back, he was presumably reminded by the arresting officer of that most important American right, the right to remain silent. Good lawyers tell their clients to take advantage of this right, and never share information unnecessarily. Good traders should tell their brokers to do the same.

Dan Mathisson, a Managing Director and the Head of Advanced Execution Services (AES) at Credit Suisse, is a contributing writer to Traders Magazine.

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