Recent public criticism over the swelling number of exchange order types can be partly addressed by changing a key part of Regulation NMS, argues a top brokerage compliance official. Specifically, changing the locked and crossed markets rule will go a long way towards reducing the number of order types.
“We have a locked markets rule that was made for a different era,” Jerry O’Connell, the chief compliance officer at Susquehanna International Group, said last week 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 that there are too many order types and that their numbers add undue complexity to the marketplace.
At the same time, trading executives note that most order types are justified because they help exchanges comply with federal regulations and route orders to other market centers.
“Before Reg NMS we had very few order types,” Chris Concannon, a partner at market makers Virtu Financial, and a former Nasdaq OMX official, told U.S. senators at a hearing in Washington two weeks ago. “It was because of the complexity of Reg NMS-that interconnected all of our markets and gave us 50 dark pools-that we ended up with all these order types.”
Complaints about a marketplace overrun with overly complex order types first surfaced at a market structure conference in Washington sponsored by Georgetown University on September 19. There, panelists questioned whether a moratorium on new order types was warranted.
Andy Brooks, head of U.S. equity trading at T. Rowe Price, attended the conference and later told the senators at the Senate Banking Committee hearing that the order types had added complexity to the marketplace. “We wonder why,” Brooks asked at the hearing. “Why are people trying to make things more complex?” He was echoed by Concannon. “I agree we have way too many order types,” Concannon told the senators.
O’Connell argues that the locked and crossed market 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 any 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 of the order types allow traders to “book” hidden quotes that would otherwise lock the National Best Bid or 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. With Reg NMS, the SEC outlawed them, 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 market rules, 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 market rule doesn’t take into account these practices. Before Reg NMS, it was understood that an order for a NYSE-listed stock that would otherwise lock the market would simply fill against the prevailing quote, he explained.
But “in this day and age, when people are getting rebates, it’s not so easy because you may not want to be matched up with everybody at a price,” he told the SIFMA crowd. “So we’re left with a quandary. We should probably figure out a better way to deal with the locked market rule than to continue the drumbeat of all these new order types.”
That may not be so easy, according to one exchange official. “It’s a really complicated problem,” Larry Leibowitz, chief operating officer at NYSE Euronext, said at SIFMA. “You can’t solve it in isolation. It’s the result of interaction between the rebate and the trading increment.”
Leibowitz points out that traders look to lock the market because relative to spreads, the access fees “are too high.” Any reform would have to tackle such issues as the appropriate trading increments and access fees for a given security, the exec said.
No data exists but actual locked quotes are minimal, according to O’Connell. Perhaps only 5 percent of all quotes are locked, he said. The problem is not one of locked markets, per se, but the use of complex order types and hidden liquidity in order to avoid locked markets, O’Connell explained.
