'The Problem with Exchanges Giving Their Members Dark Looks'

By: Ray Pellecchia

File Under: NYSE, NYSE Amex, NYSE Arca

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Media coverage continues to grow on the issue of certain marketplaces holding up orders and giving certain members a look at those orders before they are executed, a problematic practice covered in this space here, here, here and here.

Miranda Mizen, a principal at Tabb Group, last week published a commentary, "The Problem with Exchange Giving Their Members Dark Looks". My main takeaways from it:

• "There used to be a general market dislike of the ability for specialist's algorithms to see orders destined for the NYSE, and there was a round of applause when the market structure was changed. In the case of the NYSE, orders were not being systematically held up, but the concept of a first look (with no guarantee of a match) found disfavor with the buy side as it gave the perception of inequality at an exchange..." Yet, other markets have re-created "the look," and to boot they have added holding up orders, and they don't even have the specialist's market-making obligations.

• Dark looks benefit the recipient and the venue; the order sender is only a potential beneficiary, the sender may miss the market.

• ..."[I]t is unclear where the responsibility now lies to monitor the behavior of those who receive dark looks to ensure order flow is not gamed."

• Dark looks could erode the quality of the quote by discouraging order display and tight quotes. They could also divide the market into multiple tiers. "An order that sets the best price may move from being rewarded to being taken advantage of, while incoming orders will run the gauntlet of information leakage as they hit computers whose job it is to react to information."

Traders Magazine's recently ran the comprehensive "Flash Point" by Nina Mehta. Excerpt:

The primary argument against flash orders is that they create private markets and are therefore a step back for market structure. "These programs are creating a private locked market for a small group of participants, and they are holding up the execution process for that marketable order," Mecane said. He added that the Big Board operator isn't against dark pools, competition or innovative business models. "Our issue is that this creates a tiered market," he said.

Market maker GETCO told the SEC that by creating a two-tiered market, flash orders give professionals receiving the flashes a leg up over other investors. Non-public quotes could also "negatively affect the broader market, including retail investors who rely on the NBBO to ensure that their orders obtain the best, reasonably available price," the firm said. GETCO argued that flash orders, like dark liquidity that executes at the NBBO, also leave limit orders that established the best price in the lurch.

Jamie Selway, managing director at institutional broker White Cap Trading, believes that flash orders undermine aspects of Reg NMS, including the requirement that brokers and exchanges avoid locked markets. A locked market occurs when a protected bid equals a protected offer. "Firms are locking the market by design, but not by the SEC's definition," Selway said. "The problem with the way the SEC has architected this exception to quoting requirements is that it's now a private locked market instead of a public locked market. This kludge of a half-second definition is brand new."

Direct Edge's O'Brien draws a distinction between how the information his market disseminates is seen and what Nasdaq and BATS are doing. His flashes, he said, are sent out on a different data feed than the ECN's depth-of-book feed, while Nasdaq's and BATS's flash orders are not. As a result, the latter exchanges' feeds look like they're locking the market. (Last month, both exchanges added a flag to flashed orders to identify them for subscribers.)

In Selway's view, this argument clouds the point. The point, he said, is that order messages are being broadcast at prices that, effectively, lock protected quotes. This creates an elite tier of traders with access to better-priced orders than those receiving public quotes through the securities information processors, giving flash recipients an information advantage, he said.

And today, Charles Duhigg of the New York Times has "Stock Traders Find Speed Pays, in Milliseconds". The article is mostly about high-frequency trading, but notably, flashing order information is at the heart of the article's central anecdote:

It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and canceling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.