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Pegged orders: an unfair trade Posted: January 12, 2009, 9:48 PM by NP Editor Jeffrey MacIntosh, alternative trading systems Alternative trading systems make stock trading cheaper and more efficient. But widespread use of pegged orders is inconsistent with a competitive marketplace.
By Jeffrey MacIntosh
In the old days, stock exchanges had a monopoly on trading listed stocks. Not any more. These days, electronic platforms known as “alternative trading systems” (ATSs) provide investors with a variety of trading forums. Some of these, like BlockBook, Liquidnet and MATCH Now, exist solely to cross large (mostly institutional) blocks of stock. But others, like Pure Trading, Alpha, Chi-X Canada and Omega, serve the entire investment community — trading some or all of the TSX and TSX-V listed stocks.
By introducing competition to stock trading, ATSs have already lowered the cost and increased the speed and efficiency with which stocks are traded. Nonetheless, the ATS phenomenon is still in its infancy in Canada — and so is the regulatory framework. While the regulatory apparatus mostly works very well, some recent trading practices have arisen that materially compromise the fundamental principles of price discovery and liquidity that lie at the very core of a modern trading system.
Price discovery involves the determination of a suitable trading price for a given security. Liquidity occurs when investors can easily (and at reasonable cost) find a counterparty with whom to trade.
Price discovery works best when all traders have ready access to all other orders submitted for execution. Likewise, the likelihood of finding a trading counterparty is maximized when all orders rub shoulders. Thus — at least in theory — by “fragmenting” the order flow between different trading venues, ATSs pose a danger to both price discovery and liquidity.
The regulatory response to this danger is to build a framework of rules that, in essence, turns the various disparate markets into a “virtual” single market, so that no matter where a trader submits an order, it will interact with orders posted on all of the other markets.
Canadian regulators achieve this by requiring any marketplace that displays orders to anyone (which includes all but the confidential block matching systems) must make its order book publicly available through an information vendor. In addition, professional traders processing client orders must comply with “best execution” and “best price” obligations.
The duty of best execution is an adjunct to the dealer’s fiduciary duty to the client, and requires the dealer to ensure that each client receives that combination of price, speed, certainty and cost of execution that is most appropriate for each client. This is commonly thought to put an onus on the dealer (albeit of somewhat uncertain scope) to access pricing and depth of market information in alternative markets when processing client trades.
The best price obligation is more specific and is designed to prevent “trade throughs.” A trade through occurs when a lower priced bid, or higher priced ask is allowed to trade “through” (or ahead of) a superior bid or ask. This is a violation of the most basic principle of stock trading — that the highest priced bid (or lowest priced ask) have priority for execution over all other orders. At present, the “best price” obligation attaches to dealers, and requires them to put in place policies and procedures that minimize the likelihood that a trade through will occur. It is a duty owed to the entire marketplace and not merely to the dealer’s clients.
In practice, many dealers comply with this obligation by using a “smart order router” (SOR). A smart order router is connected to all trading venues, and will aggregate information on pricing and depth of market in all marketplaces. Because an order may be too large to be executed in the marketplace displaying the “national best bid or offer” (NBBO), the SOR uses complex algorithms to first direct part of the order to the marketplace displaying the NBBO, and the remainder to other markets — again on the basis of price priority. SOR services may be offered by a third party vendor, a marketplace or by the dealer itself using proprietary software.
The combination of order visibility, the duties of best execution and best price and the availability of SORs thus addresses the fragmentation problem by pooling price information and liquidity across the different marketplaces.
A downside of having multiple marketplaces, however, is that only price, rather than price-time priority can effectively be enforced given existing technology. Herein lies the problem. Exploiting the absence of inter-market price-time priority, some trading venues have created order types that pose a danger to the virtual single market.
Some marketplaces, for example, have allowed their customers to enter “pegged” orders that adjust automatically to match the NBBO. These marketplaces then allow these orders to be executed ahead of identically priced orders that were previously posted on another marketplace — a practice that is highly damaging to the marketplace as a whole. The current technological state-of-the-art does not allow regulators to generally enforce inter-market price-time priority. However, pegged orders result in an obvious violation of inter-market price-time priority — and one that they are in a very good position to enjoin and to enforce.
Allowing pegged orders to scoop the NBBO does more than create the impression of an unfair market. It allows traders using pegged orders to effectively remove their orders from the price discovery process. It also imprisons liquidity within a single marketplace, reducing the extent to which orders on different marketplaces interact. If my bid on Market A is the NBBO, for example, I would normally expect that a matching offer on Market B will be forwarded to Market A for execution. However, if Market B permits pegged orders, an inferior bid in Market B’s order book will jump the queue, leaving my order unexecuted. If this happens often, I will clearly think twice before lining Market A’s books — or any other market’s books — with orders.
This is simply because pegged orders reduce the returns to posting limit orders. This constitutes a direct assault on what makes stock exchanges tick. Those who post limit orders are liquidity makers, since they offer other traders the opportunity to trade at the posted price. Those who hit these orders are liquidity “takers.” Since liquidity is a valuable commodity, a limit order thus has an “option” value to all potential traders. It is for this reason that most modern stock trading venues actually pay traders to post limit orders, charging only the “active” side on any trade that results.
Liquidity makers and liquidity takers exist because traders and trading strategies are heterogeneous. One cannot exist without the other. Harming the interests of one harms the interests of both.
The use of parasitic orders such as pegged orders thus interferes with price discovery and the pooling of liquidity from different markets. It is also anti-competitive, because it penalizes traders who do not post their liquidity to the market (or markets) permitting pegged orders. Indeed, the very purpose of pegged orders may be to force liquidity out of some venues and into others. Since no market can survive without offering liquidity (i.e., having a book of limit orders), the widespread use of pegged orders is fundamentally inconsistent with a competitive marketplace.
In the extreme, permitting pegged orders potentially leads to a Doomsday scenario in which all markets imprison some or all of their liquidity by permitting pegged orders. This could potentially lead us back in the direction of a monopoly provider of trading services — to the detriment of all but the monopolist.
Some trading venues have started to use another strategy whose effects are similar to pegged orders. Many institutional and other large block traders use confidential trading venues (such as the upstairs market and large block ATSs) to keep their orders secret. This is designed to ensure that public knowledge of the order does not move the market price against the investor. By regulatory fiat, these orders must be executed at or between the best bid and ask.
Because these “crossing markets” or “dark pools” use a price derived from the public market, they contribute nothing to price discovery. Nonetheless, by giving big block traders better execution than they can achieve in the public market, they substantially enhance big block liquidity. It is for this reason that these dark pools are allowed to exist.
A practice has recently sprung up, however, of using dark pools to trade small orders that would normally be destined for the public market. Since these orders are executed at or between the best bid and ask, they have the potential to offer clients some measure of price improvement. However, like pegged orders they are “parasitic orders” that remove order flow from the visible public market, adversely impacting both price discovery and public market liquidity.
They are another device that can be used to imprison liquidity within a dealer and/or marketplace, to the ultimate long-term detriment not merely of the public market, but the dealer’s own clients. Unlike large block crosses, there is no rationale for withholding small trades from the public market, other than to allow the dealer to earn two commissions on the trade — and to withhold business from other dealers and/or marketplaces.
Canadian financial markets are at a critical juncture, with a variety of new trading venues aggressively challenging the hegemony of the historical incumbent. It is thus a particularly important time to make sure that the rules of the game ensure that competition, though vigorous, is fair. It is imperative that regulators take the bull by the horns and act quickly to prohibit trade types that operate against the best interest of Canadian corporations and the entire financial community.
Financial Post Jeffrey MacIntosh is the Toronto Stock Exchange Professor of Capital Markets at the Faculty of Law, University of Toronto, and is a director of the Canadian National Stock Exchange (CNSX), which owns and operates Pure Trading.
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I bet you made a lot of money in trading didnt you glass
-------------------- It isn't so much that liberals are ignorant. It's just that they know so many things that aren't so. Posts: 6949 | Registered: Apr 2004
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quote:Stock Traders Find Speed Pays, in Milliseconds
By CHARLES DUHIGG Published: July 23, 2009
It is the hot new thing on Wall Street, a way for a handful of traders to master the stock market, peek at investors’ orders and, critics say, even subtly manipulate share prices.
It is called high-frequency trading — and it is suddenly one of the most talked-about and mysterious forces in the markets.
Powerful computers, some housed right next to the machines that drive marketplaces like the New York Stock Exchange, enable high-frequency traders to transmit millions of orders at lightning speed and, their detractors contend, reap billions at everyone else’s expense.
These systems are so fast they can outsmart or outrun other investors, humans and computers alike. And after growing in the shadows for years, they are generating lots of talk.
Nearly everyone on Wall Street is wondering how hedge funds and large banks like Goldman Sachs are making so much money so soon after the financial system nearly collapsed. High-frequency trading is one answer.
And when a former Goldman Sachs programmer was accused this month of stealing secret computer codes — software that a federal prosecutor said could “manipulate markets in unfair ways” — it only added to the mystery. Goldman acknowledges that it profits from high-frequency trading, but disputes that it has an unfair advantage.
Yet high-frequency specialists clearly have an edge over typical traders, let alone ordinary investors. The Securities and Exchange Commission says it is examining certain aspects of the strategy.
“This is where all the money is getting made,” said William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund. “If an individual investor doesn’t have the means to keep up, they’re at a huge disadvantage.”
For most of Wall Street’s history, stock trading was fairly straightforward: buyers and sellers gathered on exchange floors and dickered until they struck a deal. Then, in 1998, the Securities and Exchange Commission authorized electronic exchanges to compete with marketplaces like the New York Stock Exchange. The intent was to open markets to anyone with a desktop computer and a fresh idea.
But as new marketplaces have emerged, PCs have been unable to compete with Wall Street’s computers. Powerful algorithms — “algos,” in industry parlance — execute millions of orders a second and scan dozens of public and private marketplaces simultaneously. They can spot trends before other investors can blink, changing orders and strategies within milliseconds.
High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.
High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.
“It’s become a technological arms race, and what separates winners and losers is how fast they can move,” said Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange. “Markets need liquidity, and high-frequency traders provide opportunities for other investors to buy and sell.”
The rise of high-frequency trading helps explain why activity on the nation’s stock exchanges has exploded. Average daily volume has soared by 164 percent since 2005, according to data from NYSE. Although precise figures are elusive, stock exchanges say that a handful of high-frequency traders now account for a more than half of all trades. To understand this high-speed world, consider what happened when slow-moving traders went up against high-frequency robots earlier this month, and ended up handing spoils to lightning-fast computers.
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.
Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates.
“You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that make the markets more efficient,” said Andrew M. Brooks, head of United States equity trading at T. Rowe Price, a mutual fund and investment company that often competes with and uses high-frequency techniques. “But we’re moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity.”
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