Tuesday's mini tech flash crash and the SEC's upcoming report on the causes of and fixes for the May 6th market flash crash have high frequency trading and market structure topics back in the headlines. Bloomberg Businessweek's lead Markets & Finance article in this week's issue is titled "Missing: The Stock Exchange Buyers of Last Resort" arguing that the move away from the NYSE specialist has eliminated the only key source of liquidity during tumultuous markets. (Some smart writers over there, sounds a lot like T3Live's article published in this week's Advanced Trading magazine titled "A Flawed Model: Relying on High Frequency Traders As Liquidity Providers".)
A primary solution to the liquidity problem is to rethink Reg NMS and, in particular, repeal the Order Protection (or Trade Through) Rule.
What is Reg NMS and Rule 611?
The SEC describes Regulation National Market System (NMS) as "a series of initiatives designed to modernize and strengthen the national market system for equity securities." The laws were passed in 2005 and intended to lower costs and promote fairness to all competitors in the financial markets. Rule 611 of the regulation was the Order Protection Rule essentially giving priority to limit orders on the inside market. This rule made it impossible to pay through the market and forced transactions to occur at the quotes on the inside market.The Order Protection Rule has been controversial since its passage with some claiming that it forces traders to execute on possibly slow or unreliable venues only because the venue is offering the best price quote. Yet, the trader may be happy to pay a slightly higher price if execution is faster, more reliable or of greater size. Others believe the rule rightly forces brokers to act in the best interests of their clients. Still others think the rule isn't stringent enough.
What has Reg NMS caused?
While Reg NMS was passed with good intentions, the ensuing consequences have arguably caused greater fragmentation of the markets and extremely unreliable order books. The rule fueled the explosion of so-called "footprint detection" high frequency trading firms that gauge transactions to find larger players and take advantage of their intention to buy or sell. Thus, large buyside firms have responded in kind.
First, buyside firms have invested heavily in algorithm equipment to shield their order flow from opportunistic HFT looking to take advantage of their relatively large and slow limit orders. Second, these firms have taken their order flow off so-called lit markets and moved it to dark markets. These dark pools allow large institutions to trade blocks with each other without displaying the liquidity on public order books. Dark pool transactions are considered over-the-counter and represent exactly the type of market fragmentation Reg NMS was designed to fix.
The Trade Through Rule has inadvertently forced large buyside firms to unveil their intentions by first executing on the inside market. So, 100 shares posted on the inside market must be transacted with first rather than perhaps the 5,000 shares behind. For larger institutions, the 100 shares likely posted by an HFT market maker offers ultra-fast computers an albeit minor peak, but a peak nonetheless, into the buyer's intentions. Yet, this tip of the hand occurs with no benefit to the large institution as the 100 share fill is entirely inconsequential if the order is for say for 20,000 shares. It is not difficult to guess what happens next; the liquidity posted behind that order immediately disappears.
The passage of Reg NMS has unintentionally made markets much less liquid and quotes much less reliable. The extremely high quote cancellation rate is a direct result of HFT firms adjusting to the footprints large players are mandated to make by transacting small, irrelevant orders on the inside market before being allowed to access the orders of material size that sit behind. (In the past we have advocated an Order Cancellation Tax to correct this problem). The slowdown in order fills essentially effects latency arbitrage opportunities for HFT. HFTs are faster and can cancel before the buyer can buy them.Knowledge of this rule has also allowed nefarious traders to manipulate stocks by layering the order book outside of the inside market. The trader does not intend to receive a fill and will back away if he believes he may be filled, but he uses disproportionately large orders just outside the inside market to artificially prop a stock up or push it down.
The flash crash was a direct result of false liquidity in the marketplace insulated by the Order Protection Rule. While there may have been visible orders across stocks and markets, the minute large-scale sell-side volume started hitting the tape, the assumed liquidity disappeared as HFTs backed away from their bids. Any imbalance to the sell-side is immediately recognized and the bids are all pulled at once. This all happens nearly instantaneously causing the flash drops in shares of stocks. And it should be recognized that these are not one-off events and they will continue to happen under current regulation and market structure.
How to fix Reg NMS?
Rule 611 within Reg NMS should be repealed. The inability to pay through the inside market has removed any incentive to sit outside the inside market with a block of liquidity. It forces traders to pay the small players that create a tighter inside spread. Yet, the "real" spread in terms of sizable, reliable liquidity may be a few cents out on either side. The inability to simultaneously execute orders through the inside market allows HFTs to layer stocks and then rapidly cancel upon the first transaction.
Relaxing the Order Protection Rule would allow traders to go after the real liquidity in the market and force greater reliability of orders that are placed outside the inside market. While the regulation's aim of assuring brokers have their clients best interests at heart when executing orders is certainly valid, Rule 611 has unexpectedly damaged market efficiency overall. The goal of any market reform should be to reduce fragmentation and bring reliable liquidity back to lit markets. Repealing Rule 611 would accomplish both.
By: Sean Hendelman and Brandon Rowley