Zero Sum Game?

IOSCO, the International Organization of Securities Commissions, has set August 12th as the deadline for responses to its Consultation Report on the “Impact of Technological Changes on Market Integrity and Efficiency”. IOSCO’s input has a long term impact on the evolution of rules by national regulators, and in this instance IOSCO is responding to a specific request from the G20 and the Financial Stability Board.


The Consultation Report reviews some of IOSCO’s previous work on related topics. Whether intended or unintended, the document’s use of phrases such as "no universally acknowledged method for determining", "precise quantitative assessment ... is challenging", "empirical evidence is still scarce", and "further research is necessary" simply serve to highlight the paucity of detailed empirical evidence to support well-crafted regulation in this space.


The report does clearly set out two useful definitions of regulators’ key goals:


“Market integrity is the extent to which a market operates in a manner that is, and is perceived to be, fair and orderly and where effective rules are in place and enforced by regulators so that confidence and participation in the market is fostered.


Market efficiency refers to the ability of market participants to transact business easily and at a price that reflects all available market information. Factors considered when determining if a market is efficient include liquidity, price discovery and transparency.”


And there are definitely some interesting nuggets, including the following on page 12 (my emphasis added)…


“For instance, the use of sophisticated low-latency algorithmic trading techniques may prompt less sophisticated traders to withdraw from the market as a result of their fear of being gamed by low latency firms that use faster technology.


Some anecdotal evidence presented to IOSCO suggests this may be particularly true of traditional institutional investors, who, as fundamental investors, are supposed to base their trading decisions on the perceived fundamental value of securities. If such participants withdraw, reflecting a loss of faith in the integrity of the market, the information content of public market prices, may be altered as a knock-on effect. This may potentially result in a less efficient price formation process and possibly cause others to reduce their participation.”


The above quote raises some interesting questions -


• Are “traditional” institutional investors and the brokers that service them really to be considered “less sophisticated”? Based on their public marketing materials, many large brokers now offer algorithmic trading solutions that encapsulate the same techniques as used by low-latency algorithmic firms.


• Does IOSCO consider “anecdotal evidence” of a “fear of being gamed” to be adequate grounds for further regulation, or are they actively trying to highlight the need to establish clearer empirical evidence (to establish how widespread the ‘fears’ are and/or to establish whether the ‘fear’ is warranted by evidence of actual gaming)?


• Absent fundamental investors, does it make sense that the “information content” of prices would be altered (and in a good or bad way), and would this necessarily result in “less efficient price formation”?


A related question is raised on page 27;


“… a challenge posed by HFT is the need to understand whether HFT firms’ superior trading capabilities result in an unfair advantage over other market participants, such that the overall fairness and integrity of the market are put at risk. In the case of HFT, it has been argued that this advantage arises due to the ability to assimilate market signals and execute trades faster than other market participants.”


With or without empirical evidence, there’s no denying that many institutional investors are afraid of HFT (which encapsulates a number of strategies employed by different types of market participant), and that perception of whether the market is “fair” is of huge significance. So how do we know if the fears of gaming and unfair advantage are rational or irrational?


There are three key questions to answer:


1. Is there actually a zero-sum game competition between institutional investors and firms using HFT in which one side is the winner and the other the loser?


2. If there is such a competition, how could we measure the extent to which institutional investors are losing out?


3. If institutional investors are losing out, how can we determine whether the winners enjoy an unfair advantage, or are behaving in ways which constitute market manipulation/abuse?



1. Is there a zero-sum game competition?

• For various reasons the market has struggled to reach a consensus on this question:
• Firms using HFT implement a number of strategies – from those that provide resting liquidity to those that are entirely aggressive in nature. So some HFT activities may reduce investors’ execution costs, whilst others may exacerbate market momentum. So there may be a mixture of win-win and win-lose (we discussed this before).
• It’s not clear how the profits of HFT liquidity providers compare to the profits of traditional market makers whose role they are fulfilling to some extent (by bridging the temporal gap between the arrival of natural buyers and sellers), but if traditional market makers were ‘squeezed out’ by more efficient and automated firms, surely that should represent an overall saving to market users?
• But another intriguing question is the extent to which HFT strategies actually compete with other (“less sophisticated”) market participants…
• o One thing we monitor at Turquoise is each member’s ‘hit rate’ - their ability to capture the ‘displayed liquidity’ they see when originating aggressive orders.
• If speed conveyed a material advantage, and if HFT and other participants were competing directly for the same liquidity, then we would (for example) expect co-located algorithmic firms to have a higher ‘hit rate’ than non co-located agency brokers (who by virtue of being slower would miss out on capturing liquidity).
• But we actually see the exact opposite – with apparently less-sophisticated agency brokers achieving higher hit rates (consistently above 95% in some cases) compared to below 80% for their supposed ‘competitors’. What this probably means is that there is not a direct competition between these firms with different types of strategy and trading horizon. Whilst firms using HFT may compete with one another, and are very focussed on latency as a source of relative advantage, brokers executing institutional flow are seemingly uncorrelated, and have not tended to focus so much on latency because it doesn’t appear to be necessary to achieve best execution with a high degree of certainty.
• So we would recommend that regulators investigate whether our data is representative of the broader market, in which case there might not be a case to answer in respect of speed conveying an advantage.

2. But if there was direct competition between firms using HFT and institutional investors, how would we discern the extent to which the traditional institutions are losing?

• Any “advantage” enjoyed by firms using HFT, and/or the “gaming” for which they might be responsible, should presumably be reflected in higher trading costs for traditional investors, and should be measurable by Transaction Cost Analysis (TCA) providers. But how might this be measured in isolation from all the other dynamic factors in the market? We should be looking for evidence for rising realised trading costs (market impact) or a rising proportion of orders which cannot be completed due to prices moving adversely (opportunity cost) in a manner that controls for concentration amongst asset managers, general market volatility, and other such factors. We suggest two areas for consideration where there should be data readily available to facilitate discussion. 
• First, for index managers who have less choice regarding their holdings and typically complete execution of all orders (and hence their costs should materialise as market impact rather than opportunity costs), we should search for evidence of growing underperformance vs. their index benchmarks. Such a trend, if present, will be difficult to attribute to specific aspects of market structure, but might support or challenge the concern that current market structure is somehow disadvantaging institutional investors. 
• Second, for asset managers more widely, and looking at opportunity costs, we should look for evidence of a degradation in costs for liquid stocks (where HFT activity is more prevalent, and fragmentation is greater) relative to illiquid stocks. We would expect that TCA providers may have data to support such a study.
• We would recommend that regulators search for empirical evidence to support the argument that institutions are being disadvantaged by either the market structure or the behaviour of some participants.

3. And if there is evidence of institutional investors systematically losing out to faster or more sophisticated market participants, how do we determine if this is due to an “unfair advantage”, to “gaming”, or to factors that will be eroded naturally over time?

• IOSCO suggests that the “advantage arises due to the ability to assimilate market signals and execute trades faster”. It seems likely to us that it is the first of those two points which matters most, and as such, we wonder whether anything can or should be done, since IOSCO itself promotes efficient markets in which the “price that reflects all available market information”. That also leads us to conclude that suggested initiatives such as minimum resting times and order-to-trade ratio caps that seek to control or limit execution will have no positive impact in terms of reducing any information advantage enjoyed by firms using HFT (but will have a host of negative consequences for market quality and costs to issuers and investors). 
• Others have suggested non-HFT participants cannot afford to make the infrastructure investments that HFT firms make, and that the “unfair advantage” flows from this “barrier to entry”. But it seems obvious from conversations with brokers and technology vendors that any such “barriers” are rapidly reducing through a rapid commoditisation of hardware and software solutions to enable low-latency data processing and trading.
• And returning to the definition of market efficiency used by IOSCO, we have questioned before whether markets might have become too transparent, and too efficient for the liking of many institutional investors seeking to trade large size. Does HFT vex institutional investors precisely because it ensures that “prices reflect all available information” - particularly when the “information” in question is the institutions’ unfulfilled trading intentions. Have the developments in European market structure and growth of HFT created a market more suited for ‘retail sized’ business? And does the creation of an efficient ‘retail sized’ market ignore the needs of the institutional investor community? Philip Warland, Head of Public Policy at Fidelity International, expressed concerns of this nature at the recent SunGard City Day in London, saying “We have spoken to the European Commission to highlight that too much transparency actually undermines our ability to achieve best execution, and will ultimately hurt investor returns.”
• And finally, how can we determine if “gaming” plays an element in the discovery of such “information”, and how do we write market rules that preclude such behaviour? This is possibly the most challenging and contentious issue of all and one on which, as the author of rules for our own market, we would welcome thoughtful contributions. We look forward to the European Commission’s proposals on Market Abuse in this respect.

So we’re not persuaded that there is any “unfair advantage” (if any relevant advantage at all) available. And absent a clear definition of what constitutes gaming (or evidence for whether it’s a genuine problem), we think it’s dangerous to start amending the rules. But - we recognise that perception matters - and so we strongly support further data gathering and research on these topics, and are encouraged by the UK Government Foresight Project’s commitment to an evidence-based approach.


And on a separate but related topic, we note that the SEC has voted unanimously for adoption of a “Large Trader Reporting Regime”, under which a unique Large Trader ID (LTID) will be assigned to every large market participant (brokers, proprietary traders, hedge funds and asset managers), and member firms will, upon request, report all trades (with timestamps) by those firms to the SEC. The assignment of these unique IDs for each market participant will allow regulators to piece together the activity of these firms irrespective of how many brokers they use for execution. But it also opens the door to two further developments –

• If brokers were required to pass on the LTID on every order routed to market, surveillance by venues could then be undertaken at the granularity of the end client. This would reduce false positives (which arise because brokers typically trade for many clients simultaneously) and allow for surveillance of end participants independent of how many brokers they use. Of course, venues would likely need to adjust their trading interfaces to accommodate the LTID on order messages.
• Provision of LTIDs to the venues would remove a significant obstacle to the creation of a Consolidated Audit Trail through which markets might be required to disclose to regulators in real time the detailed activity (orders and trades) of all participants – although a number of other practical and philosophical issue remain (see a prior blog on this topic).
  

We invite feedback from brokers, competitors, regulators and institutional investors on our approach and our views. Previous editions of Turquoise Talks can be found here under the ‘Blogs’ tab.


P.S. We encourage our clients to complete the Automated Trader 2011 Algorithmic Trading Survey

The End of Time

Once Upon a Time… our markets consisted of a single CLOB (Central Limit Order Book) by country. Absent competition, these order books were slower & participants’ fees were higher. Such CLOB markets worked with strict ‘Price-Time’ priority. Additionally, in many continental European markets there were concentration rules mandating broker-dealers to execute client orders in the CLOB – so the Price-Time priority in the CLOB was to a significant extent the only game in town (although with support for iceberg orders, some would characterize it as ‘Price-Display-Time’).

As we’re all familiar with, MiFID changed our market structure by sweeping away the concentration rules mandating use of a single CLOB by country, and allowing the emergence of multiple competing PLOBs (Public Limit Order Books). This has resulted in a period of intense competition and rapid innovation, driving dramatic reductions in trading tariffs, huge improvements in system performance and capacity, and the emergence of dark Midpoint orders books, and so on and so forth. And as brokers have developed the technology to participate in multiple lit PLOBs and dark midpoint books, they have also deployed internal crossing networks where they seek to internalise customer flow before or in parallel to routing it to external venues.

How have all these developments impacted Price-Time priority in our market?

Most individual PLOBs operate with Price-Time priority (we’ll get to those that don’t a bit later), but the fact that there are more than one means that brokers need to calculate in which price-time queue the speedy execution their own limit orders is more certain.

Imagine a multi-lane motorway (each lane is a Price-Time queue of a PLOB), with traffic (limit orders to Buy) queuing up to pass through a set of toll booths (marking the Best Bid in each venue). Coming from the other direction are the Sell orders, also queuing in the same number of lanes for each booth. Booth operators (exchanges and MTFs) are supposed to keep their particular queue moving in a fair and orderly manner. Happily, the collision of a Buy and Sell order results in a Trade (which is published) rather than a car crash, and such collisions happen when somebody pays the toll (the venue’s fee and the spread) to cross and meet the oncoming other queue. So, if you’re in a hurry you can jump to the front of the queue by setting a new best Bid or best Offer, or you can pay a premium for immediacy by submitting an aggressive order.

Where there are multiple venues with the same displayed price, how do brokers decide which ones to access? We should expect a SOR’s venue selection to be driven by cost, certainty of execution, and (possibly) market impact.

• Cost includes the explicit tariff for aggressive flow and also the related post-trade costs.
• Certainty of execution determined by a variety of factors including the broker’s latency to the venue (both for inbound market data and order routing), the average lifespan of limit orders at each venue, and the share volume or number of different orders/participants at the BBO. To estimate certainty, some brokers measure the historical success rate of capturing a targeted bid/offer price when routing to each venue, whilst others use displayed size or a venue’s share of trading as proxies for this.
• Market impact in this context depends on whether there are differences (by venue) in the propensity of prices to rebound (or fade further) after being hit by a marketable order

Assuming you don’t want to cross the spread, and you have decided to join the queue with a particular limit price, which queue is the right one to post your limit order in?

In the beginning brokers either chose which venue(s) to post to on the basis of each venue’s overall share of trading in the stock (or group of stocks) – a bit like joining a queue because everyone else is (very English), and trusting in the wisdom of the crowd. Others set specific ratios for each queue, and in doing so some brokers were doubtless influenced by the payment of rebates for getting to the front of MTF queues and by a desire to stimulate and support competition amongst venues.

But as both brokers and their clients have become more sophisticated, so the criteria for venue selection have evolved. It’s increasingly the case that brokers are applying a variety of predictive signals to determine which queue they can get to the front of quickest. What factors are they considering, and how do they capture these in their SOR decisions? Basically – how long is each queue and how fast is it moving?

• When setting a new EBBO, brokers can jump to the front of any queue they choose. But their choice still matters, because if their new price is subsequently matched on other venues, they want to ensure that they’re in a queue where the booth is moving quickly – a venue that’s reliably attractive to contra-side aggressive flow.
• If joining an existing queue, they need to consider the length of the queue in relation to the speed at which it’s moving. This similarly depends on the arrival rate of contra-side aggressive flow.

In choosing where to post their limit orders, brokers have to predict the behaviour of prospective counterparties aggressing the market. For example, markets with lower take-fees, more participants and lower latency may enjoy more success in attracting aggressive flow, and hence become more attractive venues for posting.

But that’s not the whole picture – the twin forces of competition and technological innovation have changed the landscape in two ways that arguably reduce the certainty of execution for publically displayed limit orders (and hence reduce the incentives to post them):

• There are a whole bunch of other queues that you can’t see – effectively another private motorway next to yours that you may or may not be entitled to use. You’re waiting patiently in your queue on the public highway, and you see reports of other people’s executions on the private motorway, but the public traffic doesn’t seem to be moving.
• Having reached the front of your chosen public queue, you’re expecting to trade when an incoming contra-side order crosses the spread. Instead, somebody sneaks ahead of you at the last second, or you get only a partial execution as some of it is allocated to the people behind you.

Both brokers and exchanges have started to monetize time/place priority as the valuable commodity that it is…

First, brokers…

• With SORs in place, brokers had the opportunity to introduce their own crossing networks (whether ATSs or BCNs) without doing a disservice to their clients (previously an order kept ‘upstairs’ could not easily also be represented in multiple other places). With ”take” fees being high on US exchanges and ECNs (relative to equivalent fees in Europe), it made particular sense for brokers to internalise marketable flow. Some firms already had the necessary internal market making capabilities, some acquired the capability by buying specialists in the field, and others approached the big market makers active in public markets and encouraged them to do the same thing in their own pools.
• Whilst many market makers are pro-transparency and are, in principle at least, against internalisation, getting a chance to intercept liquidity before your competitors was a fairly compelling opportunity. Brokers realised that the customer flow they were executing was a valuable commodity that could be monetised by offering electronic market makers an earlier opportunity to interact - in essence selling those market makers ‘time/place priority’. So whilst electronic market makers may have displaced the traditional market making businesses of many large banks, within brokers’ own liquidity pools they have become a source of revenues and/or cost savings.
• The same is beginning to happen in Europe, although the ambiguity surrounding provision of 3rd party “non-discretionary” access to Broker Crossing Systems acts as a partial brake on some firms.

And then exchanges/ECNs and MTFs…

As competition has heated up, exchanges have also started to experiment with different routing or “allocation” models (most of which are breaks from the traditional price-display-time model).

• NYSE’s model offers Designated Market Makers and Floor Brokers ‘parity’ - the ability to participate in a trade even when they’re not at the front of the queue. The exchange dilutes time priority for normal participants (as just under two-thirds of the liquidity they might have captured in a strict price-time model is instead allocated elsewhere) in return for the fees and committed liquidity they get from the DMMs. This model has recently attracted regulatory criticism, although it’s worth noting that diluting price-time priority lowers the importance of pure speed as a market advantage (instead it’s about your relationship with the exchange) – and hence does not necessarily favour HFT firms. Such models exist because the committed liquidity that DMMs bring can give the exchange a competitive advantage.
• DirectEdge’s “flash orders” were seen by some as an attempt by the market to subvert price-time priority and instead ‘sell’ priority to a selective subset of customers.
• NASDAQ’s PSX introduces size priority, allocating incoming contra-side shares pro-rata to the displayed size of participants at the BBO.
• The arrival of Taker-Maker books (in which a rebate is paid for removing liquidity) can be understood as an attempt to create a venue in which limit orders enjoy superior time (or price) priority over those posted in venues that charge for liquidity removal.

Some exchanges are arguing against internalization on the basis that (as a result of reducing the certainty of execution for public limit orders), it will reduce incentives to post limit orders in public order books and lead to a vicious circle of widening spreads and increasing internalisation. Basically they appear to be against the dilution of price-display-time priority. And yet the exchanges have also exacerbated the dilution of price-display-time priority through the launch of multiple competing order books and alternative “allocation” models.

All of this makes for a more complex market structure than either participants or regulators are accustomed to, and means we’ll probably be debating these topics for some time.

• Since the regulators have clearly opted for a competitive (and thereby fragmented) market structure, should we worry about the degree of fragmentation?
• Is the continual evolution of technology leading us towards a much more distributed market model in which the role of displayed order books is less prominent?
• How much volume do we need in public order books to provide reliable price formation?
• To what extent does price discovery rely upon there being price-time priority within the market?
• And if the death of price-time priority does ultimately undermine the efficacy of the price formation process, then “who done it”?
• Was it regulators with the introduction of RegATS, RegNMS and MiFID to stimulate competitive (and fragmented) markets?
• Was it exchanges introducing innovations that that give ‘first look’ or privileged interaction rights to a subset of members?
• Was it brokers leveraging their SOR investments by introducing their own dark pools to which they give precedence over public markets?
• Was it exchanges operating multiple order books with differential tariff models?
• Or, like Murder on the Orient Express, were we all guilty?

Size Matters...

Amongst the many questions posed in the CESR/ESMA MiFID II consultation is this one;
“Is it necessary that minimum tick sizes are prescribed?"

Almost everyone (apparently excluding NYSE Euronext) agreed (at least until two days ago) that a lack of tick-size harmonisation is an unnecessary inefficiency that depresses volumes, creates trading errors and results in significant maintenance costs for venue operators and participants. And consensus seems to be growing that the dangers of restricting order-to-trade ratios or imposing minimum resting times on orders would outweigh any potential (poorly articulated) benefits. So attention is refocusing on tick sizes. And yet getting and keeping a consensus on tick sizes has been difficult, so, perhaps it’s worth revisiting why tick sizes matter so much, and to whom.

What are the pros and cons of small tick sizes?

• Smaller ticks intensify competition amongst market-makers and liquidity providers, and thus attract more liquidity and tighten spreads.
  
  
  
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    Tighter spreads are the most obvious measure of market quality. They reduce transaction costs for marketable orders.
  
  
  • For larger orders, greater depth of liquidity is required to reduce effective and realised spreads – and there has been a strong correlation between tighter bid-ask spreads and increasing depth of liquidity.
  
  
  • More tick granularity improves the efficiency with which statistical arbitrageurs can “port” liquidity from one asset to a related one, resulting in more efficient and more liquid market.
  
  
  • So on the face of it, narrow ticks allow tighter spreads, and tighter spreads improve overall market efficiency.
  
  
• But, with many more price points to choose from, liquidity is naturally distributed across more price points, which has a number of possible implications:




• Liquidity at the touch (and every other individual price point) may be lower, which some have used to support a somewhat disingenuous argument that “liquidity has reduced since MiFID”. This argument is weak, since the “effective spread” or cost to trade any given size of order has declined due to an increase in visible liquidity when all price points are considered.


• This distribution of liquidity, and smaller volume at each tick, might reduce incentives to post larger orders, as they will be more easily discerned by other market participants. So smaller tick sizes can encourage the further slicing & dicing of orders.


• The participation by algorithms and market makers at a greater number of price points subsequently requires more order amendments and cancellations as markets move, driving higher volumes of market data and putting strain on the infrastructure of market operators, data vendors and consumers alike.

• Some argue that tick sizes can be too low (although exactly what constitutes “too low” is a subject of fierce debate):




• Where the tick size is too low, the cost of setting a new best bid/offer is small, and so large orders are more prone to being “stepped ahead of”. This reduces the incentives to display size in the public markets, continuing the trend towards smaller order and trade sizes and more frequent data updates.


• Lower liquidity (shorter queues) at each price point, combined with a number of competing order books for each security, might also dilutes the incentives to leave orders in the market for a period of time so as to reach the front of queue – and without such an incentive orders will tend to have a shorter duration – once again fuelling faster market data update rates.

What about larger tick sizes?

• Larger ticks force a consolidation of liquidity at fewer price points, leading to greater price stability and potentially strengthening the “time” component of “price-time” priority by requiring orders to remain in the book for a while in order to reach the front of the queue. This has the potential to drive greater stability and hence to reduce market data volumes.


• But, and it’s a very big ‘but’, larger ticks reduce the capacity for participants to price improve, and force wider spreads, and thus they:




• Materially increase transaction costs for marketable orders (particularly smaller orders from retail participants or algorithms).


• Exclude some liquidity from the market that cannot afford to cross the spread, and which is unable to gain time priority by setting a new best price.


• Increase incentives for investors to find price-improvement via non-display or OTC trading avenues.


• Increase the potential profits of market makers, creating stronger incentives for firms with a substantial distribution network to internalise client flow rather than route it to public markets.

Who wins with larger ticks?

• Many market makers and day-traders have seen their profits eroded by smaller spreads, and hence typically advocate larger ticks (or at least argue against further reduction). Whilst sustaining the profitability of such participants is unlikely to be regulators’ principal concern, a lack of profitability will lead to a further reduction in liquidity from such participants.


• Smaller brokers (and often investors executing on a DMA basis) struggle to execute amongst the “blur” resulting from smaller tick sizes and hence higher data volumes. Only those with significant IT budgets can invest in Smart Order Routers capable of capturing the visible liquidity spread across many price points and venues. So perhaps many would welcome a re-consolidation of liquidity at fewer price points, even if it moderately increased their transaction costs. And exchanges to whom such members are more important might reach different conclusions about the optimal level for tick sizes.


• Both data vendors and data consumers have been stretched by the climb in the order-to-trade ratio. Might they breathe a sigh of relief if tick sizes were increased?

Who prefers smaller ticks and spreads?

• For retail brokers, tighter spreads translate directly into lower transaction costs.


• Firms with diversified investment portfolios (e.g. index and quant investors) who rely heavily on algorithmic trading should also realise lower transaction costs.


• Electronic market makers and some retail brokers, who prefer “egalitarian” markets in which they can interact with liquidity on a fair and equal basis with banks and brokers, like smaller ticks because they reduce brokers’ appetite and capacity to internalise flow. Reduced internalisation, they argue, results in more natural liquidity reaching the public markets, thereby reducing the potential for adverse selection and encouraging greater limit order liquidity (whether from market makers or investors) into the markets.


• Statistical arbitrageurs, upon whom market participants rely to transfer liquidity and risk across venues and correlated instruments, are negatively impacted by larger ticks and by internalisation, and so hence have a strong preference for smaller tick sizes.


• Any individual venue enjoys a relative advantage if it allows smaller ticks than its competitors, simply because it can publish a tighter BBO, and hence attract order flow from brokers seeking best execution. But, this is tragedy (of the commons) waiting to happen, and can lead to a “race to the bottom” which harms market quality.

Historically, tick sizes were set by exchanges. They sought to balance the needs of different types of market participant. In the UK, the buyside, led by the IMA, consistently lobbied for smaller ticks, with the banks (and market makers in particular) resisting, and the exchange was stuck in the middle. Only as the business migrated towards DMA did this impasse clear, with narrower ticks becoming more widely accepted.

Then the MTFs arrived, and by offering standardised pan-European ticks across their own markets and adopting smaller ticks, we succeeded in attracting new liquidity to our platforms and to the market as a whole. The success of MTFs in attracting this liquidity forced exchanges to follow suit or find that they no longer offered best execution.

After a while, market participants, struggling with inconsistent tick-size regimes across venues, then gave impetus to the discussions that have resulted in today’s “gentleman’s agreement” on harmonised dynamic tick tables for many markets. And somewhere along the way, some on the buyside seem to have switched to the other side of the debate, and now advocate larger ticks.

So what happens next?

• The harmonisation of tick sizes, attractive in principle, requires a compromise between firms with opposing interests. How robust is the consensus that harmonisation should trump individual venue’s ability to tailor their market to their customers needs? NYSE Euronext seem to be challenging the need for a consensus by announcing changes to their own ticks (deviating from the FESE tables) without consulting many market participants or other platforms.


• If we aim to retain harmonised ticks, how do we allow different types of market participant to have an appropriate level of influence in the debate, or should we be looking to put the decisions in the hands of academics or regulators rather than practitioners with vested interests?


• Can the current “gentleman’s agreement” approach involving venues and brokers working be relied upon to keep working, as new MTFs spring up, or in the face of a global exchange group announcing changes (whether considered good or bad) without consultation?


• If ESMA intends to prescribe tick sizes, then how should the terms of reference be set to ensure they reach an appropriate balance between Europe-wide harmonisation and the dynamics of different markets?

Regardless of who makes the decisions, a larger problem is determining whether proposed changes are likely to be beneficial for investors (who should matter more than intermediaries). There are two problems:

1. We have no universally accepted measure for market quality.


2. Because MiFID coincided with the credit crisis, we have no way of disaggregating MiFID’s effects on liquidity and market quality from the effects of the crisis.

Perhaps we can take a leaf out the SEC’s book in the US. When considering changes of this kind, the SEC has a longstanding practice of running short pilot programmes (of a few months), applying the proposed changes to a small but representative sample of securities. This allows the SEC, market participants and academics to gather solid empirical evidence and evaluate the impact of the changes on liquidity and transaction costs relative to a control group of stocks for which no changes were made. I don’t suppose this resolves the arguments or competing interests, but it must surely guarantee a more informed debate.

Or perhaps the dynamic tick tables we use in Europe (whereby the tick size changes intra-day based on the instrument’s price) already provide adequate data for academics to pour over?

This has been, and will continue to be, an imperfect process, and I worry that this week's announcement by NYSE Euronext will harm our ability to maintain a consensus in the future.

Lots of Cooks

IOSCO (the International Organization of Securities Commissions) recently published a Consultation Report titled “Issues Raised by Dark Liquidity”. And the ECON Committee of the European Parliament voted on 9 November to adopt a report intended to influence the MiFID review, with an emphasis on encouraging the use of pre-trade transparent venues. So how similar were the recommendations?

IOSCO’s headline recommendations from its press release were rather mundane, reflecting existing best practice rather than suggesting any radically new ideas. But reading between the lines…

“Principle 3: In those jurisdictions where dark trading is generally permitted, regulators should take steps to support the use of transparent orders rather than dark orders executed on transparent markets or orders submitted into dark pools. Transparent orders should have priority over dark orders at the same price within a trading venue.”

Not too exciting really, given that most exchanges, MTFs, and ECNs already apply price-visibility-time priority. So why state the obvious, and what didn’t they say?

First, the US practice of Flash Orders (which the SEC proposes to ban) probably contravene these guidelines, especially where marketable orders are reflected to preferred liquidity partners (whose liquidity is “dark”) prior to interacting with lit bids or offers in the venue’s book.

Second, the report goes on to emphasise that rather than restrict dark orders per se, regulators should instead “look at ways to incentivize market participants within the regulatory framework to use transparent orders… the key interest is in taking steps to ensure that there are adequate transparent orders in the marketplace.”

• In Europe, MiFID sought to promote transparency by banning most hidden and discretionary orders in lit books. However, rather than encourage the use of transparent order types as anticipated, this tougher stance spawned the creation of discrete dark books (both MTF and broker-operated) which are isolated from the lit orders books. The effect has been to demote transparent books in the order routing hierarchy for certain types of flow.


• If European regulators were to take IOSCO’s recommendations to heart, they might instead consider encouraging more flexible use of dark orders within transparent order books (e.g. relaxing the LIS constraint), so as to encourage participants who want to post dark orders to use these venues. After all, lit books offer far greater certainty of execution, and so would be very attractive for smaller hidden orders.


• Unfortunately, the political tide seems to be flowing in the other direction, with the ECON Committee contemplating whether further restrictions to dark order types and venues would “encourage” liquidity into lit venues. Personally, I doubt that “forcing” such orders to be displayed will produce the desired outcome. Lit markets have evolved, and put simply, they are just too transparent and too efficient for some investors/orders – with prices changing more quickly than ever to reflect slight imbalances between supply and demand. So I worry that further restrictions will drive liquidity out of the markets altogether.

Third, giving transparent orders priority over dark orders within each venue can only be expected to have a beneficial impact if much of the dark liquidity is in venues that also have transparent orders. With most of the dark liquidity residing in discrete dark MTFs or BCNs, this prescription lacks impact. Both the SEC and Canadian IIROC have considered going further, giving transparent orders priority vs. dark orders at the same price across markets, e.g. by requiring that dark pool executions always offer both participants material price improvement (e.g. at least one tick) vs. the best available lit price for equivalent size.

Turning to the ECON Committee report, it’s clear that it is a product of negotiation & compromise, and an attempt to square the many competing vested interests. The general thrust is that since MiFID introduced competition, the pace of innovation has outstripped the ability of regulators to keep up, and also that competition has produced some unexpected or unwelcome outcomes (including the emergence of non-display MTFs and broker crossing networks). The final report avoids some of the more over-protective prescriptions that had been in circulation previously, and which would have harmed market quality, for which the committee should be commended. But even in this compromise document, there were a few recitals/recommendations that caught my eye:

• “Whereas market fragmentation in equities trading has had an undesired impact upon liquidity and market efficiency…”
  I think a more positive view of MiFID is warranted, because although many participants are still adjusting to the new landscape, spreads and liquidity depth are demonstrably superior in stocks that are subject to competitive trading (thankfully Spain’s failure to implement MiFID properly creates a useful control group), and given that trading tariffs are some 90% lower than they were pre-MiFID.


• “Asks for an investigation by the Commission into the effects of setting a minimum order size for all dark transactions, and if it could be rigorously enforced so as to maintain adequate flow of trade through the lit venues in the interests of price discovery;”
  The target here is both MTF/Exchange dark pools and broker crossing networks. But what’s missing is any discussion as to what is meant by “adequate”. Certainly, there is no sign that price formation has been in any way weakened thus far, and economic theory suggests that price formation is much more robust than regulators/politicians are giving credit for. Personally, I have more sympathy for the SEC’s emphasis on “avoiding a two tier market” as a rationale for ensuring the pre-eminence of venues with non-discriminatory access. Again, I believe it would be better for market efficiency and liquidity if regulators allowed small dark transactions to be handled by lit venues, rather than see them ban such order types altogether.


• “Suggests ESMA conduct a study of the maker/taker fee model to determine whether any recipient of the more favourable "maker" fee structure should also be subject to formal market maker obligations and supervision;”
  To me, this suggests a limited understanding of the topic and of market structure. Firstly, MTFs treat all members equally – and hence all MTF members (basically every major bank or brokerage house in Europe) are receiving the “maker” rebates for a proportion of their business. Secondly, and related to the point of equal treatment, most European markets no longer have a concept of market makers with particular privileges and obligations for liquid stocks. And thirdly, some MTFs pay rebates for passive liquidity, whilst others pay rebates for aggressive flow, making receipt of rebates a poor basis to define “market making”.


• “Requests that no unregulated market participant be able to gain direct or unfiltered sponsored access to formal trading venues and that significant market participants trading on their own account be required to register with the regulator…”
  Many proprietary trading firms have been told by their domestic competent authorities that their activities are not subject to regulation, so this would be a significant change.


• “Calls for an investigation into whether to regulate firms that pursue HFT strategies to ensure that they have robust systems and controls… and the ability to demonstrate that they have strong management procedures in place for abnormal events”
  Clearly, HFT firms are risk management specialists (people trading with their own money and seeking to capture low-alpha opportunities have a healthy appreciation for risk), and faced with failings of market infrastructure/regulation during the US flash crash, they behaved appropriately by stopping trading. Perhaps regulators would have preferred them to “stand in front of the train”, and keep buying the face of a tsunami of sell orders – but that would simply convert a brief liquidity shock (albeit with nasty implications for consumer confidence in the integrity of markets) into a more serious systematic-risk issue that could have bankrupt firms and/or their clearing brokers.


• “Asks for an investigation into OTC trading of equities and calls for improvements to the way in which OTC trading is regulated with a view to ensuring the use of RMs and MTFs in the execution of orders on a multilateral basis and of SIs in the execution of orders on a bilateral basis increases, and that the proportion of equities trading carried out OTC declines substantially”
  This is actually one of several recitals explicitly calling for a reduction OTC trading in favour of transparent exchanges and MTFs. Still, the suggestion that “improvements to the way in which OTC trading is regulated” should lead to less OTC trading seems somewhat odd.

Even though some of the Committee’s recommendations might benefit MTFs such as Turquoise at the expense of OTC, I’m troubled by assertions/conclusions that contradict the empirical evidence and by the emphasis on “protecting” lit markets by restricting innovation and investor/intermediary choice, rather than by allowing them the flexibility to compete.

Hopefully CESR/ESMA will find a way to address the Committee’s concerns whilst recognising that MiFID is actually working, and that much of the anxiety over fragmentation and “opacity” can be attributed to growing pains that will subside as participants become accustomed to the new market structure.

As for unintended consequences, I’m willing to bet that these efforts to drive trading towards transparent venues will lead to a further proliferation of non-display MTFs. Any takers?

The Fifteen Year ITCH

Back in May, a small US broker dealer published a white paper highlighting that information published in relation to some exchange or MTF dark pools could allow participants to identify the direction and longevity of (supposedly dark) resting orders. In Europe, another broker-dealer brought the issue to the attention of their buyside clients, who demanded that problem be addressed, forcing the affected venues to amend their data feeds (which they did within days). All water under the bridge, or so I thought.

But recently there have been further accusations that exchanges continue to “deliberately sell confidential order data to HFT firms”, with some suggesting that there’s a grand conspiracy amongst exchanges, regulators and HFT firms to defraud institutional investors. These new allegations are being levelled at exchanges in relation to their public lit order books. I think they’re wide of the mark and reveal a lack of appreciation for how public data feeds work.

Here’s a quote from my previous (in fact, first) blog entry:
“When exchanges first started offering electronic order entry disseminating a public data feed, participants wanted to be able to identify their own orders and executions in the public data feed. This allowed participants to know their queue position in the order book, and to display this on a client front-end. It allowed them to perform better transaction cost analytics – by identifying which executions on the ‘tape’ were theirs. It allowed them to measure the latency of the public market data against their own Execution Reports. And it allowed multiple OMS and EMS systems within the firm to identify their own orders & executions without having to feed each system with drop-copies of the order entry/execution feed.”

I repeat this to illustrate that the inclusion of OrderIDs in exchanges’ public data feeds was a response to participant demand. Dark pools aside, participants do expect exchanges and MTFs to provide this information.

First, brokers and market data vendors need to build and maintain a copy of the order book for each instrument – converting individual order-add/amend/delete and trade messages disseminated by the market into a depth-of-book representation that can be used for trading decisions. The OrderID assigned to each order is essential to facilitating this process.

Second, investors, brokers and markets all need to be able to relate individual trades back to the orders they belong to. This is essential for order management (e.g. to know the cumulative traded quantity and residual quantity for an order), for transaction cost analytics and for regulatory compliance amongst other things. The way this is typically achieved is by making the OrderID an attribute of each Trade. So it’s easy to find and sum all the Trades linked to a particular OrderID. This is turn makes it important that an OrderID is persisted throughout its lifetime – as changing the OrderID half way through would cause the ‘loss’ of the related trades, and consequently over-trade errors (which I know to be true from personal experience – a lowlight of my days as a trader).

But, I also said then:
“The specs make it relatively easy to identify iceberg/reserve orders as soon as the visible peak is first refreshed, and also to identify pegged orders as soon as they are modified by the market.”

This observation seems to form the basis of the ongoing allegations. So I want to delve a little deeper and explain why changing the way these data feeds work would represent a huge cost to the industry for little or no benefit:

How does it work exactly?

• When an Order is first received, an OrderID is assigned to it, and both communicated back to the participant (in the acknowledgement message) and disseminated in the public market data (allowing the participant to see where they stand in the book).
• From that point forward, the OrderID is used to communicate any events affecting the order:
• Each execution reported back to a participant carries the OrderID to which the trade belongs. If it was a visible order that traded, a single “Order Executed” message in the public data feed tells recipients that there has been a trade against the specified order, and hence that the remaining quantity in the book should be reduced. If it was the visible portion of an iceberg/reserve order, most communicate that there was an execution against the order, but that it remains alive with a new display quantity (typically with a loss of time priority).
• For each order amendment or cancellation, the public data-feed refers to the OrderID and communicates which attributes have been amended.
• And when the exchange automatically adjusts the price of a pegged order, the data feed refers to the OrderID and communicates the new price. (I believe some exchanges go so far as to label pegged orders explicitly, although I confess I don’t see a good reason to do so).

The persistence and dissemination of the OrderID in the public data feed is key to enabling participants to trade and manage their orders effectively, but also makes the market more transparent than some participants may have appreciated.

Exchange and HFT detractors argue that even if we arrived at this situation innocently, it’s still wrong, and that institutional traders had no idea that their information was being ‘compromised’ in this fashion. Since nothing has changed since the now widely-used ITCH protocol arrived on the scene over 15 years ago (with its specification public ever since), it’s somewhat surprising that this is news to some market professionals. But, timing aside, how serious are the concerns about information leakage regarding iceberg and pegged orders, and should markets be changing their public data feeds to assuage the critics?

Ceasing to publish any OrderIDs in the public data would render market data useless and break most OMS systems. But, in relation to iceberg and pegged orders, could exchanges switch from publishing amendments to the existing OrderID to instead sending a cancellation of the order and then the addition of a replacement order (with a different OrderID)? This sounds alluring, except that:

1. Without significant design changes, this would break the link between trades and the OrderID, and as I explained above, that’s not a good idea. Avoiding this would require very substantial investment by data vendors, brokers, OMS vendors etc – for which there is very little appetite.
2. This would double the volume of market data being disseminated in relation to order amendments and iceberg executions (two messages instead of one).
3. And most importantly - it wouldn’t materially reduce information leakage. Even if replacement OrderIDs were used in the scenarios above, iceberg executions and pegged order amendments would still glaringly obvious to any consumer of the data feed from the immediacy with which they followed executions or peg reference-price changes. In short, we’d make making market data less efficient and forcing an overhaul of OMS systems for no good reason.

So what should an institution do?

Frankly, they probably shouldn’t worry about it too much. If they’re using a sophisticated broker, then the broker will have already developed their algorithms to mitigate the risk of information leakage. They could insist that brokers don’t use the iceberg functionality of exchanges – but such a decision would come with a cost of less participation in the marketable liquidity passing through the exchange. They could insist that their brokers don’t use exchange pegging functionality – but I expect they’d find that most brokers already don’t (in fact, due to lack of demand, Turquoise didn’t implement pegging functionality in its new Millennium Exchange platform). Or they could insist that brokers cancel and replace orders rather than amending them (and again would find that this is common practice for many big brokers already).

The simple fact is that ‘lit’ markets are very transparent, exactly as regulators wanted them to be. Meanwhile, all the empirical data suggests that this improved transparency, the competition amongst various markets, and the supplanting of traditional market making by the electronic variety have coincided with an ongoing reduction in the total transaction costs experienced by institutional and retail investors alike. And whilst correlation doesn’t prove causation, this positive trend reduces the force of arguments that this level transparency is harmful to institutional investors.

HFT Bashing

HFT bashing by politicians and the media seems to be locked into a self-reinforcing cycle. The media cites growing concerns amongst politicians and public officials who in turn point to the media as evidence of public concern warranting intervention.

There is lots of woolly thinking that ought to be challenged:

• Recent suggestions that medium-term volatility in asset prices relative to underlying fundamentals is attributable to HFT are nonsense. By the most commonly accepted definition, HFT firms end each day (if not each minute) with no positions, so they cannot affect inter-day supply and demand unless their presence is precluding other classes of long term liquidity-supplying investors from participating in markets. If the medium-term volatility is growing, so are the opportunities for such contrarian investors, and it’s hard to see how HFT would be keeping them away.
• Allegations that HFTs caused the May 6th flash crash by ‘withdrawing their liquidity’ are inconsistent with arguments that during normal market times the liquidity they provide is ‘ethereal’.
• Talk of “growing evidence” that HFT is bad is too often just a reference to the clamouring of market participants with a particular vested interest or to the circus of media coverage. Indeed, the only empirical study I’m aware of seems to contradict most of the popular arguments levelled against HFT. It’s encouraging to hear that the UK Treasury is commissioning an independent study by one of its economists.
• The fact that HFT firms are profitable (although less so of late according to the published results of several large players) does not necessarily mean that normal investors are losing out. It may be that HFT firms have supplanted traditional market makers and specialists and are providing the market with liquidity at lower cost than was previously the case.

And yet, despite the lack of coherent argument or empirical evidence thus far that HFT is detrimental, the debate seems to be progressing inexorably towards the adoption of measures to forcibly constrain HFT.

Clearly I’m un-persuaded that forcibly constraining HFT will improve market quality or benefit long-term investors, but intellectual curiosity compels me to consider some of the measures being recommended (usually by politicians) as a way to limit HFT participation in our public markets:

• A proposed “minimum quote duration” would be counterproductive (by which I mean idiotic). It misses the point that not all HFT is ‘passive’ by nature – there are plenty of HFT firms whose trading flow is entirely ‘aggressive’. A minimum quote duration would allow aggressive HFT firms to systematically exploit brokers (and their investor clients) who would be unable to adjust/cancel their orders in response to price movements in other relate instruments.
• Rationing orders or capping the “order-to-trade ratio” of individual HFT firms might well reduce the number of orders/quotes each individual firm generates – but the medium term impact is likely to be the emergence of more HFT firms. If there are profitable strategies that individual firms are prevented from executing, others will eventually discover those strategies.
• Imposing a tax on order messages or cancellations “to cover the cost of market infrastructure” seems somewhat draconian. Is it appropriate for politicians to tell commercial companies they must charge more for a service?
• In the US context, where there is a centrally funded consolidated quote system (which seems increasingly obsolete), wouldn’t it be better to start by reforming the problematic formula that defines how consolidated quote data revenues are shared amongst markets (and then their participants) in relation to the number of quotes and trades generated (and which arguably creates commercial incentives to update quotes more frequently)?
• In Europe, where regulators already worry that broker crossing networks and MTF dark pools might undermine price formation in lit markets, would introducing additional costs to provide liquidity in lit markets make sense? If the goal is to drive more liquidity towards the central, lit markets – is a new tax on their use the optimal way to achieve it?
• The (apparently popular) suggestion that “market makers” should be subject to “obligations” to provide liquidity in times of market stress doesn’t appear to be grounded in reality.
• Most European equity markets no longer have a formal market-maker designation – so rulebooks would need to be changed to establish which firms would be burdened by these new obligations.
• No firm would take on an obligation to lose money (for that is exactly what is required to stabilise markets in times of stress) without being offered some counterbalancing privileges. Given MiFIDs emphasis on the “fair and non-discriminatory treatment” of all participants by exchanges and MTFs, should we welcome the creation of a privileged elite amongst market participants?
• The reality is that the economics of liquidity provision have changed dramatically. Traditional market-making no longer exists because it ceased to be profitable. Given the competitive nature of HFT (many firms say that a typical strategy has a “shelf life” of only a few weeks), it’s unlikely that they have the scope to absorb the losses required by new obligations if they’re to be in any way effective. It just won’t work without sufficient “incentives” – which takes me back to the dangers of creating a privileged few.
• It won’t work anyway. The benefits are illusory. No trading firm would sign up to the potential for unlimited losses – they’ll always want an “out” in extreme cases. For example, how could they be compelled to continue supplying liquidity if there’s a failure by exchanges to process orders or publish data in a timely fashion (as apparently happened on May 6th)?
• Suggesting that all markets “synchronise their market data output” so as to prevent latency arbitrage is a total nonsense that would either require us to suspend the laws of physics or mandate all markets and all participants to operate from a single geographic location. In a technology enabled and geographically dispersed world there is no “single NBBO/EBBO” – it depends where you are relative to the different market centres.
• Significantly increasing tick sizes would reduce the potential for client orders to be “stepped ahead of” at marginal cost. There would potentially be more liquidity at each price point, and thus stronger incentives to leave quotes live for longer (so as to reach the front of the queue). The minimum hurdles for a strategy to be profitable would be larger, and hence there would presumably be less HFT. This sounds like a viable approach, but unlike the other suggestions, the inherent costs are more obvious:
• Spreads would be wider, resulting in higher trading costs for all market participants and for retail investors in particular (they typically submit marketable orders).
• Wider spreads would increase the opportunity for brokers to offer clients price improvement via their internalisation services (BCNs, SIs) or via price-referencing midpoint MTFs – potentially resulting in more volume migrating away from lit markets.

So there’s no free lunch - surprise, surprise.

I eagerly await the conclusions of the Treasury’s study. And if the conclusion is that HFT is detrimental to market quality, I expect a lively debate about what to do about it. In the meantime, I expect that regulators will prioritise the prevention of another flash crash – and so expect (and support) further developments around market-wide volatility interruptions.

Is laissez-faire fairest?

In the debate about high frequency trading, the arguments that HFT has distorted the market can be divided into two categories.

• One set of arguments suggests that HFT firms are playing within the rules, but that the rules are wrong. Blame for this is often laid at the feet of market operators or regulators.
• Another set of arguments suggest that HFTs are playing outside of the rules, and that the rules are not being adequately enforced. Blame for this is often laid at the feet of market operators or regulators.

I have shared my own (broadly positive) opinions on HFT previously, but the propensity of others to blame market operators for changes to the nature of the markets lead me to question the approach to surveillance and enforcement in our (now) competitive market landscape.

An easy observation is that no-one is sufficiently well informed to reliably spot market manipulation:

• As an MTF operator, we are only responsible for conduct of participants on our MTF. Assuming that a devious participant smart enough to manipulate the market would be also smart enough to disguise their intentions by using multiple MTFs or exchanges, we can only hope to catch the stupid ones.
• Secondly, the data we have for our own MTF only identifies the participant entering the order. If we identify a set of orders or trades that constitute (in our judgement) suspicious activity by a participant, we cannot know (without calling them to ask) whether they are attributable to one end-client or many. So a surveillance system looking for certain patterns of behaviour typically generates many “false positives” that turn out to be unconnected trades by a number of different end clients. Add to that the fact that end clients (whether asset managers, hedge funds or high-frequency prop trading) can and do split their business amongst multiple brokers, and it becomes harder still to identify what individual participants are doing.
• So if somebody wanted to monitor trading activity across all venues, they would need to combine “attributed” (identifying the owner) and “privileged” (including non-public information on hidden and iceberg orders) data from all the venues. This just isn’t possible today.

This situation is a few years old, but the US Flash Crash has recently prompted regulators to try and tackle it – with the SEC having made the most detailed proposals. Broadly speaking, there are two proposed technical solutions to the problem of fragmented/incomplete data.

1. Markets should be told by brokers who the underlying client is. A “client identifier” will be included with each order sent to market. It will not be disseminated in the market data, but will be available for surveillance purposes. This would allow individual markets to better identify behaviour of individual clients, irrespective of how many brokers they use.
2. There should be a “consolidated audit trail” to which all markets (and not just equity markets) will contribute their attributed data feed - including every order, amendment, cancellation and trade for every broker and identifying the underlying client for each. The entity receiving this consolidated information could then be responsible for surveillance across the multiple venues.

There are, however, some practical problems with these proposals:

• Markets will have to amend their interface protocols to accommodate the new client identifier
• It’s not clear if there’s an existing convention for client identifiers (e.g. BIC codes) that will cover all of the intended firms, or whether a new standard needs to be defined (and then a directory maintained).
• Markets will then need to develop a secure (and presumably standardised) way of publishing the attributed and privileged data to the consolidated audit trail.
• The consolidated audit trail for US security and derivative markets has been estimated by the SEC to cost $4billion to set up, and a further $3billion each year to operate. For many participants, that seems like too high a price to pay for an unquantifiable improvement in market quality (although I note that a number of vendors have approached the SEC with lower-cost proposals).

Assuming the practical problems can be overcome, there are still some other thorny issues to resolve:

• Given our fragmented regulatory landscape, who will undertake surveillance using the consolidated audit trail?
• Do the regulators have the necessary expertise, or might they outsource the function (as recently proposed to the SEC by Senator Edward Kaufman)?
• And if the individual undertaking the analysis is smart enough to make sense of the consolidated audit trail and understand the trading strategies behind a (presumably anonymous) participant’s behaviour, how do we reassure participants that their intellectual property will be safeguarded if that individual decides it’s time to become a trader?

And that brings me to my real question – Do regulators, market operators, participants or academics actually agree on what constitutes illegal or immoral behaviour?

I believe there is consensus with respect to insider dealing and front-running of client orders, but what about practices that might amount to “market manipulation” depending on the intent of the participant?

The falling costs and lower latencies stimulated by competition amongst markets have changed trading behaviours dramatically – and many of the practices (such as high order cancellation rates, the presence of orders at multiple price points, the presence of orders on both sides of the book, or speedy position reversals) that might have previously been associated with market manipulation are now routinely exhibited by legitimate trading strategies (whether market making or the algorithmic execution of client orders).

I tried to explain this difficulty to a (non UK) regulator, who first told me that we should identify orders submitted where “the participant doesn’t really want to trade”. This is tricky for market operators, since our markets only accept firm orders (there is no risk-free option to post into the order book during continuous trading), and because our mind-reading skills are not as developed as regulators apparently suppose. And if the risk of trading truly is the most effective disincentive to submitting “misleading” orders, then is competition amongst market participants the best way of achieving a fair market?

He responded that we should discourage speculative orders priced far from the prevailing BBO – but in my mind that’s just a recipe for shallow and volatile markets. I would argue, for example, that rather than attack the use of “stub quotes”, the correct response to the Flash Crash should be to encourage more participants to place “speculative” orders so that competition amongst them creates a deeper and more stable market.

What about “momentum ignition”, described by the SEC as the practice of “spoofing” algorithms or human traders into crossing the spread by “stepping ahead” of them in the order book, or printing small trades at the Bid or Offer, thus creating momentum which increases transaction costs for customer orders… How can regulators or market operators draw a line between “igniting momentum” and the (presumably legitimate) practice of detecting an imbalance in supply and demand and stepping ahead to profit from the anticipated price movement? Most brokers seem to take the view that it is their responsibility (and not regulators’ or market operators’) to protect their clients, improving their algorithms such that they are less prone to being spoofed and consequently trading “at the wrong price”.

Setting aside the obvious abuses of insider dealing and front running, if markets are competitive by nature, is it realistic to “protect” participants from one another? And if there are limitations to how “safe” we can make the market, how do we at least ensure that they are “fair” (so that no one participant or group enjoys an innate advantage over another)? Before we design the all-singing, all-dancing technical solution to the problem of policing fragmented markets, we need to be clear about what we’re trying to achieve. What would it take to identify and police all types of “manipulative” trading strategy, how effective can the policing be, and do market participants think it’s worth bearing the cost? And to what extent should we rely on surveillance and enforcement to create a fair market, versus competition amongst participants seeking best execution for themselves or their clients?

We invite feedback from brokers, competitors, regulators and institutional investors on our approach and our views.

P.S.

• Turquoise takes great pride in its sophisticated surveillance capabilities, places great emphasis on the quality of its marketplace, and takes its regulatory responsibilities very seriously. We raise this topic because we think it is a market-wide issue which we cannot address alone.
• Turquoise has retained its number one position in the dark for a third successive month, slightly increasing its share of dark trading.
• Our migration to Millennium Exchange takes place next month. Please let us know if you need our assistance in making preparations. The dress rehearsals are on September 11th and 18th.

Blowing Our own Trumpet

CESR has just published their Technical Advice on the MiFID Review - so I'll probably have something to say once I've digested the 162 pages. But in the meantime, here is the text of the Press Release we issued this morning.

Turquoise number one MTF dark pool for second month running

• July dark volumes show Turquoise extending lead ahead of competitors
• Lit pool also showing steady growth – now 2nd largest MTF for majority of stocks listed
  

Turquoise’s pan-European mid-point book looks set to remain the largest MTF dark pool for the second month running, extending its lead over its nearest competitor during July as the number of active participants continued to grow. According to statistics from Thomson Reuters, it is the only dark MTF to have exceeded €4 billion of traded value in Stoxx600 Europe constituents for the month to date, and is on track to beat its record performance in June despite lower overall market volumes during July.

David Lester, CEO of Turquoise, said:

“We are grateful for the support of our clients in driving the success of our mid-point book. Clients are responding to the growing pool of liquidity and expressing their support for our functionality roadmap which will offer participants greater control and choice when trading in our dark pool. ”

Turquoise has also seen steady growth in its lit pan-European order books, especially pronounced in mid and small cap segments where it has become the second largest MTF for the significant majority of stocks.

David Lester added:

“With growing and diverse liquidity in both our order books, we have positive momentum leading up to the launch of our new trading platform. Given the number of clients and prospects actively testing the new system, we expect the growth to continue once we switch over to Millennium Exchange in October.”

Chart - Mid-point Book Consideration Traded by Month

A Change is Gonna Come...

It would seem that we now have a European equivalent of the SEC’s far-reaching Concept Release. Kay Swinburne’s draft report on MiFID, submitted to the European Parliament’s Committee on Economic and Monetary Affairs, is wide-ranging and ambitious.

The following highlights grabbed my attention;

With regard to Dark MTFs & BCNs, the report

• Explicitly acknowledges that BCNs are different to dark MTFs in that they are an extension of the ‘traditional, discretionary broker-client relationship’.
• Calls for BCNs to disclose to regulators the details of orders matched in the system (which is a significant volume of data), as well as information on the trading methodology, level of broker discretion, and methods of access.
• Calls for an investigation into whether there should be a volume threshold above which BCNs must convert into MTFs.
• Calls for an investigation into setting a minimum order size on BCNs and MTFs as a way of encouraging greater flow of trade to lit venues in the interests of price discovery. And, calls for a review to consider whether such a minimum size threshold be applied to the Reference Price waiver upon which dark midpoint MTFs are reliant (but which does not currently apply to BCNs).
• Calls for a consultation on whether market-making within BCNs should be permitted, or whether they should be restricted to the crossing of ‘buy side customer orders’.
• Calls for a review to consider reducing the current Large in Scale thresholds, and also to broaden the Reference Price waiver to allow matching anywhere in the spread (which could be intended to allow the waiver, including a potential minimum size threshold, to be applied to BCNs also).

With regard to HFT, Co-location and Sponsored Access, the report

• Blames the US May 6th ‘flash crash’ on the withdrawal of HFT liquidity, and suggests a study into whether ‘informal market makers’ receiving a ‘maker’ rebate should have formal liquidity provision obligations and supervision.
• Calls for HFT firms to be regulated to ensure they have robust risk controls in place, and for market operators to stress-test their systems and introduce volatility interrupts and circuit breakers so as to avoid a European ‘flash-crash’.
• Calls for an investigation into the true impact/contribution of HFT trading on other market users, particularly institutional investors.
• Calls for unregulated proprietary trading firms to execute into markets through regulated firms (currently, MiFID allows these firms to join exchanges and MTFs directly).
• Calls for ‘unfiltered sponsored access’ to be expressly prohibited and for the Commission to adopt IOSCO’s principles on sponsored access, relating to the contractual arrangements and respective responsibilities for risk controls & filters – including an obligation for the sponsoring firm to have ‘pre-trade filters’ in place (although it doesn’t address the role of MTFs/exchanges in implementing pre-trade filters on behalf of the sponsor).
• Calls for trading venues providing co-location themselves, or indirectly via third parties, to ensure their co-location arrangements provide equal latency to all co-located customers (which could drive an interesting intrusion by market operators into the commercial affairs of independent data-centre operators).

With regard to market data, the report

• Calls for CESR to clarify and tighten post-trade reporting standards to ensure greater consistency so as to better facilitate data consolidation.
• Calls for venues to unbundle pre and post-trade data so that post-trade data can be acquired (and consolidated) more cheaply.
• Calls for the establishment of a working group to ‘overcome the barriers’ to a European Consolidated Tape and establish a privately run system (without any taxpayer funding).
  

And on other miscellaneous topics, the report

• Calls for all ‘equity like’ instruments including ETFs and DRs to be captured in the scope of MiFID.
• Supports the extension of MiFID to derivative instruments
• Requests that the Council consider extending the MiFID per & post-trade transparency requirements to all non-equity instruments subject to significant secondary trading (including an explicit mention of government and corporate bonds, though no mention of FX).
• Suggests that regulators must have sufficient data to be able to ‘re-create the order book’ – so as to understand the market dynamic and participants’ involvement (similar to the SEC’s $4billion proposal for a ‘Consolidated Audit Trail’ to gather attributed (identifying the underlying end-client) order & trade data across all market venues).
• Suggests that ‘flash orders’ that undermine the equal treatment of all exchange/MTF customers be banned (although it is not clear whether the routing services offered by Chi-x and BATS, and delivered via relationships with selected market participants, are intended to be captured by this).
  

A great deal of thought (and I suspect lobbying) has gone into this report, and the challenges now will be;

• To prioritise amongst the many recommendations to identify those that best promote competition and safeguard the efficiency and integrity of our markets, and to determine how much can be done and how quickly.
• To conduct the multiple investigations, consultations and reviews in an efficient and transparent fashion, ensuring that all the relevant parties have sufficient opportunity to contribute.
• To address the many inter-related issues in a holistic manner, without unintentionally advantaging or disadvantaging different categories of market participant through the uneven introduction of new rules.
  

I’ll return to many of these topics in future posts (although they will likely be every few weeks going forward).

Trade At

In its ‘Concept Release’ published earlier this year, the SEC asked for feedback on a ‘Trade At’ rule. Given that we don’t even have an EBBO or ‘Trade Through’ rule in Europe (indeed, I’ve previously argued against introducing either), you might assume that this idea would have no applicability to our markets – but it is an interesting (and contentious) topic. I decided to blog on this after reading a couple of related posts (titled ‘Recipe for a Toxic Market’) on TabbForum.

The current US Trade-Through Rule principally applies to market centres – and essentially stops any market from trading outside of the NBBO. So if a marketable order cannot be filled at the NBBO in a particular market, the market must either reject the order or onward-route it to a market that can satisfy it at the NBBO. The whole ‘Flash Order’ debate in the US was about market operators trying to avoid returning or routing orders to their competitors (as the rule requires) by instead introducing a brief delay during which it would seek to match these orders against selected liquidity partners.

Some interpreted the SEC’s ‘Trade At’ proposal to imply a tightening of the Trade Through rule, effectively enforcing time-priority across the competing lit venues. This could have the same effect as mandating a virtual Central Limit Order Book (CLOB), possibly undermining competition.

But the real thrust of the debate appears to be whether the ‘Trade At’ rule should apply to non-displayed order matching, including broker internalisation. What exactly does this mean?
The proposed ‘Trade At’ rule is that, when non-displayed orders are matched, brokers and market operators should be required to price-improve on the BBO by a minimum amount - either a full price-tick or a minimum proportion of the spread. In other words, they cannot ‘Trade At’ the BBO price without trading with the best publicly displayed Bid or Offer – effectively giving priority to the participant prepared to display their limit order.

Where displayed markets include non-displayed orders they effectively have a Trade At rule, in that displayed orders typically take priority over non displayed orders to give an execution priority of price, display type. For a non-displayed order to execute, it must be a minimum price increment better than the best displayed price. The same is also true of midpoint (dark) books operated by MTFs under the reference price waiver – they never give a non-displayed order priority over a displayed order at the same price.

Brokers internalise client flow whenever they can – whether they use an (American) ATS or a (European) BCN/BCS or SI as the platform. This makes economic sense both for the broker and for the clients – the broker avoids the exchange and clearing fees associated with trading in a Public Limit Order Book (PLOB), and the clients interact with natural liquidity without signalling their intentions publicly. Often, though not always, the trade will happen inside the spread, offering both clients price improvement versus what they might have achieved in the public market. The more a broker internalises, the more competitive its commission rates for clients can be.

Those market operators accustomed to concentration rules might argue that internalisation shouldn’t be permitted. But it’s also hard to make a principled argument as to why a broker should be forced to buy services from an exchange/MTF and CCP if those services are not actually needed (which is the case if the broker has two clients willing to trade with one another). Especially where the level of post-trade transparency is adequate, it’s not clear who benefits (other than the exchange and CCP) from forcing brokers to use services they don’t need. And if the trade is being executed inside the spread, then there are not, by definition, any other market participants who are advertising their willingness to interact with either the buyer or the seller at that price.

On the other hand, many internalised transactions (especially of retail orders in US markets) happen at (or very close to) the public BBO. This raises two interesting questions;

1. If brokers commit capital to internalise flow at the BBO whenever it is attractive to them to do so, what can be said about the flow that they don’t internalise?
   • Some argue that such non-internalised exhaust flow is ‘more informed’, and hence makes the PLOBs less attractive for posting limit orders than they would be if the flow reaching them was ‘more balanced’.
   • Is there a point at which, when internalisation reaches a certain threshold, the mix of marketable flow reaching PLOBs becomes less attractive, leading to wider spreads?
2. When internalisation happens at the BBO, is this fair to the participant bidding/offering at the BBO in a lit PLOB?
   • Firms post their bids & offers publicly, releasing information which may impact the price, in return for a greater certainty of trading. If the stock can trade repeatedly at your advertised price, but you don’t get filled, does this undermine the incentive to post displayed limit orders in the first place?

Of course, certainty of trade has already been undermined by having multiple competing markets (each with its own queue) – but at least in this case competition is between participants prepared to display their quotes publicly.

So there is a rational economic argument that internalisation of retail flow at the BBO will ultimately lead to wider spreads, (though proving that it’s actually happening would be rather tricky).

Proponents of a Trade At rule argue that this would continue to allow unimpeded matching of client flow within the spread, whilst driving more market-making activity (where the broker buys at the Bid or sells at the Offer) into the public markets. Greater marketable flow reaching the public markets would strengthen incentives for others to post displayed limit orders – driving tighter public spreads.

Firms that prefer to see more liquidity transact in public limit order books (exchanges, MTFs, prop-traders, brokers without the scale to internalise) therefore should be expected to support a Trade At rule. Unsurprisingly, this is indeed the case, although the politics of advocating something that’s potentially unpopular with your largest customers means that the contribution to the debate from exchanges and MTFs is somewhat subdued.

Still, collectivism isn’t a popular concept in capital markets – so arguing that brokers should consume and pay for services that they don’t need because “it’s in the public good” is contentious. And rightly so – legislating a revenue stream is hardly a recipe for competitive behaviour. Indeed, some might characterise it as a form of ‘concentration rule’ – albeit one that doesn’t mandate a single CLOB.

So how do you balance the legitimate (at least as far as I’m concerned) right of brokers to internalise client flow with the public good ensuring PLOB’s remain attractive places to display limit orders?

• You could quite reasonably take the view retail brokers are perfectly equipped to decide what is best for them and their clients – whether that is routing to an exchange or trading OTC against a broker that (through internalisation) offers lower (or zero) commissions.
• You could also argue sensibly that, absent any evidence that spreads are actually widening, there are insufficient grounds to consider such a significant change in regulation.
• If, however, regulators were serious about pursuing a Trade At rule, then one would want either
  • A manageable way to exempt brokers from the requirement to interact with the public markets if they’re already contributing publicly to the BBO price at which they want to trade (because in such a scenario, it is harder to argue that the internalisation has undermined the incentive to post a limit order publicly), OR
  • Alternatively, if an exemption-based approach was impossible to monitor effectively, another solution could be for regulators to mandate a Trade At rule without exemptions, but leave it to market operators to offer reduced cost (and non-cleared) ‘own firm preferencing’ within their order books such that brokers could ‘outsource’ their internalisation.

As I said, contentious. What do institutional investors think?