Untangling the web of HFT

06-12-09 © VrenderIn the words of Sir Walter Scott, “Oh, what a tangled web we weave, when first we practice to deceive.”

A key notion, one which it might even be fair to call a “deception,” underlying much of the regulation of the technical side of securities trading in the 21st century is the idea that regulators want to “level the playing field.” The expression, meaning nothing beyond the fragility of metaphor, may sound like it means an end to some sort of privilege or other. In fact, though, administrative action to ‘level playing fields’ invariably brings about the creation of privileges.

Since regulators don’t necessarily mean to deceive, since they might in fact be perfectly sincere in their assertions that, for example, the unifed one-best-price system is better than a pluralistic approach to trading centers, some may feel that the direct application of Scott’s couplet is a bit harsh in this context.

Accordingly, I offer my own effort [with apologies] at creating a couplet that will describe the situation with more precision:

Oh! What a risk is raised unhedged,

With doors left wide to privilege!

It’s only a half rhyme, but I did manage to preserve Scott’s meter.

A Prosaic Comment Letter

The reflection arises because the Securities and Exchange Commission has now approved a rule change proposed by the New York Stock Exchange as an SRO, the NYSE’s amendment of its Rule 13, Orders and Modifiers.

Bloomberg Tradebook had submitted a comment letter on the question, and had explained itself and the context of this comment letter on its website. Bloomberg’s intervention is what drew my attention to this rule change, and persuaded me that we can learn a good deal from this about the state of play as to order types.

An Intermarket Sweep Order is an order that will “sweep” several different markets, filling its demands with as many shares as possible from each. Critics think that ISOs in general are an abusive practice.

The key point for our purposes is that the ISO is an exception to the order protection rule of NMS, a rule that demands that investors receive an execution prices be consistent among exchanges wherever more than one exchange in the national system list the same security.

An ISO is a limit order which is identified as such when routed to a trading center and which is bundled with other limit orders, routed to execute against better-priced protected quotes. The idea behind the exemption is that institutional traders should be able to forego the best-price requirement so as to sweep the centers in this way and fill large orders.

End-Running the IOC Condition

The NYSE under the pre-amendment rules treated all ISOs with an immediate-or-cancel time-in-force condition. That is: it would immediately execute an ISO on arrival to the extent possible. The portion it didn’t execute it would automatically cancel. It was this IOC condition that NYSE sought to modify in its rule change.

The exchange’s modification creates a “Day ISO,” which will now allow the remaining unexecuted portion of an ISO so designated to be posted to the NYSE’s book at its limit price.

The NYSE has told the SEC that it will “consider any protected quotes that existed at the time of the arrival of the Day ISO as cleared when it posts any remainder of a Day ISO to the Exchange’s book.”

The NYSE also decided to allow another sort of order, also claiming that this comes within the regulatory umbrella of the original NMS exemption for ISOs: the other new order type would be known as Day ISO Add Liquidity Only, or ALO.

Bloomberg’s objection to both the Day ISO itself and the ALO variant was that the ISO exemption created by the drafters of the NMS rule ought to remain narrow.

But the SEC has now (October 9th) approved the proposed rule changes, effectively embracing a broad notion of permissible intermarket sweeps.

Broader Point

The point justifying the above recourse to verse, though, is that the proliferation of order types involves a continuous jockeying for privilege among traders (not really among “investors”). The jockeying for privilege on the one hand has long since brought about a jockeying for the power to sell privilege on the part of the trading centers on the other. No decision the SEC could make on this matter will change that. It will only continue the game that NMS has become.

What candle is this game thought to be worth?

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