Securities Markets and HFT
Week 2
Dermot Murphy
1
Introduction
We continue Week 2 with a second lecture session
Specifically, we will be covering the following topics:
Limit Order Markets (STPP 4)
 Multiple/Fragmented Markets (STPP 5)

We will also work through a few examples today
Dermot Murphy
2
Limit Order Markets
The electronic limit order market is the dominant
trading mechanism for:
Equities
 Exchange-traded futures contracts (ETFs)
 Options

Dealer markets dominate:
Foreign exchange
 Bonds
 Swaps

Today, we focus on limit order markets
Dermot Murphy
3
Limit Order Markets – The Basics
An order has three components:
Direction (Buy or Sell)
 Quantity
 Price

“Buy 100 MSFT, limit 27”

That is, buy 100 shares of Microsoft for no more than
$27.00 per share
“Sell 200 MSFT, limit 28”

Sell 200 shares of Microsoft for no less than $28.00 per
share
Dermot Murphy
4
Limit Order Markets – The Basics
If an order cannot be matched (“executed”) on arrival,
it is added to the limit order book (LOB)

And the limit order book is the collection of unexecuted
(“resting”) orders
Arriving orders are compared to the limit order book

If there is a compatible counterparty order already on the
book, then there is a match (i.e. a trade, an execution)
Dermot Murphy
5
Limit Order Markets – The Basics
The quantity of the trade is the smaller of the
quantities in the two orders

If “Buy 500 MSFT, limit 27” matches with an existing resting
order of “Sell 300 MSFT, limit 27”, then the buyer receives
300 shares for $27.00
The match price is the limit price of the resting order

If “Buy 500 MSFT, limit 27” matches with an existing resting
order of “Sell 500 MSFT, limit 26”, then the buyer receives
500 shares for $26.00
Dermot Murphy
6
Limit Order Book
Sample limit order book for the S&P 500 ETF (symbol:
SPY) on BATS
http://www.batstrading.com/book/SPY
Dermot Murphy
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Example 1
Suppose there is one bid in the book:

“Buy 200 ABC, limit 20”
What happens if I place the following order and what
does the limit order book look like after placing that
order?
a)
b)
c)
d)
“Sell 200 ABC, limit 19”
“Sell 50 ABC, limit 21”
“Sell 50 ABC, limit 20”
“Sell 500 ABC, limit 18”
Dermot Murphy
8
Limit Order Book – Priority
Suppose that the buy side of the book consists of five
100-share bids for MSFT with limit prices of $10
Suppose that I place the following order: “Sell 100
MSFT, limit 10”. Who gets filled?
In most markets, priorities are:

Price: more aggressive prices (higher bids, lower asks) get
higher priority
Visibility: displayed orders have priority over hidden orders
 Time: orders entered earlier have priority

That is, most markets have price-visibility-time priority
Dermot Murphy
9
Example 2
Suppose that we have the following LOB:
Price
Quantity Submitted
Trader
50.12
1,000
9:30
Cathy
50.11
500
9:32
Bill
H 50.10
200
9:30
Gina
SELL
50.10
400
9:31
Amy
BUY
50.05
1,000
9:30
David
50.04
500
9:32
Ellen
50.03
400
9:31
Fred
Dermot Murphy
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Example 2
What happens if Harry submits the following order?
(consider each case individually)
a)
“Buy 200, limit 50.10”
b)
“Sell 1200, limit 50.04”
c)
“Sell 1200, limit 50.05”
d)
“Buy 500, limit 50.11”
(note: “H” on the LOB stands for hidden order)
Dermot Murphy
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Order Modifiers/Qualifications
Immediate or Cancel (IOC)
Do it now or not at all
 Partial fill is okay, but cancel the remainder

All or None (AON)
Do not give me a partial fill
 Order held unexecuted until it can be filled in its entirety

Fill or Kill (FOK)
IOC + AON
 Execute the entire order right now. Otherwise, cancel

IOC is very common; AON less common
Dermot Murphy
12
Example 3
Suppose that we have the following LOB:
Price
Quantity Submitted
Trader
50.12
1,000
9:30
Cathy
50.11
500
9:32
Bill
H 50.10
200
9:30
Gina
50.10
400
9:31
Amy
SELL
H 50.09
100
9:29
Martin
BUY
50.05
1,000
9:30
David
Dermot Murphy
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Example 3
What happens if Harry submits the following order?
(consider each case individually)
a)
“Buy 500, limit 50.09”
b)
“Buy 500, limit 50.09 IOC”
c)
“Buy 500, limit 50.09 AON”
d)
“Buy 2000, limit 50.10 IOC”
e)
“Buy 2000, limit 50.10 FOK”
Dermot Murphy
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Limit Order Book – Access
Most exchanges make their LOBs available in real time
for a fee
BATS provides real time LOBs for no charge
Access batstrading.com during trading hours
 Try viewing SPY to see an extremely active LOB
 PRK is a good example of a less active LOB

Dermot Murphy
15
Multiple/Fragmented Markets
In the second half of today, we will discuss
fragmented markets (STPP 5)
In a fragmented market, trading occurs in multiple
places or systems

US equity markets, for example, have multiple trading
systems and limit order books
In contrast, in a consolidated market, all trading
occurs in one place
One trading floor at one exchange
 One computer system

Dermot Murphy
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Trading and Listing of US Equities
The “home” for trading a stock is the issue’s primary
listing exchange

The exchange provides trading facilities/procedures for the
stock
The listing exchange, however, does not have
monopoly trading rights
Trading occurs in many venues, through many
mechanisms
Dermot Murphy
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Volume Statistics, 9/3/2015
Listing Exchange
NYSE
Executing exchange Volume (shares) Percent
New York
888,211,019 25.5%
Chicago
32,179,766
0.9%
NYSE Arca
268,314,314
7.7%
Nasdaq
483,244,025 13.9%
Finra/Nasdaq TRF
1,028,036,386 29.5%
PSX
34,570,784
1.0%
NYSE MKT
Boston
64,346,462
1.8%
BATS
220,062,627
6.3%
BATS Y
141,654,672
4.1%
EdgeA
83,144,604
2.4%
EdgeX
244,826,872
7.0%
Composite (total)
3,488,591,531 100.0%
Dermot Murphy
Nasdaq
Volume (shares) Percent
4,734,313
0.3%
190,499,278 10.7%
462,893,665 26.0%
618,930,619 34.7%
22,131,465
1.2%
4,054,051
0.2%
36,566,140
2.1%
123,326,549
6.9%
74,398,173
4.2%
43,220,696
2.4%
202,827,823 11.4%
1,783,582,772 100.0%
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Partial Key
Finra/Nasdaq TRF (trade reporting facility)
Reporting channel for “dark” trades
 A mechanism for the reporting of off-exchange transactions

PSX (Nasdaq-owned former Philadelphia Stock
Exchange)
BATS (“Best Alternative Trading System”)
EdgeA and EdgeX: operated by Direct Edge, which was
recently bought out by BATS
Dermot Murphy
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LOBs on BATS
As mentioned earlier, we can view the live book for
securities such as SPY (during regular trading hours) at
batstrading.com

The “main” BATS exchange is BZX
We can actually toggle between the LOBs for BZX,
BYX, EDGX, and EDGA
How are these different? Why would we send an
order to one or another?

Minor differences in rules and fees, which we will discuss
later in the course
Dermot Murphy
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SPY LOBs: BZX and BYX
Dermot Murphy
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SPY LOBs: EDGX and EDGY
Dermot Murphy
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Fragmented Markets
In theory, a fragmented market is difficult to use

Buyers and sellers must search all markets for the best
terms of trade
To simplify the process, there are linking systems in
place to create virtual consolidation

Information from fragmented markets is linked to
approximate the appearance of a consolidated market
Some of these systems are mandated by regulation

SIP: Securities Information Processor
Others have arisen in competitive response to
perceived needs
Dermot Murphy
23
Market Information Systems
Market information systems transmit trade reports,
bid and ask quotes, etc. from the market centers to
the users

They are one-way: they do not allow users to transmit
orders to the market
The market information systems also consolidate
information
The most important piece: the highest bid across all
market systems and the lowest offer
Dermot Murphy
24
National Best Bid and Offer (NBBO)
All quoting market centers communicate their bids
and offers to a consolidation system
The highest bid is the National Best Bid (NBB); the
lowest offer is the National Best Offer (NBO)
NYSE-listed securities: Consolidated Quotation System (CQS)
 Nasdaq-listed securities: Unlisted Trading Privileges (UTP)
Quote Data Feed
 Bloomberg and Reuters purchase these feeds, redistribute
the data to customers

The NBBO are widely used as reference marks

Price retail orders and dark trades, assess trading costs
Dermot Murphy
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Determination of the NBB
Market centers generate quote updates through time
If we maintain a list of what each center is bidding,
then the NBB is the maximum price on the list at that
point of time
If we maintain a list of what each center is offering,
then the NBO is the minimum price on the list at that
point of time
Next, we will go through an example to understand
this in more detail
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Example 4
You are provided with a
consolidated data feed for a
single security on the right
First, determine the NBB for
each of the first five
minutes, along with the
exchange offering the NBB
Dermot Murphy
The quote data stream
Time Exchange Bid
Offer
9:31
A
10.01 10.04
9:32
B
10.03 10.07
9:33
C
10.00 10.04
9:34
A
10.02 10.03
9:35
A
10.01 10.07
9:36
B
10.00 10.04
9:37
C
10.01 10.09
9:38
B
10.01 10.06
9:39
B
10.01 10.05
9:40
C
10.04 10.08
9:41
B
10.03 10.07
9:42
A
10.04 10.05
9:43
C
10.01 10.03
9:44
A
10.05 10.07
9:45
C
10.06 10.10
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Example 4
Next, determine the NBO
for each of the first five
minutes, along with the
exchange offering the NBO
Finally, determine the NBBO
spread for each of the first
five minutes (defined as
NBO minus NBB)
Dermot Murphy
The quote data stream
Time Exchange Bid
Offer
9:31
A
10.01 10.04
9:32
B
10.03 10.07
9:33
C
10.00 10.04
9:34
A
10.02 10.03
9:35
A
10.01 10.07
9:36
B
10.00 10.04
9:37
C
10.01 10.09
9:38
B
10.01 10.06
9:39
B
10.01 10.05
9:40
C
10.04 10.08
9:41
B
10.03 10.07
9:42
A
10.04 10.05
9:43
C
10.01 10.03
9:44
A
10.05 10.07
9:45
C
10.06 10.10
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Locked and Crossed Markets
The market is said to be locked when the NBB equals
the NBO (𝑠𝑝𝑟𝑒𝑎𝑑 = 0)

In principle, a trade could occur
The market is said to be crossed when the NBB is
greater than the NBO (𝑠𝑝𝑟𝑒𝑎𝑑 < 0)

In principle, an arbitrage opportunity exists
Locked and crossed markets can only arise across
different exchanges, but never on a single exchange
Are there any instances of locked or crossed markets
in Example 4?
Dermot Murphy
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Example 5
Refer to the handout for this example
Determine the NBB, NBO, and Spread for each minute
Hints/reminders:
Finish each column before moving on to the next
 If the bid for A is not updated in a particular row, continue
filling in the most recent bid for A
 For each minute, the NBB is the max of the bids and the
NBO is the min of the offers in that minute

Dermot Murphy
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Latency in Market Info Systems
Most traders obtain data through consolidated feeds
Many market centers allow users (“subscribers”) to
obtain direct lines, which are faster
Next slide: two data paths, one for user J, one for user K
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Latency in Market Info Systems
User J
Direct subscriber line
Direct subscriber line
NYSE trade
execution (100 sh
SPY @ 70.11)
NASDAQ trade
execution (200 sh
SPY @ 71.12)
“The consolidated feed”
Consolidated
Trade System
Bloomberg
Dermot Murphy
User K
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Latency in Market Info Systems
The previous diagram shows the feed for the
Consolidated Trade System
As mentioned before, there is also the Consolidated
Quote System (CQS) that computes the “official”
NBBO

That also has a direct subscriber line
In the previous slide, who has an information
advantage? Does the other party even care about
being at a disadvantage?
Dermot Murphy
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Access Systems
To “access” a quote is to achieve an execution against
that quote
Access systems transmit orders and other messages
from users to the market centers

Where you must have verification and security to prevent
unauthorized trading
Most traders trade through a broker, although Direct
Market Access is certainly another option
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Access Systems
User J: “Buy 200 sh
SPY @ 80”
Brokered access
Broker
Direct access
Nasdaq
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Broker Access
With certain restrictions, a broker can decide where
to send an order based on market conditions,
relationships, legal obligations, and so on
For example, suppose I enter a market order to buy
100 shares of MSFT at E*TRADE (a broker)
They might send it to a market maker such as Citadel
 … which might execute the order internally, or send it to
Nasdaq, or send it to ???

This also slows down execution speed (if you care
about that sort of thing)
Dermot Murphy
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Direct Market Access (DMA)
Direct Market Access is advantageous in that you
connect to the market directly
Speeds up execution, especially since the order is not
rerouted elsewhere before execution
 You still have to pay for the technology, usually in the form
of a flat-rate trading commission or a per-share pricing
schedule
 Examples of direct access brokers: Interactive Brokers,
ThinkOrSwim, SpeedTrader

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Priority in a Fragmented Market
In a single LOB, orders are usually prioritized by price,
visibility, time
When there are orders on two different LOBs, any and
all of these priorities may be violated
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Trade-throughs
A trade-through is a violation of price priority
For example, suppose that:
Trader A bids $100
 Trader B bids $99
 Trader C sells to B at $99
• “C traded through A’s bid”
 The disadvantaged parties are A and C

Dermot Murphy
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Trade-throughs
Why do trade-throughs occur?
Ignorance: C may not be aware of A’s bid
C may desire a rapid execution
C may doubt the firmness of A’s bid
Violations of broker’s agency responsibility to the
client
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Regulation NMS (“Reg NMS”)
NMS: National Market System
Adopted in 2005 after much debate
Established the ground rules for interaction of
multiple US equity markets
Provisions:
Order protection against trade-throughs
 Access fees
 Subpenny rule
 Market data rules

Dermot Murphy
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Regulation NMS (“Reg NMS”)
Before a market center executes an order, it must
check to ensure it would not cause a trade-through
Which would involve checking the bids and offers at the top
of every other market’s visible LOBs
 Hidden orders and orders below the top of the LOB are not
protected against trade-throughs

If the execution would cause a trade-through, the
market center must either:
Return the order unexecuted, or
 Route the order to a market where it would be executed

The primary responsibility for avoiding trade-throughs
falls on the market centers
Dermot Murphy
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Example 6
Suppose we are given the following bid books for
Market A and Market B:
Bid
50.4
50.39
50.38
Market A
Trader Quantity
Amy
200
Alan
300
Ava
500
Time
1:30
1:32
1:31
Visible
No
Yes
Yes
Bid
50.38
50.38
50.37
Market B
Trader Quantity
Beth
100
Ben
200
Beverly
300
Time
1:25
1:26
1:24
Visible
Yes
Yes
Yes
Dermot Murphy
43
Example 6
According to Reg NMS, which orders are considered
“protected”?
Suppose that I told my broker to sell 100 shares with a
limit price of $50.37 to Market B. If my broker
followed my instructions and Market B executed this
order, would that be considered a trade-through?
Reg NMS prohibits trade-throughs for protected bids
and offers. What are some of the Market B’s
alternatives if my broker submitted to it the limit
order above?
Dermot Murphy
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Intermarket Sweep Orders
Suppose that I am an institution that needs to very
quickly buy a lot of shares
Difficult to do under the trade-through rule, as markets
have to constantly make sure portions of my order are not
“trading through” prices on other markets
 This can significantly slow things down for the institution,
which can be harmful if its information is short-lived

Solution: the Intermarket Sweep Order (ISO), which
allows me to execute portions of my trade in different
markets all at once
Dermot Murphy
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Intermarket Sweep Orders
As long as my ISO does not trade through protected
orders, I can send a very large portion to any market
Even if it trades through unprotected orders!
 The ISO provision was meant to alleviate concerns that
institutions would have difficulty trading quickly
• Any unintended consequences of this provision? Could
other trader types make use of this order type?

Dermot Murphy
46
Example 7
Suppose we are given the following bid books for
Market A and Market B:
Bid
102
100
Bid
103
102
101
Trader
Amy
Alan
Market A
Quantity
100
300
Time
2:00
2:01
Visible
Trader
Beth
Ben
Beverly
Market B
Quantity
100
100
300
Time
1:59
1:57
2:02
Visible
Dermot Murphy
Yes
Yes
Yes
Yes
Yes
47
Example 7
Suppose I am a seller and route 200 shares limit $100
to Market A and 100 shares limit $100 to Market B,
where both orders are marked ISO

Does this satisfy Reg NMS? Does this trade through any
protected orders? Does this trade through any unprotected
orders?
Suppose I am a seller and route 100 shares limit $100
to Market A and 50 shares limit $100 to Market B,
where both orders are marked ISO

Does this satisfy Reg NMS? Does this trade through any
protected orders? Does this trade through any unprotected
orders?
Dermot Murphy
48
Order Protection Rule – Canada
There is also a version of the order protection rule in
Canada that was introduced in 2011 by the Canadian
Securities Administrators (CSA)
The full LOB is protected from trade-throughs, as opposed
to the USA, where only the top of the LOB is protected from
trade-throughs
 Advantages? Disadvantages?

Dermot Murphy
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Next Week
We begin our first trading day
We will go through the basics of trading on the RIT Client

And the basics of using Excel to interact with the RIT Client
We will mainly practice trading using the “Trading as a
Principal” case (the LT1 case)
RIT help files have been posted to Blackboard, and I
recommend reviewing these files for next week
See you then!
Dermot Murphy
50