DECIMUS CAPITAL MARKETS, LLC
FOW
The Problem of HFT
December 10, 2013
Haim Bodek
Copyright © 2012-2013 Decimus Capital Markets, LLC
Highly Confidential - Do Not Redistribute Without Permission
Haim Bodek Consulting
SM
Decimus Capital Markets, LLC
March 2012
4/3/12: “SEC Probes Ties to High-Speed Traders Links to Exchanges
Scrutinized, New Types of Trades, Too”
Jean Eaglesham, Jenny Strasburg, and Scott Patterson, Wall Street Journal
“One order type, called "Hide Not Slide" and offered by the exchange
operator Direct Edge Holdings LLC, is among those being scrutinized by
the SEC, according to people familiar with the matter. The agency is also
looking at a similar order type offered by computerized stock
exchange BATS Global Markets Inc., the people said.”
“The SEC is examining whether such order types unfairly allow highspeed traders to jump ahead of other investors in an exchange's "order
book," or the queue of buy and sell orders that are typically ranked by
price and when they were received, according to people familiar with the
matter.”
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Decimus Capital Markets, LLC
September 2012
9/19/12: “For Superfast Stock Traders, a Way to Jump Ahead in Line”
Scott Patterson and Jenny Strasburg, Wall Street Journal
“At issue is whether exchanges sometimes allow high-speed trading
firms to trade ahead of less-sophisticated investors, potentially
disadvantaging them and violating regulatory rules. The inclusion of
Nasdaq and NYSE in this high-profile probe, and the role Mr. Bodek
has played in it, haven't previously been reported”
“Among questions the regulators want to answer is whether
exchanges have at times misled them in seeking approval for certain
order types or mischaracterized to investors how the orders work,
those familiar with the probe say.”
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HFT Scalping Strategies
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The dominant form of HFT in equities markets
Lean on order book depth & capture a micro-spread
Requires price-time priority market structure
Low-latency electronic trading environment
Subsidized by maker-taker market model
– Sometimes referred to as rebate arbitrage
• Facilitated by HFT-oriented market structure
– Primary HFT activity on lit market venues
– NASDAQ, NYSE ARCA, BATS, DIRECT EDGE
• Algorithmic tradition evolved from future markets
– The “0+ Scalping Strategy” is an early example
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HFT Scalping Strategies - Features
• High Frequency Turnover – passive scalping of a
micro-spread
• Queue Position – a dependence on order rank
and order book depth
• Low Latency – precise and timely reaction to
market microstructure events
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HFT Scalping Strategies - Features
• Exchange Microstructure – usage of special
order types and order matching engine features
• Rebate Capture – subsidized costs through
“post only” orders and tiered rebates
• Low Risk Tolerance – avoidance of risk and
usage of market book depth to reduce risk
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Regulation NMS
• Formulated in 2005, established in 2007.
• “…a series of initiatives designed to modernize
and strengthen the national market system for
equity securities.“
• The adoption of REG NMS coincides with a
period of intense HFT volume growth
http://www.sec.gov/rules/final/34-51808.pdf
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Rule 610 – Market Access Rule
• Rule 610 – Banned locked markets
A trading center must “prohibit its members from
engaging in a pattern or practice of displaying
quotations that lock or cross any protected
quotation in an NMS stock”
• Critical constraint impacting HFT strategies
• Order handling – actively adjusts order to comply
with the ban on locked markets often interfering with
aggressive limit orders which improve the NBBO
http://www.sec.gov/rules/final/34-51808.pdf
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What is REG NMS Price Sliding?
Price sliding occurs automatically on a REG NMS
compliant exchange when an incoming order
would lock or cross a protected quotation at an
away exchange.
NASDAQ: “Price sliding allows orders submitted at
impermissible prices to be booked in a sensible
and convenient way. The particular behavior varies
by order type and port configuration.”
http://www.nasdaqtrader.com/content/productsservices/trading/PriceSliding_factsheet.pdf
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What is the Impact of Price Sliding?
• Price sliding is a key element in exchange order
handling that in part:
– Governs when a new national best bid and offer
(NBBO) can be accepted and displayed on
regulatory price feeds
– Determines which orders are placed in favorable or
unfavorable queue positions
– Determines when and what price orders are
booked, thus defining eligibility for maker rebates
and taker fees
• Effectively picks winner and losers in the context of
HFT scalping strategies
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The Dark Side of REG NMS Price-Sliding
• Order can be disadvantaged by being kicked to the
back of the queue
• Orders can be promoted to the front of the queue
• Maker/taker fee allocation can be attributed in an
opaque and unusual manner
• Creates unexpected collisions between sophisticated
participants and unsophisticated participants that
otherwise would not have occurred
• The impact of price-sliding on order type precedence
is not properly disclosed by exchanges
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Order Matching Engine Practices
• The complex sequence of microstructure events
tied to price moves dictate HFT profitability
• Exchange order handling is now a primary factor
impacting execution performance and slippage
• Exchanges order handling decisions effectively pick
winner and losers
– Significant differences between order handling
treatment of HFT-oriented order types and “vanilla”
professional order types commonly used by
institutional investors
• HFT-oriented special order types avoid and in fact
benefit from disadvantages that frequently impact
traditional order types
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Exchange “Innovation”
"We created all these different order types to
accommodate how they wanted to trade,” recalls one
former Archipelago employee. “We tweaked how the
order would interact with our book according to what
they wanted. A lot of the unique orders were created
at the request of a customer, typically a high
frequency customer. You had to be a sophisticated
customer to learn how to use it. They'd send it in and
we'd respond. It was a happy little circle."
- Dark Pools, Scott Patterson, page 237.
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Special Order Types
• The VIP door to each exchange – but only if you know how
to unlock it!
• The undocumented features of special order types :
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Enable HFTs to leap ahead of customer orders
Permit HFTs to dump toxic trades upon customer orders
Force customer orders eligible for rebates to pay fees to HFTs
Provide HFTs information on the buy and sell intent of
customer orders
Assist HFTs in gaining speed advantages over customers
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Orders that “Hide & Light”
• BATS: “eliminates the need for traders to retry orders
multiple times in rapid succession trying to be high in
priority at the next NBBO price.”
• Orders that lock the NBBO are hidden instead of
rejected or price-slid
• Important:
– Hidden orders exempt from prohibition against
locking protected quotes
• When the NBBO unlocks, the special order type is
displayed (i.e. lit) and becomes the best price
http://batstrading.com/resources/features/bats_exchange_pricesliding.pdf
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Flavors of “Hide & Light”
• BATS: BATS Only Post Only (BOPO)
• Direct Edge: ALO + Hide Not Slide
• NYSE ARCA: Post No Preference ALO Blind (PNP
ALO B)
• NASDAQ: Post Only + “Automatic Re-Entry”
These are the “vanilla” professional order types that HFTs
utilize in place of non-routable day limit orders.
Non-routable day limit orders are typically used by smart
order routers servicing retail brokers.
http://batstrading.com/resources/features/bats_exchange_pricesliding.pdf
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Queue Jumping: “Hide & Light” vs. Non-Routable
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Assume the market for XYZ is 20.01 20.02, 1,000 up and an institution
sends a NON-ROUTABLE order to buy 10,000 for 20.02 that locks an
away market
Institution buys the 1,000 at 20.02 and wants to pay 20.02 for another
9,000 but is price-slid to 20.01 upon locking the away market
The trading firm sees the 1,000 trade at 20.02 and sees the new priceslid bid for 9,000 at 20.01.
The trading firm then steps ahead of the institution by posting a “Hide
& Light” hidden order, locking the market at 20.02 ahead of the
institutional order (complies with Rule 610).
Meanwhile a phantom order is displayed at 20.01, seemingly behind
the institutional order
Then as the offers have all cleared at 20.02, the “Hide & Light” is
rebooked as a displayed order at 20.02. The institution’s original order
is then rebooked displayed at 20.02, placed after the trading firm.
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Lighting Unfairly Advantages HFTs
• Limit prices of all orders came in at same price
• To comply with the ban on locked markets, these orders
were modified by price sliding treatment dictated by
order type
• These modified orders would be posted on the SIP in
price-time priority on the SIP (phantom order posted
also for “Hide & Light” orders)
• When the market unlocked, the modified orders were
canceled and then rebooked as displayed orders (i.e. lit)
• Exchange unfairly lit HFT-oriented orders ahead of
orders commonly used by institutions and smart order
routers
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Classes of Order Matching Engine Abuse
Queue Jumping – unfair order handling practices that permit
HFTs to step ahead of investor orders
Cannon Fodder – unfair rebooking and repositioning of investor
orders that permit HFTs to flip out of toxic trades
Fish Food – unfair conversion of investor orders eligible for maker
rebates into unfavorable executions incurring taker fees
Bait & Switch – unfair insertion of HFT intermediaries in between
legitimate customer to customer matching
Catch Me If You Can – unfair and discriminatory order handling of
investor orders during sudden price movements
Decimus Capital Markets, LLC
Classes of Order Matching Engine Abuse
Queue Jumping – unfair order handling practices that permit
HFTs to step ahead of investor orders
Cannon Fodder – unfair rebooking and repositioning of investor
orders that permit HFTs to flip out of toxic trades
Fish Food – unfair conversion of investor orders eligible for maker
rebates into unfavorable executions incurring taker fees
Bait & Switch – unfair insertion of HFT intermediaries in between
legitimate customer to customer matching
Catch Me If You Can – unfair and discriminatory order handling of
investor orders during sudden price movements
Decimus Capital Markets, LLC
November 2012
11/19/12: “Exchanges Get Closer Inspection”
Scott Patterson and Jean Eaglesham, Wall Street Journal
“ The SEC has expanded its scrutiny of order types from its
enforcement division to its Office of Compliance Inspections and
Examinations, or OCIE, which oversees how exchanges, brokers and
other securities firms comply with regulations.”
“OCIE's involvement indicates that regulators are looking beyond
specific order-type concerns into long-standing procedures at
exchanges involving how they craft order types, who they give
information about order types to, and whether their public
disclosures adequately explain how order types work.”
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Decimus Capital Markets, LLC
November 2012
11/19/12: “Exchanges Get Closer Inspection”
Scott Patterson and Jean Eaglesham, Wall Street Journal
“The order-type probe was a "come to Jesus moment" for
regulators about how exchanges appear to have systematically
developed trading advantages for certain sophisticated clients,
often with insufficient regulatory oversight or understanding of
products, the person said.”
“Enforcement officials are looking at why exchanges offer certain
order types and whether they were adopted at the request of
certain clients, according to people familiar with the probe.”
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Decimus Capital Markets, LLC
February 2013
2/22/13: “SEC Examining How Exchanges Develop Order Types”
Traders Magazine, Tom Steinert-Threlkeld
“Each of the exchanges has been sent documents seeking details
on how they develop ideas for new order types…The examiners
will be looking at how methods of governing order creation and
approval at each exchange are similar and how they differ. …
Among the most concerning are hidden orders, which do not, in
some cases, get activated until the price of a given stock slides or
some other action takes place.”
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Decimus Capital Markets, LLC
Market Structure Matters
haim@haimbodek.com
Twitter: @haimbodek
www.haimbodek.com
Copyright © 2012-2013 Decimus Capital Markets, LLC
Highly Confidential - Do Not Redistribute Without Permission
Haim Bodek Consulting
SM
Decimus Capital Markets, LLC
Haim Bodek
Managing Principal
203-286-4470
haim@haimbodek.com
Decimus Capital Markets, LLC | 11 Sea Beach Drive | Stamford, CT 06902 | 203.286.4470 | www.haimbodek.com
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Copyright © 2012-2013 Decimus Capital Markets, LLC
Highly Confidential - Do Not Redistribute Without Permission
Haim Bodek Consulting
SM