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The Securities and Exchange Commission may crack down on a controversial practice that has caught on at various U.S. stock market centers, including Nasdaq, Bats Exchange and Direct Edge, that gives some traders privileged access to key market information.
In a letter fired off Friday, Sen. Charles Schumer (D-N.Y.) asked that the SEC ban so-called flash order types, which route stock pricing information for a brief period of time away from the displayed market centers, where all investors can see current orders and prices, and shows it to a limited group of member traders who can then decide whether to fill an order before it is routed out to another market.
The issue has been one of increasing controversy on Wall Street. Flash quotes fly in the face of four-year old rules that were supposed to level the playing field for all investors and make pricing information more accessible. Yet until now the SEC has allowed the three market centers to proceed.
Regulation National Market System required that orders be filled at the best price at any given time regardless of where that price was located. So if Nasdaq did not display the best price for a given stock as the order came in but Bats did, Nasdaq would have to route the order to Bats.
The flash quote programs hold up that process by displaying orders to members for as much as 500 milliseconds–an eternity in electronic trading–before routing out. Some say that gives traders with access to the flash quotes an advantage in that they can fill an order for a lower cost than it may be once it gets routed back out to another market.
Given the explosion in market volumes in the last year, and the fractionalization of the markets caused by Regulation NMS, the major stock trading venues have an incentive to try to fill orders in-house without routing out to rival centers. Direct Edge, an electronic communications network backed by Goldman Sachs ( GS – news – people ), Citadel and Knight Trading, was the first to offer such an order type to its members and recently has used it to great success in siphoning market volume away from NYSE, Bats and Nasdaq.
From Wall Street and Technology:
At a well-attended low-latency trading event today at Credit Suisse’s Flatiron district office, hosted by 29West, Wall Street executives noted that their focus on lowering data latency in their trading environments has not softened, despite the economic climate, and shared some of their latest efforts to reduce latency further.
For Credit Suisse, and especially for its CrossFinder dark pool, “Latency is our differentiator,” says Alex Roitgarts, director at the firm and the person responsible for latency. “Latency is a barrier to trading strategies. As a result, the key differentiator is how fast you can process and how much volume you can process. Logically, you don’t have to be zero latency, you just have to be faster than the other guy. Since you don’t know what the other guy is doing, you need to tune your operation like a Swiss watch every single day.” Even customers who don’t express any direct interest in latency are concerned about the performance of their trading algorithms. “The algo itself is becoming latency sensitive,” he says.
While two to three years ago latency was measured in the tens of milliseconds, today Credit Suisse’s round-trip trade order latency is within 300-350 microseconds. “I wouldn’t be surprised if within a few years people start measuring latency in nanoseconds,” Roitgarts says.
To reduce latency, the Swiss firm is installing new, faster network routers that will cause only three microseconds latency, versus 20 microseconds for the current technology. It closely monitors its trading applications by putting time stamps within trade messages and watching performance against certain thresholds. The firm doesn’t try to measure latency on every trade, though. “We try to take a top down, practical approach,” Roitgarts says. “If you try to measure latency on every signal that happens, the process of measurement may slow you down.” Instead Credit Suisse looks at logical check points. As soon as a lag is detected, “we immediately try to figure out why it happened,” he says. If nothing seems amiss with the application, the routers and network appliances are investigated.
At the National Stock Exchange, CIO Saro Jahani tries to take a holistic approach to latency. “We have to make sure that not only our matching engines, FIX engines and network are fast enough, good enough, and stable and controlled enough, we also have to make sure we have policies in place that help our clients to do smart colocations,” he says. “I have assigned a team of people within my organization to to make the system as low stress and low latency as possible.” Many times, customers’ latency is actually caused by their firewalls and workload balancers, he says.
Sean Gilman, CTO of foreign exchange ECN Currenex, points out that what his organization offers is a “fungible asset” — clients can trade wherever they want to. “When they come to us, they expect to get the price and market data first and to be able to hit that price first and faster than their competitors.” For instance, Currenex had a hedge fund client performing arbitrage based on trading models that frequently complained it was losing money because it was putting in orders that weren’t getting filled. “We found that another customer was hitting that same price, each time. The models are the same between these different hedge funds, but one was faster by one millisecond or a few microseconds. It doesn’t matter what the granularity is, you’re fastest or you lose. It really is a race.”
To keep up, Currenex upgrades its core servers every 16 months and its network every two years. The exchange also separates simple orders from complex ones, which are handled on a separate matching engine, allowing the common orders fast throughput.
For latency monitoring, Currenex finds SNMP [Simple Network Management Protocol] useful for basic devices such as routers and switches and boxes. “But the real problems tend not to be there,” Gilman notes. “That’s not usually the type of thing that bites us.” Instead, the forex venue focuses on applicational latencies between different services, storing statistics and charting trends to detect possible causes of latency, such as a code change.
A year after becoming an equities exchange, BATS plans to grab a
chunk of the options market through aggressive pricing that appeals to
some of the same automated liquidity-providing firms that helped make
it the third-largest exchange operator in U.S. equities.
“Compared
to our competitors in this space, we’re lean, based on our direct
monthly expenses and capital outlay to get into options, so we’re
operating on a different scale than other exchanges,” said Joe
Ratterman, CEO of BATS Exchange. “Because of that, we can be
aggressively priced.”
BATS Options will have maker-taker
pricing in a price-time market model. The exchange hasn’t yet announced
its pricing, but will target all options classes, and not just those
quoted in penny increments, Ratterman said. He does not think the
exchange will offer different pricing for penny-quoted and
non-penny-quoted options, but noted that the final decision hasn’t yet
been made. In equities BATS has sometimes used inverted maker-taker
pricing to attract volume.
“If history is any guide, they’re
very aggressive with their pricing metrics, and will enter the options
space with a pricing structure that will undercut the competition and
will attract interest and competition from trading entities,” said Andy
Nybo, a principal at research firm TABB Group.
BATS’s
ambitions for options are aggressive. “We wouldn’t be going into this
market if there wasn’t a big opportunity for BATS to come in, make
improvements and gain market share,” Ratterman said. “U.S. equities was
one of the most competitive markets in the world and we managed to do
very well when we broke into that space. There’s nothing to keep us
from being successful in options.”
Ratterman expects BATS’s
eventual options market share to equal its share in equities. In June,
BATS accounted for 10.7 percent of equities volume. BATS, formerly an
ECN, opened for trading in January 2006 and became an exchange in
August 2008.
BATS intends to build its options market by
appealing to a range of investors, including institutions, retail
brokers and market-making firms. “We’ll attract as much diversity [of
flow] as possible,” Ratterman said. “We have a fair and open model in
the equities world and will have that in options.”
But the
exchange’s strong suit is its appeal to automated market makers. “The
performance metrics of our system have traditionally appealed to
automated market-making firms because of the low-risk characteristics
of their trading on our markets, and the consistency and performance of
our system,” Ratterman said. “It’s likely we’ll have as much influence
on the options side.”
TABB’s Nybo notes that BATS’s reputation
for having a strong technology platform and low-latency infrastructure
will boost its prospects in options. “They are looking to attract
quantitative trading firms using low-latency, high-frequency strategies
and those that arbitrage fleeting price discrepancies,” he said.
BATS
will file the rule set for its new market “shortly,” according to
Ratterman. He said the launch of BATS Options is targeted for January
or February of next year, subject to approval by the Securities and
Exchange Commission.
BATS Options will join a growing
marketplace populated by seven options exchanges. Last month, 296
million equity options contracts changed hands, up 5.6 percent over the
previous June’s volume. The industry traded a record 3.3 billion equity
options contracts in 2008, an increase of 26.7 percent over 2007’s
record volume. This year is on pace to exceed last year’s volume.
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