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Market Surveillance 2.0: Beyond the Crisis

28 August 2014

10 Words That Could Subvert the Tick Pilot

The tick pilot proposal submitted to the SEC by the exchanges and FINRA expands the scope of the trade-at requirement in what looks to be an obvious attempt on the part of the exchanges to promote their own interests.

The real story of this week’s tick pilot filing by FINRA and the exchanges are the 10 words at the top of page 16 that have been added to the SEC’s definition of “trade-at.” These 10 words significantly broaden the scope of the trade-at requirement in Test Group 3 beyond what the SEC asked of the exchanges and FINRA.

The 10 words are: “but only up to the amount of its displayed size.”

The SEC proposal defines trade-at this way:

“Generally, a trade-at requirement is intended to prevent price matching by a trading center not displaying the NBBO at the time it received an incoming marketable order.”

The proposal is silent about a trading center that is displaying the NBBO. Thus a trading center that is displaying the NBBO in any size has no trade-at requirement under the SEC’s definition. This grants permission to any trading center to execute its own undisplayed reserve quantity along with its displayed quantity – without having to route to other trading centers to take out their protected quotations.

[Related: “Tick Size Pilot Plan Finalized”]

In contrast, the proposal from the exchanges and FINRA “will (1) prevent a trading center that was not quoting from price-matching protected quotations” – same as the SEC – “and (2) permit a trading center that was quoting at a protected quotation to execute orders at that level, but only up to the amount of its displayed size.” The addition of this second point means a trading center will not be permitted to execute its own reserve quantity without first routing to take out the displayed quotations at all other displaying market centers.

This looks to be an obvious attempt on the part of the exchanges to promote their own interests. Using the SEC’s language, broker-sponsored dark pools can avoid the routing obligations of trade-at by posting displayed quotations of any size at the NBBO. Just 100 shares would do it. With the 10 words added by the exchanges and FINRA, they can’t.

If the pilot is implemented as now proposed, Test Group 3 would deliver new flows and additional revenues to the leading quoting venues. Broker-sponsored ATSs, on the other hand, would receive a heavy blow if they don’t change their model, with trading effectively limited to mid-point executions. It would severely handicap wholesale market-makers, a long-time exchange nemesis, diminishing their ability to provide retail clients with size improvement at the NBBO. By turning a significant portion of what is now a profitable principal trade into a costly agency route, it would saddle wholesale market-makers with expenses that would inevitably be passed through to the retail customer.

The implications extend beyond the market-share battle between exchanges and non-exchanges. To provide themselves with this gift, the exchanges have ratcheted up the scope and impact of Reg NMS to mind-boggling levels. Under this proposal, an NBBO quote is not protected until it is 1 second old, so fleeting quotes can be ignored. And block trades are exempt from the obligation. But beyond those and a handful of other exceptions, the proposal effectively extends the obligations of Reg NMS to the NBBO. A lot more trading happens at the NBBO than outside it. That’s why those 10 words have turned Test Group 3 into Reg NMS on steroids.

And that’s assuming the market structure landscape remains unaltered. Consider that broker-sponsored dark pools would be able to mitigate some of the effects of this proposal by displaying quotations at the NBBO. With a public quotation of, say, 200 shares, a broker could print an ATS trade at the NBBO up to 200 shares. Without the ability to post quotes, they would have to route and pay another venue’s access fees. With an incentive like that, expect broker-sponsored dark pools to start posting their own quotations in small quantities. As an added benefit, nobody could call them dark pools anymore.

That seems likely to happen under the SEC’s definition of trade-at. And what a feather in the regulator’s cap: increased transparency, and no more dark pools!

But with the exchange/FINRA proposal, those new quoting venues also become protected venues too. Imagine the level of complexity of Reg NMS compliance when there are 40 or 50 venues to be protected.

To be sure, some of this effect may be softened by the impact of nickel increments. More size may congregate at the NBBO, creating a high lower-bound where venues can print without routing, and not a lot of distance to the exemption for block size at the upper-bound. Even so, to ensure that you don’t violate trade-at, each quoting venue would have to monitor the quotes (and the ages of those quotes) and be ready to route to every other trading venue. All 50 of them.

The typical pattern in our industry is for participants who are unhappy with the status quo to lobby Capitol Hill and the regulatory bodies for change, and then later to blame the regulators for all the unintended consequences that inevitably come with change imposed by regulation. It is amazing how many anti-government free-marketers in our industry turn to government as their first choice solution to their problems. You can’t at the same time blame Reg NMS for today’s market structure problems – as Michael Lewis and others do – and lend support for this proposal, even if it is just a pilot.

Commenters, start your engines.

[Related: “Is Test Group 3 of the Tick Size Pilot Program Being Set Up To Fail?”]

Spotlight-white-trans For more stories in the Market Surveillance 2.0: Beyond the Crisis Spotlight Series click here.

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4 Comments to "10 Words That Could Subvert the Tick Pilot":
  • Comment_10x29_mackie_headshot

    29 August 2014

    There has been a great deal of noise about flaws in Test Group 3 so I'm interested to hear what you and other think should have been done with this portion of the pilot program instead. What was missed? What should have been added or deleted? Should there be more than 4 pilots (recognizing that the first group is the control group)? 

    I am not an expert in this area but it seems to me that focusing all of the attention on one, small aspect of a bigger program runs the risk of missing the forest for the trees. Thoughts?

  • Missing
    kevin foley

    02 September 2014

    Hi Chris, really enjoy your comments on this forum. My opinion? I was no fan of decimalization when it happened, but I'm not a fan of rolling it back all these years later. I'd be curious if someone had a different view, but I don't really see widening spreads translating into increased profits for brokers, and in turn more resources committed to research, mainly because I think those days are gone and Nasdaq has evolved into an order-driven, agency market. As I say, I'd like to be corrected if I'm wrong, but hasn't the institutional brokerage business gone mostly to an agency model? So even if there are greater trading profits if spreads are wider, I don't see how finds its way into the pockets of research providers. I also think a pilot program is a big burden on small to firms and a barrier to entry to new ones -- not necessarily a bad thing from my point of view, I guess. Having said that, in my view the SEC did a bang-up job crafting this program. They're going to gather data, the analysis will be available for all, and while policy opinions may still differ, at least people will be debating over a common set of facts. My observations concern is with the implementation, not the SEC's plan. What Finra and the exchanges have given the SEC is not what the SEC asked for. It's going to be interesting to see how it plays out.

  • Anon_avatar

    03 September 2014

    The author of this article apparently is unaware that SEC staff told the exchanges and FINRA that the Commission intended the trade-at restriction in Test Group 3 to permit a market center to execute only up to its displayed size then satisfying displayed liquidity at that price at other market centers before trading additional size at that price.


    The article states, "These 10 words significantly broaden the scope of the trade-at requirement in Test Group 3 beyond what the SEC asked of the exchanges and FINRA."   That sentence ignores the clear verbal instructions given to the exchanges and FINRA by SEC staff on this topic.  Taking into consideration the verbal instructions given by the SEC staff, the exchanges and FINRA did precisely what they were instructed to do by the SEC.  There was no broadening by the exchanges or FINRA.

  • Comment_foley

    03 September 2014

    So much for my conspiracy theory! Thank you, Anonymous -- if the SEC issued verbal instructions then I stand corrected. Perhaps their initial omission was just an oversight,

    If accurate, this means the the trade-at obligation will fall just as heavily on the exchanges themselves and not just on everybody else. Anyone who imagined that trade-at would just mean other market centers routing to exchanges should take note. As Anonymous explains, exchanges will have to route ISOs to each other -- and to any other displayed center displaying the NBBO -- before executing their own reserve quantities. Trade-at will probably mean more displayed centers and everybody routing to everybody.

    Which is why anyone who likes to hate Reg NMS is going to love to hate Test Group 3.

    Whereas if those ten words don't survive the comment period and the SEC chooses to drop them from the plan, the very same trade-at obligation would apply to systems that remain dark. Dark pools would have to route at the NBBO. But you would create an incentive driving more market centers to volunteer to display liquidity, and fewer -- if any -- that choose to remain dark pools. And no Reg NMS on steroids.

    I think that's worth highlighting during the comment period.

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