In light of the growing significance of special order types since 2007, their absence from industry dialogue before 2012 is noteworthy. In fact, in the hundreds of articles, interviews, conference talks, and academic papers that addressed the topic of HFT, there was virtually no mention of the role of special order types in modern HFT until the first quarter of 2012, when regulatory scrutiny of HFT-oriented special order types became public knowledge (“SEC Puts Exchanges on Notice Over Computer-Driven Trades,” Bloomberg News, April 4, 2012).
Over the period from 2007 to 2012, while an unprecedented flurry of new HFT-oriented special order types were either introduced into the marketplace or revised and updated with new features, scarcely a word was spoken about these developments in the unending HFT debate. There was, of course, no mention in industry dialogue of the importance to HFT strategies of exploiting unfair and discriminatory features embedded in special order types, features that gave HFTs preferential treatment over the public customers (and that were exploited by HFTs in combination with their speed advantage).
More specifically, these innovations resulted in a number of order matching engine practices that served to preference HFTs over the public investor:
Unfair order handling practices that permit HFTs to step ahead of investor orders in violation of price-time priority.
Unfair rebooking and repositioning of investor orders that permit HFTs to flip out of toxic trades.
Unfair conversion of investor orders eligible for maker rebates into unfavorable executions incurring taker fees.
Unfair insertion of HFT intermediaries in between legitimate customer-to-customer matching.
Unfair and discriminatory order handling of investor orders during sudden price movements.
These order matching engine practices either currently exist or have existed on nearly every major electronic exchange. The tendency for each electronic exchange to match feature for feature with rival exchanges resulted in similar functionality across market venues. Furthermore, although the specific practices noted above are well understood by HFTs and exchanges, being central to the “guaranteed economics” arrangement afforded HFTs, these order matching engine practices are, for the most part, undocumented.
The order matching engine abuses noted above represent primary alphas that assisted HFTs in growing their volumes to dominate more than half of US equity volume, features that have made traditional order types impossible to use without being subjected to order matching engine abuses.The total economic impact and the bulk of HFT edge-capture are tied to these features, in conjunction with the corresponding special order types that exploit the matching engine (order types that are noted in a later section).
For the most part, the rest of the market was focused on the wrong problem: speed. Most participants (including myself) who struggled to execute effectively on HFT-oriented exchanges assumed they were using the exchange correctly via the traditional vanilla professional order types. Most market participants just thought that they weren’t fast enough to compete against HFTs.
But HFTs Were Already Playing a New Game ...
Metaphorically speaking, if the market was a chess board, HFTs were using queens, rooks, knights, and bishops. In contrast, traditional investors weren’t even using pawns – they were using checkers pieces.
To take the chess metaphor further, most non-insider players didn’t realize that the checkers pieces they were using had no chance against any of the chess pieces, or perhaps didn’t realize that chess pieces existed at all.
For the most part, no one thought that the problem was that the game had changed and you couldn’t play checkers anymore. Many reputable and quite sophisticated firms that invested in the technological arms race were in essence simply trying to play checkers faster. But if you didn’t use the right pieces and play the right game, you were going to lose. You had to learn chess, and use the new pieces. There was no way around it. HFT was all about playing the right game with the right pieces -- and playing it very well against the public customer who was effectively playing the wrong game with the wrong pieces.
For five long years, the greater investment community was subjected to unnecessary transaction costs as they transferred “guaranteed economics” to HFT firms and exchanges through mechanisms unbeknownst to them. As long as HFT practices remained opaque, it was so much easier to believe HFTs were simply faster than it was to admit HFTs thrived through artificial means.
For more details on order types and how they have created an advantage for high-frequency trading firms, read Haim Bodek’s four-part series on TabbFORUM.