Yes, speed matters. However, the core HFT alpha can only be realized if you know what order type to send and when to send it. This process is completely dictated by how exchanges implemented REG NMS, Rule 610, order matching engine features, and very specific order types.
In theory, for a single price movement in the U.S. equities marketplace to occur, each exchange would have to show a gap of two or more ticks before a new price would be accepted on any exchange that established a more aggressive price level. With 13 exchanges, we know that HFTs are not waiting for a two-tick-wide national best bid and offer before placing their bets. Understanding this and mastering exceptions to Rule 610 became the name of the game, whether such features are adequately documented or, in many cases, not.
Prior to Rule 610, HFT scalping strategies could lock markets. Rule 610 changed the HFT game in such a significant manner that it can be thought of as a different phase of the HFT algorithmic trading tradition. The ban resulted in HFTs being forced to engage in “spam and cancel” strategies that repeatedly attempted to get to the top of the order queue on a price move. Such strategies would attempt to “step in the middle” to set a new aggressive price. This invariably locked away markets. Rule 610 demanded that such orders not be accepted at the entered price.
This activity caused immense load on exchanges, but in no way did exchanges want to discourage high-volume HFT order flow. To court HFTs, exchanges provided a number of specialized features to assist “spam and cancel” strategies, many of which are still operational today.
A common order matching engine feature that exchanges used to fulfill Rule 610 was to “price slide” the order. This practice modifies the price of an order that locked the market by, in the words of one exchange, ticking the order back in a “convenient” and “sensible” manner. When these orders were slid back, and did not have a high queue placement, the HFTs would first know that there was an order ahead in a better queue position, and second, cancel the order and retry.
While HFTs canceled their slid orders, traditional investor orders would typically just slide without being canceled. This causes the institutional orders to move to the back of the queue and away from the trading action. In this strategy, the HFTs would monopolize the top of the book, interacting with marketable orders, while the institutional-side orders would be at the bottom of the queue only to be executed when a large buyer or seller cleared the book.
To execute these spam-and-cancel strategies even more quickly, HFTs utilized specialized order confirmation information to detect being slid so they could quickly cancel the price-slid order. Exchanges also provided alternative cancel-back or “opt out” options that literally rejected orders that might have otherwise been placed in a disadvantaged queue position.
Many institutions have no idea that their orders are being slid away from the top of the book. In many instances, institutional clients and their brokers are not being adequately informed. In some instances institutions and brokers are not even receiving price-sliding information on exchange confirmations unless they specifically ask for it.
Many people believe that high cancel rates are an attempt to sniff out larger orders; however, many times it is these spam-and-cancel strategies jockeying for top-of-book status that just push institutional orders out of the way, only to trade when the market moves against them.
This is one early example of how seemingly straight-forward and appropriate order types are being leveraged not to take advantage of institutional flow, but to make institutional flow irrelevant to the point where the institutional order is disadvantaged.
This spam-and-cancel order-handling treatment is the precursor of special order types, which, for all practical purposes, exist to assist a specific type of sophisticated trader whose primary intent is to step ahead of all other customers.
In summary, Rule 610, which banned locked markets, dramatically changed microstructure to dictate when HFT scalping strategies were permitted to get to the top of queue. In practice, Rule 610 created an environment in which HFT scalping strategies needed to use a feedback loop of price-sliding information or plain rejects iteratively, sending and canceling large numbers of unexecuted transactions to get an order to “stick” at the best price at the top of an order book. Such strategies were lucrative but burdened exchanges with heavy transaction rates and canceled orders.
In the next article, we will explore how exchanges courted firms engaged in “spam and cancel” strategies by providing them specialized order types and order matching features that provided a more efficient and lucrative means of achieving superior queue position.
See: Locked Markets, Priority and Why HFTs Have an Advantage: Part 2: Hide & Light
For more on Haim Bodek's views on high-frequency trading, check out "For Superfast Stock Traders, a Way to Jump Ahead in Line," from the Wall Street Journal.