For better or worse, the credit for inventing the first “hide and light” order type should be given to NASDAQ for its Price to Comply order type. Originally conceived in mid-2006, the Price to Comply order type was intended to assist NASDAQ in integrating its three platforms into a single order book in a manner that respected the recently adopted Regulation NMS framework.
The influence of the Price to Comply order would find its way into every exchange in the US equities marketplace. It was an innovation that would permanently conjoin the high-frequency trading tradition with the nuances of Regulation NMS, and in particular with Rule 610(d), which banned locked markets.
As I have described in previous articles, Regulation NMS was, among other things, a regulatory framework that was intended to bind the highly fragmented US equities marketplace into a coherent national best bid and offer (NBBO). One of the problems it sought to address was the problem of locked and crossed markets, where the best price on one securities exchange was marketable against the best price on a competing venue. The concern was that a locked market was perceived as a manifestation of inefficiency, an aberration of a national market system that was intended to match parties willing to trade at the same price when their offsetting orders were represented at competing market venues.
However, in part the concern was also aimed at intentional distortions of the maker-taker model that made it economically sensible for parties to lock markets to attempt to execute for rebate, when such parties would otherwise incur a taker fee if they were routed to the venue displaying the best price. In the words of regulators: “Often, the locking market participant is not truly willing to trade at the displayed locking price, but instead chooses to lock rather than execute against the already-displayed quotation to receive a liquidity rebate.” Thus Rule 610(d) of Regulation NMS and the ban of locked markets were also directed at eliminating one of the primary activities of high-frequency traders engaged in rebate-subsidized scalping strategies. Clearly, Rule 610(d) was unsuccessful within this regard.
To grasp the significance of the Price to Comply order type, we first need to focus on its stated purpose: to re-price an order to comply with Reg NMS Rule 610(d). By this, the rule stipulates that NASDAQ was not to display a quote that was the best bid if that price was equal or greater to the best offer on an away exchange – say, NYSE ARCA (and comparable logic applies for the case of a displayed offer). The rule also emphasized the obligation of NASDAQ to proactively police its members and to “prohibit its members from engaging in a pattern or practice of displaying quotations that lock or cross any protected quotation in an NMS stock.”
Now even before we review the details of how Price to Comply in fact disallows the locked market condition above, it is sensible to question why a complex order type is required at all to comply with Regulation NMS. And the short answer is that Price to Comply is thoroughly unnecessary for complying with Rule 610(d) and the ban on locked markets. In actuality, Price to Comply is an optional tool that provides sophisticated market participants with a way to address the inconvenience of complying with Rule 610(d) in a variety of scenarios where such participants are incentivized to lock markets.
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Now clearly, the simplest way to address a locked market would be to reroute the order to the away exchange for execution. However, the problem with this simple solution is that it interferes with the primary interests of the exchange to encourage aggressive posting that results in captive volume on the venue. Furthermore, the solution of re-routing an order to an away exchange also interferes with the primary functions of smart-order-routers and high-frequency traders, both of which have no incentive to use such routable orders.
Consider an executing broker that has invested in smart order routing technology. The idea of paying an execution fee for using NASDAQ’ssmart order router to access an away exchange is unacceptable. The incentive for such a broker is to cancel and reroute the order through its own pipes, thus avoiding the redundant routing fee while fulfilling its best execution duty.
Likewise, consider a high-frequency trader that is posting aggressively into a locked market, aiming to collect a rebate in a liquidity-providing function (and let us forget for the moment that such activity is in fact prohibited by rule 610(d) as a pattern or practice of locking away quotations). For the HFT, the idea of having his aggressive orders re-routed unexpectedly, thus incurring both a routing fee and a taker fee when executed at the away market, is completely unacceptable. And this discussion doesn’t even address the opportunity cost the HFT bears when his routed order loses the opportunity to gain a favorable top-of-queue position and collect a rebate.
So it is not only in the interest of the exchange to retain volume by providing an alternative to routable orders, it also is in the interest of smart order routers and high-frequency traders. Both types of sophisticated market participants require NASDAQ to provide non-routable orders compliant with rule 610(d) to achieve sensible economics.
The simplest way to implement a non-routable order that complies with the ban on locked markets is to kick back the order to the customer as impermissible when an away market is locked. Another solution is to adjust a non-routable order that locks a market by ticking it a price back (to the back of the queue), which NASDAQ in fact supported with its Price to Display order. However, clearly both options are unattractive for an exchange incentivized to promote volume by retaining aggressive orders that are likely to result in executions. NASDAQ’s solution was Price to Comply, the innovative order type that achieved “compliance” with Rule 610(d) by cleverly exploiting a legal exception implicit in the Regulation NMS framework itself to allow orders to be accepted at the locking price.
Price to Comply leveraged an artifact of the Regulation NMS framework that distinguished between protected quotations and hidden orders in order to “comply” with Rule 610(d). Under this rule, one wasn’t allowed to lock a protected quotation by displaying a price that locked the market, but hidden orders were exempt from the ban. Under the regulation, hidden orders were not considered protected quotations and thus could freely be used to lock markets. In other words, Price to Comply offered the user the capability of locking a market with an exempt hidden order in the cases where his displayed order would violate the ban on locked markets.
When NASDAQ received a Price to Comply order, it would check if the order price locked an away market. If the order was in fact impermissible according to Rule 610(d) and the ban on locked markets, NASDAQ would book the Price to Comply order as a hidden order at the locking price. Price to Comply was the “have your cake and eat it too” order, conveniently booked as displayed or hidden – whichever was more preferable when considered in the context of a permissible display price according to Rule 610(d).
Price to Comply had another interesting property: It would be canceled back to the user if the away market at any point was displayed at a price that was through the hidden price, which would otherwise result in a trade-through violation prohibited by Rule 611 of Regulation NMS. As we shall see later in the series, such secondary features can have significant impact on execution quality, especially when order type interaction is taken into account.
Lastly, “book once” and re-bookable versions of the order type were available depending on order interface, a topic that will be examined in more detail in the next article.
Overall, Price to Comply appears at first glance to be a relatively unsophisticated order that is no different from a traditional limit order – except in the event where it locks an away market upon order receipt in the matching engine. In that critical scenario, the “book once” version of Price to Comply is booked as a hidden order, remaining in that state until it is either executed at the hidden price or canceled back to the user in the specific case where an away market crosses through its price.
However, inherent in the formulation of the Price to Comply order type is a deep resistance to the inconvenience of Rule 610(d). The ban on locked markets simply interfered with the economic incentives of sophisticated sell-side brokers, high-frequency traders, and NASDAQ itself to permit the booking of aggressive orders that locked markets. Thus Price to Comply – the first “hide and light” order – was introduced to employ the clever regulatory workaround of a hidden state to comply with Rule 610(d) and the ban on locked markets.
In fact, when NASDAQ announced in April 2007 that it would expand the usage of the Price to Comply feature set by mandating that all variants of non-routable order types not marked InterMarket Sweep Order (ISO) employ the hidden state when joining a locked market, NASDAQ further confirmed its intention to center its order matching engine on practices that were designed primarily to assist in effectively locking markets for all practical purposes.
Price to Comply set a critical precedent for the industry as a whole where the use of convoluted order handling logic, regulatory workarounds, and opaque feature sets provided a convenient mechanism to address the inconvenience of Regulation NMS in a “compliant” manner. Indeed, with hindsight as our guide, Price to Comply might more aptly have been named “Price to Circumvent.”
In my next article, I journey down the market structure rabbit hole to examine features NASDAQ embedded in the Price to Comply order type to enable “lighting” and how such features differ between FIX and OUCH protocols.