Tuesday, July 21, 2009

Is The SLP The NYSE's Answer To Direct Edge's "Advance Look" Enhanced Liquidity Provider Program?

There is a curious article in the latest edition of Traders Magazine. It is curious mostly because it was allowed to be published, as it definitively peels off the cover of what truly happens at the pantheon of stock exchanges, that dominated by a private club of select high frequency traders, who obtain better and faster pricing than everyone else, and where the group of "select few" is seemingly legally allowed and even encouraged to front-run the "every-one else" (you, dear reader, are most likely in the latter camp). If you ever wondered why HFT generates profits of over $20 billion a year, please read this article.

As for Zero Hedge's intents, we would yet again request feedback from the proper authorities on whether one can derive more than superficial similarities between the method of operation of Direct Edge's Enhanced Liquidity Provider (ELP) program and NYSE's Supplemental Liquidity Provider program (aka, the Goldman kiss). Amusingly, it is none other than the NYSE's own Larry Leibowitz who raised the most ruckus about the potential abuse of the ELP program.

At an industry conference on market structure in May, a panel on market centers broached the subject of "flash" orders and almost ended in fisticuffs. In one corner was defending champion William O'Brien, CEO of Direct Edge. In the other was Larry Leibowitz, his hot-under-the-collar opponent from the Big Board...The head of U.S. execution and global technology at NYSE Euronext assailed Direct Edge's Enhanced Liquidity Provider or ELP program as the "enhanced look" program, comparing it to the advance look at orders that NYSE specialists used to get. That practice was seen as giving specialists unfair advantages over other market participants, and potentially disadvantaging order senders.

Wait, Flash orders, enhanced looks... What?

From the article:

Flash orders are also called "step up" or "pre-routing display" orders. The rationale for these order types is simple: Better me than you. They allow a venue to execute marketable orders in-house when that market is not at the national best bid or offer, instead of routing those orders to rival markets. They do this by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses. [TD: frontrunning is not quite the right word here, but it fits so damn well] If there are no responses, the order can be canceled or routed to the market with the best price.

All four markets with flash orders treat these orders in a similar way. If they get a marketable buy order, for instance, that would otherwise be routed to a market quoting at the NBBO, they flash the order to some or all of their participants as a bid at the same price as the national best offer. Exactly who sees the flash, how that information is conveyed and the duration of the flash vary by market. The maximum allowable time for a flash is 500 milliseconds, or half a second, although most of the markets flash routable orders for under 30 milliseconds.

NYSE Euronext's anti-flash tirade didn't end with the SIFMA conference. The exchange operator, along with market-making firm GETCO and SIFMA, weighed in on the Nasdaq and BATS flash order types with formal letters to the Securities and Exchange Commission. NYSE and SIFMA urged the SEC to abrogate the Nasdaq rule filing and reject BATS's filing. All three pushed the SEC to study the potential impact of flash orders on the marketplace before deciding whether to give them free rein.

NYSE and GETCO charged that markets with flash orders were essentially running private markets of quotes for select participants that competed with the public quote stream. With Nasdaq and BATS rolling out new order types to combat Direct Edge, the upshot, in their view, was bad market structure and probably eventual harm to investors.

[read the following paragraph very closely as it is at the heart of the 4 month long tirade on Zero Hedge against the NYSE, against Program Trading, against the SLP and against Goldman Sachs]

These firms and SIFMA argued that flash order types call into question some of the basic tenets of the equities market structure. In various combinations, they claimed that the effort to keep flow in-house undermines the concept of a quotation, impairs the meaningfulness of the NBBO, jeopardizes liquidity provision by hurting liquidity providers quoting at the NBBO, and potentially upsets the pursuit of best execution.

So the NYSE is making a mega fuss about a potential market entrant that does what everyone else does - understandable, nobody like competition, especially not the New York Stock Exchange which has been losing market presence and top line revenue by the boatload recently. Yet the question stands just how much of this "best kept secret" protocol does the NYSE employ currently to facilitate Supplementary Liquidity Providers, or rather, Provider (singular) - Goldman Sachs. When one firm dominates 50% of principal HFT trading on an exchange and, according to the above logic, can legally front run the other half, what does that mean for the rest of the world?

Continuing with the article:

NYSE Euronext, despite frowning on flash orders, may wind up joining the party. Joe Mecane, executive vice president for U.S. markets at the company, notes that if the SEC allows these flash order types to stand, NYSE Arca would probably convert an existing order type into a flash-type interaction, and would look to more broadly disseminate that information. [TD: Or already is via the SLP?] "If the SEC is implicitly allowing private access to information, we'll need to do it to be competitive," he said. NYSE Euronext may decide to offer flash orders on the NYSE as well, Mecane said. Nasdaq, for its part, is implementing a flash-type order this month on Nasdaq OMX BX, its Boston equities market.

Wait, the NYSE is waiting for the deliberations of the same SEC after it did not even care to hear back on whether or not the NYSE's SLP deserves a comment period, objections, and traditional response time, and which waited until the last day to file an extension automatically assuming it would be granted...(And granted of course it was, as the only beneficiary again was Goldman Sachs.)

The primary argument against flash orders is that they create private markets and are therefore a step back for market structure. "These programs are creating a private locked market for a small group of participants, and they are holding up the execution process for that marketable order," Mecane said. He added that the Big Board operator isn't against dark pools, competition or innovative business models. "Our issue is that this creates a tiered market," he said.

Market maker GETCO told the SEC that by creating a two-tiered market, flash orders give professionals receiving the flashes a leg up over other investors. Non-public quotes could also "negatively affect the broader market, including retail investors who rely on the NBBO to ensure that their orders obtain the best, reasonably available price," the firm said. GETCO argued that flash orders, like dark liquidity that executes at the NBBO, also leave limit orders that established the best price in the lurch.

One wonders what the response of the SEC will be to this allegation. One wonders less, once it becomes painfully clear that any condemnation of two-tiering and flash orders would potentially automatically preclude Goldman from trading 1 billion PT shares a week for its prop trading accounts.

Ironically, NASDAQ and BATS already may be in enough hot water to really raise the temperature on not only Direct Egde but the NYSE as well:

Direct Edge's O'Brien draws a distinction between how the information his market disseminates is seen and what Nasdaq and BATS are doing. His flashes, he said, are sent out on a different data feed than the ECN's depth-of-book feed, while Nasdaq's and BATS's flash orders are not. As a result, the latter exchanges' feeds look like they're locking the market. (Last month, both exchanges added a flag to flashed orders to identify them for subscribers.)

In Selway's view, this argument clouds the point. The point, he said, is that order messages are being broadcast at prices that, effectively, lock protected quotes. This creates an elite tier of traders with access to better-priced orders than those receiving public quotes through the securities information processors, giving flash recipients an information advantage, he said.

Ok, so where are the plethora of voices claiming that advanced exchange looks are completely innocuous and nobody suffers as a result of a select few profiting massively... We are waiting.

Direct Edge's O'Brien argues that critics of his market's ELP program are twisting a successful innovation into a regulatory concern for purely competitive reasons. He said the ELP program gives participants a choice about how they want their order flow handled, and enables customers to lower their market-impact and transaction costs. He also notes that critics of the ELP program, which includes dark pools among its participants, are anti-internalization. Internalization refers to the ability of brokers to match customer orders away from public markets. But the ECN's flash orders, on the contrary, O'Brien said, have "democratized access to dark liquidity sources by enabling retail customers to choose to interact with that liquidity to seek larger-size executions and potentially better prices."

Would one be shocked that the NYSE would be so vocally against Direct Edge when it has the SLP in its back pocket effectively dominating what could be the biggest flash trading market in history? Many more questions remain unanswered, but we hope readers now have a much better sense of the continuing fight against the ever more evident extensive informational advantage that Goldman Sachs may probably have thanks to its monopoly of the SLP program.

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