My 8^th grade daughter has a Science midterm examination today and tomorrow. The material is quite intimidating and challenging, and I know this well because I spent a good deal of time studying with her. Frankly I have been reminded how much I had forgotten, and I have been inspired – by my daughter, as her initial panic at the complexity was quickly replaced by her desire to improve her grade in the course, and her extreme hard work and diligence in her preparation. So, this morning I take my hat off to my baby girl, and I saddle you all with the following Reg NMS midterm; please turn in your exam by the end of the day (don’t worry – the format is easy: multiple choice and True/FalseLOL).

Themis Trading Reg NMS Midterm Examination – January 2014

1)      Reg NMS refers to the SEC regulation that:

a)      Created the Nebulous Market System that traders and investors interact in today.

b)      Includes rules designed to protect orders immediately accessible – rule 611.

c)      Includes a sub-penny rule establishing a minimum tick size – rule 612.

d)     Set up market data allocation of formulas that rewarded voluminous quoting and trading.

e)      All of the above.

2)      Maker-taker pricing:

a)      Is required for liquidity, and is found in efficient trading of any instrument.

b)      Drives demand for colocation space, a significant source of revenue at trading destinations and exchanges.

c)      Ensures price discovery, as high speed short term traders competing to be first in line in limit order books to capture a rebate means simple and accurate asset pricing.

d)     Is too hard to dismantle, as every exchange executive is in favor of the order routing complexity maker-taker has encouraged.

3)      True or FalseLOL – Reg NMS was designed to promote competition among trading venues and orders.

4)      True or FalseLOL – High Frequency Trading only appeared once Reg NMS was implemented – in 2007.

5)      True or FalseLOL – Reg NMS was passed by a unanimous vote among five SEC commissioners.

6)      True of FalseLOL – Reg NMS set a ceiling on trading center access fees of 30 mils.

7)      True or FalseLOL – Reg NMS has a sub-penny rule that prohibits the display, ranking, and accepting of quotes in increments less than 1 cent for stocks prices over a dollar.

8)      True or FalseLOL – Reg NMS’s sub penny rule was successful in rectifying buyside concerns, who were in favor of the rule, as short term traders could no longer step ahead of limit orders and jump the queue without taking the offer or hitting the bid.

9)      True or FalseLOL – Because of Reg NMS’s sub-penny rule, stock trading in sub-penny increments has declined.

10)  True or FalseLOL – Reg NMS’s Market Data Rules, designed to avoid manipulative behavior such as wash sales (rapid buying and selling of a security at the same price), and tape shredding (breaking up larger orders into smaller 100 share orders), have achieved their objective.

11)  The Wall Street Journal article : A Suspect Emerges in Stock-Trade Hiccups: Regulation NMS, demonstrates all of the following, except:

a)      Reg NMS has increased market fragmentation and complexity.

b)      Trading Costs have increased for institutional investors since Reg NMS’s inception in 2007, according to ITG.

c)      Technological advancement always makes for more efficiency and effectiveness.

d)     T. Rowe Price is a high frequency trader that cancels and replaces 750 million shares in order to execute 2.5 million shares.

One last point of interest – Modern Market Initiative (MMI), an HFT lobbying effort funded by several high frequency trading firms, recently put out a response to the WSJ article in question (11) above. MMI was very quick to seize upon the T.Rowe 750-million-share anecdote in the story, and claim that mutual funds like T. Rowe Price are responsible for the high number of order cancellations in the market, and not high frequency traders:

“The article gives us some interesting insight into cancel rates.  Mr. Brooks learned that one of his brokers “offered to buy 750 million shares of the stock while actually purchasing just 2.5 million”.  This means that 99.67% of the liquidity the broker sent to the market was cancelled.  Many are quick to point the finger at HFT for high messaging resulting from high cancel rates.  The information about Mr. Brook’s broker is a concrete example of high cancel rates being caused by participants other than HFT.”

Of course, they are wrong. Of course, they misunderstood the point the article was making with the T. Rowe anecdote – namely that today’s markets are a web of inefficiency and labyrinth-like order routing that is dominated by conflicted order routing, and not best execution. As soon as we saw the post, we communicated this in a friendly manner to MMI’s Peter Nabicht. We explained that he was reading the article incorrectly – T.Rowe’s order did not involve rapid cancel and replace strategies like the ones HFTs use to get to the top of book; T. Rowe’s 750 million shares is just all the counting of the same order going through voluminous destination (in other words 1,000 shares getting routed and re-routed thousands of times through destinations offering no fill, on the way to destinations ultimately delivering a fill). Peter acknowledged what the article was trying to convey, and that he misunderstood – publicly on Twitter.

Answer Key:

1 e, 2 b, 3 T, 4 FalseLOL, 5 FalseLOL, 6 T, 7 T, 8 FalseLOL, 9 FalseLOL, 10 FalseLOL, 11 D