Fred and Ethel a few months back called us and asked us to explain the modern stock market to them. And we did so.

It has taken them many months to just understand it from the 25,000 foot level. Bless their hearts; they have been busy doing their homework. They are pretty sure they understand how it works at 25,000 feet. Now they are hard at work trying to wrap their hands around market microstructure, and all of this order-type business. They have been hearing an awful lot about order types, and have read about how complex these order types are in the Wall Street Journal. As an aside – they still don’t like to say the words Hide not Slide, as Fred ran out of Viagra, and his new health insurance won’t pay for a scrip refill.

This weekend they called us again to learn about ISOs.

F&E: What is an ISO order?

S&J: An ISO order (intermarket sweep order) is an order type designation that provides an exemption from Reg NMS, with regard to protecting the NBBO. Reg NMS provides that under normal circumstances, one cannot by stock at $10.01 unless one has already exhausted the displayed liquidity at $10.00. However, if one tags their buy order as an ISO when trying to buy the $10.01 stock, they are implying to the exchange they route the order to that they have already checked availability at $10.00, and the exchange the buy ISO was directed to can just fill the order at $10.01. The exchange, after filling the buy ISO buy order, can cancel back any unfilled portion, but they do not have to. The ISO order is understood to be a liquidity taking order, and incurs take fees.

F&E: What is a Post –Only ISO?

S&J: A Post-only ISO is an ISO that will only interact with liquidity if it can get a rebate. If sell orders exist at $10.00 and $10.01 on an exchange, and it receives a directed Post-only ISO to buy stock at $10.01, it will cancel back the order unfilled. If there are no such sell orders, the exchange will display the $10.01 buy Post-only ISO, with the understanding that if sell orders at $10.00 and $10.01 exist on other exchanges, the originator of the Post-only ISO order will assume Reg NMS responsibility for taking out those offers independently.

F&E: Can information about order flow be leaked via some HFT firms usage of Post-only ISOs?

S&J: Good question. Why? Because the sender of a Post-Only ISO gets their order rejected back to them if there exists contra-side liquidity. Even hidden liquidity. So they then know that there is sell interest at that price, even though they paid no economic toll to find out. They got a free look.

F&E: Wait can we back up? You said Post-only ISO? Why would someone want to pay $10.01 and post a bid, and not want to buy stock at $10.00? This makes no sense.

S&J: I know it is confusing. The users of the order do not care about owning the stock cheaply. They are concerned about collecting rebates only.

F&E: Wow. This is more complicated than that whole internalization thing. What exactly was the ISO exception designed for?

S&J: The ISO exception to Reg NMS’s protection of NBBO quotes was designed to allow for aggressive orders not to be held up by slow exchanges, and so that participants can interact with posted liquidity in limit order books. Keep in mind that Reg NMS only protects the best bid or offer for each exchange. Said differently if NYSE has offers at $10.01 and 10.02, and NASDAQ has offers at $10.02 and $10.03, Reg NMS protects NYSE’s $10.01 offer and NASDAQ’s $10.02 offer, but not NYSE’s $10.02 offer.

F&E: How do the exchanges treat Day ISOs and Post-Only Day ISOs from an order book priority standpoint?

S&J: This is a magical question that is best left for each exchange to handle. Key issues are whether such a Post-only ISO at a price level takes book priority over standard orders, or even other order types (i.e. price-slid orders that become un-slid). If these order types do take priority, then price time distortion takes place, which is unfortunate.

–          Example: Imagine if one were to place a non-routable order to buy 1,000 shares at $10.01 at an exchange, when stock is not offered at $10.01 at the exchange, but is offered at $10.01 at a different exchange. The exchange will likely price-slide the $10.01 buy order to $10.00, so as not to lock the $10.01 away quote, and slide it back to $10.01 when the away quote disappears. If a new buyer were to enter a Post-only Day ISO at $10.01 after the first buyer, would they have book priority over the first $10.01 buy order after such order was un-slid?

F&E: Wait… So if ISOs are generally understood to be liquidity-removing orders, how can Post-only ISOs be allowed? Isn’t their very existence and rationale against the spirit of Reg NMS?

S&J: Good question. Today, Post-only Day ISOs are used almost exclusively by market making HFT firms. These firms are using it not to take liquidity, as Reg NMS doesn’t protect all quotes, rather they are using them to get first in line at price levels once the HFT firm has made the decision on which way the market is moving in the short term. Their goal is not to own stock at $10.00, or $10.01, or $10.02 – their goal is only to be first in line and garnish an exchange rebate at those price levels.

F&E: Don’t the stock exchanges know or care that so many of these orders are being blasted around; is anyone making sure that SOMEBODY is complying with the SEC’s Reg NMS rules and protecting the NBBO?

S&J: We don’t know the answer to that.

F&E: This is so confusing. Can you direct me where I can read up on ISOs, and Post-only ISOs?

S&J: Sure. Start here with the SEC’s FAQ’s concerning Rule 611 and Rule 610. Go to section 2.0 Treatment of ISOs, and 3.01 Handling Unexecuted Portions of ISOs, as well as Section 4: Order Routers.

F&E: Good Lord.