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The 2nd Derivative of Fragmentation-Part II

29

November, 2012

The BATS Exchange just received approval  from the SEC to operate a Retail Price Improvement Program.  Although BATS has a few slight differences, their Retail Program is very similar to the NYSE RLP program which was launched on August 1st (which just happened to be the same day as the Knight algo disaster). In their quest to steal back market share from the “internalizers”, the exchanges are essentially fragmenting the already fragmented equity market even further with these retail price improvement programs.

According to the SEC filing, the BATS program:

“Under the Program, a new class of market participants called Retail Member Organizations (“RMOs”) would be eligible to submit certain retail order flow (“Retail Orders”) to the Exchange. All Exchange Users would be permitted to provide potential price improvement for Retail Orders in the form of non-displayed interest that is better than the national best bid that is a Protected Quotation (“Protected NBB”) or the national best offer that is a Protected Quotation (“Protected NBO,” and together with the Protected NBB, the “Protected NBBO”)  called a Retail Price Improvement Order (“RPI Order”). When an RPI Order priced at least $0.001 better than the Protected Bid or Protected Offer for a particular security is available in the System, the Exchange would disseminate an identifier, known as the Retail Liquidity Identifier, indicating that such interest exists. A Retail Order would interact, to the extent possible, with available contra-side RPI Orders.”

As we expected, BATS used the approval of the NYSE RLP program as precedent in their request to get their own Retail Program approved.  We expect NASDAQ and Direct Edge to do the same.  Rather than getting into the differences of one Retail Program versus another, we would like to point out one very specific item that the NYSE RLP program and the newly approved BATS program have in common that we think is potentially very dangerous and discriminatory.

Both of these programs distribute an identifier when a Retail Order is available on their exchange. The identifier will include the symbol and the side of the order but not the price or size.  BATS claims in addition to distributing this identifier on its proprietary data feed, they will distribute the identifier through the Consolidated Quote System.  When the NYSE first proposed their RLP program, BATS wrote a comment letter  to the SEC questioning the distribution of the identifier and comparing it to a flash order:

Similar to so-called “flash orders”, NYSE would disseminate information to a private network about its best priced orders that is unavailable to anyone outside of that network. Broker-dealers who are unable or unwilling to pay for NYSE’s proprietary market data feeds, but instead rely on the CQS for top of book information, would be at a disadvantage to NYSE members taking NYSE’s proprietary market data feeds. As a consequence, many of the concerns raised in the past regarding flash orders are equally raised by the Proposal.

In particular, the Proposal represents a further step toward disconnecting the CQS from the reality of what are in fact the best prices available. The CQS has long been considered the industry reference for the market’s top of book quotes, and while its relevance has been challenged in a post-Regulation NMS environment, it has dramatically improved its latency to meet this challenge. Those efforts will be for naught if the exchanges ultimately revert to a market structure whereby their best prices are reserved for their private networks. The net result could be a two-tiered market where only those market participants who can afford to take in and process each exchange’s proprietary market data feed have access to the best prices.”

Even though BATS will be distributing their Retail Identifier to the CQS, there is still the problem of latency.  In the world of HFT, every microsecond can mean millions of dollars.  The CQS will likely be distributing the identifier at least a few milliseconds later than the direct data feeds which gives the HFT’s a huge advantage.  We think the argument that BATS initially made against the NYSE RLP identifier can also be used against their own program because of this latency effect.

The bottom line here is that the SEC is continuing to approve programs that are fragmenting the market even further.  Rather than initially rejecting the original NYSE RLP program and tackling the growing problem of off-exchange trading known as “internalization”, the SEC opened the door up for more Retail Programs.  They are doing the exact opposite of what they should be doing which is to aggregate liquidity rather than to continue to fragment liquidity.

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