HFT Short Sale Exemption? Really?


We were reading through a NASDAQ proposed rule change on the SEC’s website dated June 14th, which details how NASDAQ wants to provide their HFT customers a way to comply with the stub quote rule, and price bids and offers using new automatic order types priced typically 8% away from the NBBO. NASDAQ of course says they will provide the order types, but leaves the compliance issues around the short sale rule to the client. This is akin to posting a “No Fishing” sign at a pond, where the game warden is also selling fishing tackle and bait. Sad and comical.

Which brings us to the short sale rule (think tick requirements and more importantly stock-borrow locate requirements)…

What do you do if your fund manager wants to short a stock? Odds are the very first thing you do as a trader is “secure a borrow.” You call your prime broker and ask for the availability of shares of the stock you want to short. Or you check an “easy to borrow list” that is typically published daily. And you typically pay fees for the borrow – and these fees can be significant if the stock is in limited supply.

What do high frequency traders do when they short a stock? Do they locate a borrow? Does anyone check that they do? While there is an exemption that allows for “bona fide market makers” to be exempt from locating a borrow before executing a short, one has to ask what a bona fide market maker is in this day and age, and why on earth is an exemption for locating a borrow before shorting given to them? Certainly bona fide market makers can’t be rebate jockeys, or can they?

We think we understand who qualifies as bona fide market makers – they would be your DMMs, SLPs, ELPs, as well as any other multitude of “liquidity providing prop traders”.

Proprietary trading firms with no customers engage every day in rapid order submission, cancellation, and trading. They step ahead of your limit orders. They are virtually insured to be at the top of the limit book all the time, ahead of you, because they have tools like colocation, and especially enhanced order types, like ALO (add liquidity only) and Hide not Slide, which the exchanges designed for them so that they can price a bid at 50 cents that doesn’t trade with your 50 cent offer. The exchanges have figured out ways for “market makers” to NOT trade with existing limit orders at the same price. By contrast your limit orders as a result only get executed when they will be adversely selected against, and they stick out like NYC fannypack-wearing tourists roaming around in East New York.

So proprietary trading firms already have the deck stacked in their favor. Our next question is should prop trading HFT firms that engage in rebate arbitrage be exempt from the short sale rules that the rest of the market is not exempt from?

What are your thoughts?