The Cost Of Phantom Liquidity

It’s been almost two weeks now since the Knightmare on Wall Street and press reports are beginning to fade.  Over the past two weeks, we were pleased to hear lots of new voices speaking up about the dangers of HFT and the systemic problems that are now built into our markets.  As headlines now turn to other topics, we at Themis Trading will keep digging up new information to continue illustrating why our markets are broken.

Today we would like to highlight the SEC approval of a new NASDAQ proposal.  On August 10, the SEC approved a proposal to reflect a change in NASDAQ’s order routing functionality.  The new functionality “will allow routable orders to simultaneously execute against NASDAQ available shares and route to other markets for execution of the remainder of the order. Currently, when a routable order is entered into the NASDAQ system, the NASDAQ book is first checked for available shares. If such an order is not filled or filled only partially, then the order is routed to away markets with the best bid or best offer pursuant to NASDAQs System routing table.”

Let’s stop right there and analyze this.  NASDAQ is saying that they currently sweep their own book before routing the balance of the order to other markets for execution.  Makes economical sense for them, right?  But in a fragmented market where microseconds are worth millions, there is a downside to this.  Anybody that actively trades during the day knows exactly what usually happens next.  By the time the order is routed to NASDAQ for execution, and before it gets routed to other markets, those quotes on the other markets usually scramble like cockroaches that just had a light turned on them.  Of course, we all know there are ways to combat this type of activity, unless your smart order router has an economic incentive to route this way.  Listen to why NASDAQ has decided to make this change :

“NASDAQ has observed that upon partial execution of a routable order at NASDAQ, as in the example above, market participants often react to the order by cancelling their orders on other markets and entering new orders at inferior prices. This occurs because the current process directs the order to NASDAQ before attempting to access available liquidity at other markets and thereby allows market participants to react to the execution (an effect known as market impact’ or information leakage). As a consequence, the available shares at the away market are no longer available, resulting in a lower likelihood of successfully accessing liquidity on away markets (i.e.,the fillrate) and an increased likelihood of ultimately receiving an execution at an inferior price.”

That is what we refer to as “phantom liquidity”.  This is not a new practice and has been going on for a long time without regulatory oversight but has increased since the implementation of Reg NMS in 2007.  Five years now after Reg NMS, NASDAQ is just getting around to changing their routing methods.  How many retail and institutional orders were disadvantaged during these years?  How much money was transferred to the HFT community from traditional investors during this time period?  Remember, it’s a zero sum game – those HFT profits have to come from somebody.  The HFT lobby will say it’s only a penny or two and that’s a small price to pay for the liquidity that they supply.  But those pennies have been adding up to billions of dollars in the last few years.