Cutting the Line and Order Types

Payment for order flow, access to high speed proprietary exchange data feeds and conflicted order types are all deeply embedded in our stock market.  As regular readers of our blog (and our book Broken Markets), you already know this.  You already know that exchanges are constantly creating new order types to give advantages to their best clients.  Besides discussing this topic in Broken Markets, we have been sounding an alarm over many of these order types for well over a year.

We talked specifically about the Hide not Slide order type on numerous occasions in the past year, including this Star Ledger article, this Minyanville article, as well as in our blog in this post HFT Short Sale Exemption? Really?

In addition, we have highlighted the new NYSE Arca PL Select Order  which was designed NOT to trade with IOC and ISO orders.  This order has been approved by the SEC and will go live on September 21.  It has been approved by the SEC, as have all of these stock exchange HFT-oriented order types (Direct Edge is not alone – other exchanges have versions, such as NASDAQ’s Price to Comply Order and BATS’s Partial Post Only @ Limit Order).

We are not lone critics of these HFT-oriented and unfair order types that distort the price discovery process, as well as the demand/supply metric that is the foundation of our capital markets. Read here what the good folks at T. Rowe Price – Clive Williams, Andy Brooks, and Chris Hayes – have written about the Arca PL Select order in their comment letter to the SEC.

It is unclear to us what value this order type provides with respect to the price discovery process.

We believe that the liquidity posted on a protected venue should be  genuine  indications of intent  to  buy  or sell  securities.

Under the principles of fair access, exchanges should be discouraged from enabling firms posting orders to select the type of contra-side.  These order types could  be  misused  to  gather market color or information unfairly in addition to the trading disadvantages experienced by institutional investors.

We  believe  that  this  and  similar  other  proposals  unnecessarily  segment  clients  to  the detriment of long term investors  and erode confidence in a fair  and  orderly marketplace.

Today, there is a front page story in the WSJ titled For Superfast Stock Traders, a Way to Jump Ahead in Line.  The article is about how certain order types have been created by the exchanges that are intended to jump the queue.  Haim Bodek, who was featured in the book Dark Pools, is featured in this article.  He has done some investigating and found out some more disturbing facts about order types.  From the WSJ article:

In papers filed with the SEC, Mr. Bodek took aim not at the data streams but at the way orders from high-frequency traders work. He focused on “order types”—programmed commands traders use to tell exchanges how to handle their bids and their offers to sell.

Hundreds of order-type options are available, which translate to thousands of variations because they behave differently depending on how an investor’s trading programs are coded. One thing investigators want to know is whether stock exchanges have worked with programmers or officials at high-speed trading firms to create order types that, when used with certain trading algorithms, can be unfair to less-savvy investors, people familiar with the probe say.

In other words, take one part of one order type and mix it with another and presto, you have created a new, undocumented order type that the SEC has not wittingly approved.

A stock exchange that wants to offer a new order type must get it approved by the SEC, in a process that entails public notice and comment. That makes the probe tricky, because the SEC is examining the effects of procedures the agency itself approved. Among questions the regulators want to answer is whether exchanges have at times misled them in seeking approval for certain order types or mischaracterized to investors how the orders work, those familiar with the probe say.

Once again the integrity of the nation’s stock exchanges is being questioned.  Why do investors believe the game is rigged?  Well, when stock exchanges are advantaging one class of investor over another so that they can profit for themselves, it’s pretty obvious that the playing field is not level, and that our marketplace is broken.