The Real Story of Why Nasdaq Halted Trading Yesterday


Did it really surprise anybody that Nasdaq technology crashed the market yesterday? This time the failure was at the SIP (Securities Information Processor). The SIP is one of the most important and least understood pieces of our equity market. It aggregates all of those fragmented exchanges and distributes the NBBO (national best bid and offer). The NBBO is what all those dark pools use to price their merchandise and also what all those internalizers rely on to give sub penny price improvement. The SIP is the hub and the exchanges are the spokes.   Some HFT strategies (i.e. latency arbitrage) rely on the SIP to be slower than what an HFT can calculate themselves.  So is it any surprise that the SIP failed?

To understand what happened yesterday, it is necessary to define a few things :

Section 12(f) of the Securities and Exchange Act of 1934 permits NASDAQ to extend “unlisted trading privileges” (UTP) for its listed securities. Through UTP, other U.S. exchanges and markets are able to quote and trade issues listed on the NASDAQ Stock Market. Under the UTP Plan, all U.S. exchanges that quote and trade NASDAQ-listed securities must provide their data to a centralized securities information processor (SIP) for data consolidation and dissemination. NASDAQ currently serves as the SIP for the UTP Plan.”

The Nasdaq UTP plan was developed by the following participants :  BATS, CBOE, Chicago Stock Exchange, Direct Edge, FINRA, ISE, Nasdaq, the NSX, NYSE and NYSE Arca.   These participants select who the “processor ” of the plan will be.

One of the least read documents on Wall Street is the Nasdaq UTP Plan   It clearly states the Processors role:

The Processor shall collect from the Participants, and consolidate and disseminate to Vendors, Subscribers and News Services, Quotation Information and Transaction Reports in Eligible Securities in a manner designed to assure the prompt, accurate and reliable collection, processing and dissemination of information with respect to all Eligible Securities in a fair and non-discriminatory manner.”

Nasdaq is the processor of the UTP plan and while press reports have Nasdaq blaming NYSE Arca for the problem yesterday, the culprit is irrelevant.  What is relevant is that the system failed.  The plumbing of the equity market leaked again.

We take issue with a for-profit stock exchange being selected to run arguably the single most important part of the equity market.  While it may have been appropriate for Nasdaq to be the processor of the SIP when it was a dealer market, we think that in a highly fragmented, competing exchange market, it is no longer appropriate for Nasdaq to be the processor.  Doesn’t the SEC see a potential problem by having a for profit exchange run the SIP? Isn’t there an inherent conflict of interest here? Some HFT firms rely on the fact that the SIP is slower than their self-produced quotes.  And Nasdaq’s largest customers are HFT firms.   We believe that the SEC should require that the processor of the SIP be an independent non-UTP participant. And that independent firm should be paid with proceeds that the exchanges currently receive as tape revenue.

In addition, we believe that the SEC should mandate that the UTP participants disclose the amount of revenue that they receive each quarter from the plan.  These participants currently divide approximately $450 million (this was the last known figure that was published by the SEC in 2008) amongst themselves. This revenue comes from all of us in fees that we are assessed by the plan participants.

There is no doubt in our mind that these system issues will continue to happen until our regulators decide to address the real cause of these problems:  our overly complex and fragmented equity market structure. Rather than continuing to nibble around the edges and implement band aid fixes, regulators need to take a long hard look at the system that they themselves created. Regulators thought they were helping the retail investor with regulations like Reg NMS back in 2007. They thought they were lowering costs by increasing “competition”. But they failed to foresee how the profit motives of for profit exchanges and proprietary trading “market makers” would distort and take advantage of their newly designed market structure

No doubt the biggest disappointment of our new market structure has been the stock exchanges.   As they desperately court HFT flow, they have neglected their regulatory responsibility and failed to keep up on their own technology.   As HFT’s have demanded lower latency and more ways to race to the top of the book, the exchanges have compromised the entire market to win their business.

The biggest losers however are not the exchanges.   Instead, the biggest losers are us, the institutional and retail investors.   We have to look on as our market integrity is destroyed by the short term profit motives of the exchanges and their high frequency clients. The US equity market, which was once the best model for capital raising and capital allocation, has now become the laughing stock of the world.