Let’s Talk Locked and Crossed – Lock Stock and Two Smoking Barrels




A Little Background

In 2007 the SEC implemented Reg NMS, a rule which created a NBBO, protected it, and banned something called a “locked market” – where a buy order at one exchange is priced equally to a sell order at another exchange. The intention was of course acceptable – if the SEC is to “let a thousand flowers bloom”, and embrace the fragmentation of sixty-plus trading destinations, then they need to insure that these destinations, all operating at different speeds, clearly understand what they need to do when a locked or crossed condition occurs. Specifically – the purpose of the secondary market is to provide a liquid and orderly way for investors and traders to transfer risk, competitively, and set accurate clearing prices for financial assets.

Of course, things don’t always go according to plan. The SEC did not account for how much of the trading is actually inspired by race conditions to get exchange and dark-pool proffered rebates. To high frequency traders, who claim that they make so precious little on each trade (10 mils according to Tabb), those rebates are crucial, and the race to get them has inspired  creative ways to get them. Those ways include order types, and order type combinations, such as hide not slide, and PostOnlyDayISO – that allow jumping queue in the limit order book. They pitched the exchanges on the order types, the exchanges gave them what they designed, and the SEC approved.

Despite there being two active investigations into stock exchanges and order types, we are still without SEC action one way or another.

OK, Why Are We Talking About Locked Markets This Morning?

Recently, minimum tick sizes has been thrust front and center in the spotlight, partially thanks to the Jobs Act – should we allow wider tick sizes for smaller cap companies in order to inspire more market-making, and potentially eventually more public IPOs of small companies?

However behind the scenes another tick size argument is in play – on the Street and in Washington. Should the SEC allow zero-tick markets in some securities – should they allow a locked market? The argument has been actively discussed  since back in 2012, and perhaps earlier.

Some high-frequency traders are exploiting loopholes set up by the 2007 rules through the use of sophisticated order types and fast connections to exchanges, critics say. SEC enforcement officials have been looking at whether certain order types the exchanges offer allow high-speed firms to jump ahead of other investors, say people familiar with the probe.

Specifically, critics are focusing on the rule’s ban on “locked markets.” In a locked market, a buy order at one exchange equals a sell order at another exchange.

Today we see the discussion of the issues around locked markets frequently at industry panels, and even on Twitter.

What is the Pro Argument for Allowing Locked Markets?

Exchanges and high frequency traders alike seem to be for allowing locked markets. They argue:

–          The markets are efficient enough, that allowing locking will not harm market quality.

–          There would be no need to incur take fees – costs would come down for everyone.

–          Since critics find the race conditions around the NBBO distasteful, including special complex order types, these “games” would go away – and appease those critics.

–          Exchanges and HFTs only created the gaming to get around the SEC’s ban on locked markets to begin with.

–          Allow BAC and F to lock, and everyone wins. No take fees for HFTs. Rebates only. No gaming. No queue-jumping.


One thought leader we spoke with believes that allowing a locked market is not a bad thing. He reasons:

“It will cause massive software changes for all HFT. New order types will now have to run the gauntlet under a million watt spotlight. The SEC would have an opportunity to affirm the ban on crossed markets “we’re allowing locked markets, BUT crossed markets are a big no-no”. Perhaps experimenting is not a bad thing.

What is the Con Argument for Allowing Locked Markets?

We recently has this discussion with R.T. Leuchtkafer. He has a different take:

“Lifting the ban on locked markets is little more than de-regulatory theater.  No one’s explained how lifting the ban will make markets less complex, except to point to the proliferation of order types and say that many of these are because of the current ban on locked markets.  Lift the ban, they say, these order types go away, and markets get simpler. Really?  Do we then allow crossed markets, so, say, BATS can bid a nickel above NYSE’s offer and not trade?  And if we don’t allow crossed markets, don’t we have all the order types we have now to prevent locked and crossed markets in place to still prevent crossed markets?  If we do allow crossed markets, what does that say to the investing public when it looks at a quote and sees BATS bidding a nickel above NYSE’s offer and no one can get a fill?”

We at Themis see RTL’s point. If we allow locked markets, the race condition will not go away. We will see a great increase in crossed markets as a result – where bids on one exchange are at a higher price than offers on another exchange.

What is the problem with crossed markets?

–          What does a high incidence of crossed markets say about accurate pricing in the secondary market? Does this inspire confidence?

–          In those situations what is a fair price for an investor buy order to be filled – whether it is “retail” or an institutional child order? What will the guidelines be? If the market in a stock is:

$25.40 bid and $25.38 offered.

Will your algorithmic child buy order get filled at $25.38, or at a higher price that is indeterminate and subject to fleeting liquidity yanking like a Charlie Brown Lucy Football Yank? Who will monitor those fills?

In an environment with many crossed markets, is the liquidity provision of high speed traders reliable and robust? How will they deal with sweep risk in a marketplace?

Will your brokerage firm algorithmic tool  be able to insure fair and appropriate fills? Will you get a favorable fill 50% of the time, and an unfavorable fill 50% of the time? Will your algorithmic order be on the wrong side 99% of the time?

What unforeseen gaming will arise, should a locked market be allowed? Will the SEC actually be able to monitor and enforce a ban on crossed markets if they allow locked markets? Are you confident in that ability?

Up to 40% of trades currently trade in the dark. How will dark pools and dark trades be dealt with in locked and crossed conditions? Will that trading cease?

Maybe this argument is moot. After all, very large industry players have huge business models based on internalization and payment for order flow. Do you think their lobbying muscle and influence would even allow locked markets to begin with?


Please let us know your thoughts on this issue – we would love to hear the viewpoints from the owners of the marketplace- investors.