The Secret Behind Nasdaq’s New HOTT Ratio


We love conference call transcripts.  They usually provide much more information than the actual earnings release and give you a much better insight into what the executives at a particular company are thinking.  We particularly like to read the transcripts of the public stock exchanges.  Yesterday, we read  Nasdaq’s 1st quarter earnings call transcript and were able to get a much better view of what is going on over there.

After years of catering to their HFT clients, Nasdaq now appears to be on the  defensive and trying to distance themselves from their HFT clients.  They are doing this by trying to prove to investors that much of their revenue has nothing to do with HFT.  To prove their point, Nasdaq developed a so-called HOTT ratio which captures a “persistent pattern of high order to trade ratio.” Nasdaq says this ratio may indicate that orders are being submitted for reasons “other than obtaining an execution.”  Think about that last statement.  Nasdaq seems to be saying that they have some customers on their exchange who are “spoofing” or entering manipulative orders.  Why are they just addressing this issue now?  As an SRO isn’t it their obligation to police their own exchange?

Nasdaq concluded that customers with HOTT ratios of 60-1 or greater only represented 1% of their global revenue. Well, that solves it, Nasdaq must not have much HFT going on at their exchange. Not so fast.  Let’s take a closer look at who was excluded from this ratio:

“We are adopting an analysis that focuses on firms that show a high degree of quotation to execution orders.  We looked at those who are not registered market markers with NASDAQ and who had order-to-trade ratios of at least 60:1.”

Now why would Nasdaq exclude market makers when trying to figure out how much revenue was associated with HFT?

“Why exclude market makers? For the very good reason that under the current regulatory regime, we believe that putting capital at risk and by continuously maintaining a two- sided market, you are, one, contributing to price discovery and helping investors for providing immediacy of execution. Now, those who are not market makers who have a ratio of 60:1, 80:1 or 100:1 high order to trade will adopt the acronym HOTT, H-O-T-T.  

The market makers are not included in this bucket and we have particularly left them out.

Nasdaq claims that their market makers are “putting capital at risk by continuously maintaining a two-sided  market” and this is the reason why they are excluded from the study.  But are these market makers really risking much capital when their quoting requirements are only to be within 8% of the NBBO?  Rule 4613 says that “market makers” are not allowed to quote more than a designated percentage away from the last trade.  And what is that designated percentage you ask?  It’s at least 8% and could be as much as 30% away from the last trade (depending on the stock). Is a client that has such loose obligations really a market maker? Or are they just using this title to hide their true prop trading intentions?  We think the latter and think that excluding market makers from their HOTT study renders the study useless.