Ladies and Gentlemen, May We Proudly Present to you… (Rule 11Ac1-1 – Backing Away)
In the best seller Flash Boys, Michael Lewis tells the story of a “rigged” market through the eyes of Brad Katsuyama and the good folks at IEX. The book deals quite a bit with conflicts of interest in order routing, but one aspect of the book focused upon by the media is the anecdotal story told on Katsuyama’s white board:
Essentially, as an order travels from a broker’s router in Manhattan to execute at the stock exchanges against a public quote, it does so reaching some exchanges before it reaches the others; the laws of physics apply of course. As the order reaches the first exchange, market makers on that exchange have the colocation and technology that allow them to cancel their quotes on the other exchanges, and perhaps even take stock ahead of the… “order presenter”.
The net effect to the order presenter is an incomplete execution – and price movement away from the presenter. The order presenter curses to him/herself that they were the victim of “backing away.”
Eric Hunsader at Nanex just this past week wrote a thorough piece explaining the process with real data, in one of the most liquid instruments in the world: the HFT-loved common stock of Ford Motor. Eric looks at trades in Ford, where the stock is quiet prior to delivery of an order crossing the spread to take stock. The order arrives and hell breaks loose, with a huge spike in message traffic and order cancellations. Eric actually charts and shows that the cancellation rate is about 40% of the displayed liquidity on average. He details how “the order presenter” gets incomplete fills and adverse price movement. His transaction costs go up.
The SEC’s Gregg Berman also sees cancellation rates that are around 40%, only he says this does not raise a red flag to him (paragraph 14 of this speech). Additionally, anecdotally others in the SEC also are not surprised that quote cancellations upon presentation of an order are high… in fact some in the SEC actually expect that, and are concerned about limiting HFT market makers’ ability to “get out of the way”:
Ok… by now you are all familiar with the process in which orders get cancelled ahead of you when you try to interact with them. By now you all realize that volume does not equal liquidity. By now you realize that all the transaction cost studies that use the size of the “deep quote” at the NBBO as proof positive that our markets are more efficient than ever are… flawed.
This brings us to the point and highlight of this morning’s note – the “presentation of an order” and Rule 11Ac1-1 (firm quote rule). Our regulators implemented this rule in the late 1990s amid a flurry of complaints from market participants that market makers were not honoring their quotations, and is often referred to as the “backing away rule”. Rule 11Ac1-1 requires market makers to execute an order presented to them at a price at least favorable as their quote price, and up to the published quotation size.
In Flash Boys, hero Brad Katsuyama was shocked and outraged that this was happening to him. He repeatedly could not get executed when he presented his order. Eric Hunsader in his post reference above shows that this is still the case, and demonstrates it with data in Ford Common Stock.
All of you are perhaps numbed, and used to the same treatment when you attempt to interact with quotes. Some of you have chosen to use SORs that are “Thor-esque” to limit the poor treatment, or to use SORs that add some ELP’s into the mix to hopefully offset some of the order cancellations on the exchanges with dark liquidity being provided by ELPs and dark pools. That’s nice. You have adapted – for now. However, it is perhaps appropriate to ask a few important questions that are principle-related:
1) Why are we not enforcing standards and expectations that the regulators have outlined as per Rule 11Ac1-1?
2) Is a quotation still “owned” by a market maker? Or is it owned by a public exchange or quoting venue that the market maker uses?
3) What’s the difference between a market maker in the year 2000 showing a quote for 20,000 shares in their own acronym, and a market maker today spreading out that quotation among several public markets? What is the difference between MSCO showing a quote of 20,000 shares and having to honor it, and an HFT market maker showing the same quote today (albeit on exchanges) that is allowed/expected to cancel 40% of it? Shouldn’t the principle be the same?
4) If one market maker is quoting 50,000 shares in Ford stock, but using BATS, NYSE, ARCA, and NSDQ to do so, and you “present your order” to that market maker, shouldn’t the market maker have to honor it, without regard to where he is showing his quote? Said differently – just because your order hits BATS first coming through the tunnel, and a market maker has a portion of his full quotation on BATS, does that absolve the market maker from his duty to execute your whole order against his quote on other exchanges?
5) The scenario of backing away has always been considered patently wrong by our regulators through time. Should the plumbing and technology details of the backing away change the fundamental principal that the activity is wrong?
Perhaps these are questions for smart legal minds to ponder. Or our regulators.
PS – Please be sure to read through Hunsader’s piece.