“HFT Influence” – The Real Story Behind the Latest Stock Exchange Fine


Direct Edge was fined $14 million yesterday by the SEC for failure to disclose important information about how some of their order types worked.  Before we get into the details of this latest case, we thought it was important to give you a quick review on the controversies that have plagued Direct Edge over the past few years.

– In the summer of 2009,  Direct Edge was at the center of the “flash order” controversy  .  If you recall, Direct Edge was the first market center that employed flash orders in the equity market.  These orders helped Direct Edge skyrocket their market share from low single digits to 12%.  Of course, they gained this market share because these orders were giving free peaks to Direct Edge’s high speed clients.  Flash orders were subsequently forced out of the market by irate investors and politicians (note: the SEC still has not officially banned these orders).

– In October 2011, Direct Edge was sanctioned by the SEC for “violations of U.S. securities laws arising out of weak internal controls that resulted in millions of dollars in trading losses and a systems outage.”  It’s important to note here that this sanction required Direct Edge to cease and desist from further violations of U.S. securities laws.

– And just this past year, Direct Edge was at the heart of the “Flash Boys” debate when their CEO went on financial television and tried to attack Michael Lewis and IEX.  This backfired on him and Direct Edge was forced, by pressure from the NY Attorney General’s office, to correct the misstatements of their CEO about their usage of the SIP.​

The latest case against Direct Edge is a very detailed case about the dissemination of information to clients about their price sliding orders.  According to the SEC, Direct Edge rules failed to fully describe how their price sliding worked:

“The displayed pricing sliding process described in the rules did not accurately describe how this functionality of the Exchanges operated. Instead of a single price sliding process as described in their rules, the Exchanges accepted three different price sliding order types, called “Single Re-Price,” “Price Adjust,” and “Hide Not Slide” (“HNS”). These three variations of price sliding were not accurately reflected in the rules filed with, or filed with and approved by, as applicable, the Commission under Section 19(b) of the Exchange Act. “

We would rather not get into the gory details of “Hide-Not -Slide” in this note and instead focus on the real story that the case centers around  – the influence that some of Direct Edge’s high frequency trading clients had at the exchange.  It’s no secret that in all industries, big clients usually have an influence but a stock exchange must maintain higher standards.  The Securities Act of 1934  stated some of the responsibilities of an exchange:

The rules of the exchange are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by this title matters not related to the purposes of this title or the administration of the exchange.”

This case reveals how Direct Edge allowed a small group of high frequency trading firms (the SEC refrained from naming them and instead referred to them as “Trading Firm A” and “Trading Firm B”)  to influence the way they created and disseminated information about an order type.   We believe that Direct Edge violated the duties of an exchange as defined in the Securities Act of 1934 since they allowed some of their clients to have an unfair advantage over others.   Exchanges should be focused on helping companies raise capital and grow, but instead this case reveals that Direct Edge sold that duty out for the benefit of their bottom line.  Here are some of the details of the SEC’s case which detail the influence of Direct Edge’s high frequency trading clients:

21. Beginning in late 2008, a high frequency trading firm (“Trading Firm A”), a subscriber of the Direct Edge ECNs, encouraged Direct Edge to develop an alternative to its existing price sliding functionality that would enable an order that would lock or cross a protected quotation upon entry to retain its priority (or queue position) in Direct Edge’s order book.

22. Trading Firm A explained to Direct Edge that in order to generate profits from its trading strategy, which was designed to capture spreads and/or collect rebates offered by trading centers for providing liquidity, it required a high degree of certainty that it could enter and exit individual trades at its intended prices. Trading Firm A informed Direct Edge that one of the ways it sought to achieve such certainty was through its queue position.

23.  Trading Firm A further advised Direct Edge that implementation of such an order type would likely cause it to increase the order flow that it sent to Direct Edge from 4-5 million orders per day to 12-15 million orders per day.

 31. In May 2009, Direct Edge began contacting certain users of HNS orders and potential users of the proposed MPM order, including Trading Firm A and another high frequency trading firm (“Trading Firm B”), to solicit their feedback on the proposed MPM order logic. Trading Firm A and Trading Firm B both expressed concerns about the possible implications of the proposed MPM order logic on their trading strategies. In particular, Trading Firm A and Trading Firm B reacted negatively to Direct Edge’s plan to re-price and rank HNS orders at the NBBO mid-point on EDGX, informing Direct Edge that they preferred to know the prices at which their orders were ranked on the order book and not have the prices automatically adjusted by the platform. Trading Firm A and Trading Firm B also reacted negatively upon learning that Direct Edge proposed to give MPM orders order book priority over HNS orders. Trading Firm A and Trading Firm B took the position that HNS orders should have execution priority over MPM orders (which were not displayed) because the HNS orders were displayed orders that were entered with more aggressive limit prices.

44. The additional information that Direct Edge provided to these firms about the operation of HNS on EDGA and EDGX was not contained in the Exchanges’ rules.

45. As a result of disclosing this information to some but not all members, Direct Edge caused some members to have information about Exchange order types and order handling procedures that other members did not have, including that HNS orders on EDGX were ranked at the midpoint of the NBBO and had priority over other orders ranked at the midpoint and that a HNS post-only order could execute as a taker of liquidity if price improved on EDGX.

With this latest SEC cease and desist order, Direct Edge has violated the terms of their 2011 settlement with the SEC.  In that settlement the exchange agreed to cease and desist from further violations of U.S. securities laws.  This latest violation cost them $14 million, which according to the WSJ ​, was more than BATS had anticipated when they merged with Direct Edge last year.  We wonder if there are any more skeletons in the Direct Edge closet and how much those would cost as a third offense?