Information Leakage Part Deux – No More Seven Year Itches


Our note to you from this past Friday detailed how the NASDAQ Post Only order type has been leaking information for seven years, and NASDAQ is only now proposing to change how it works.

Essentially, sophisticated traders are able to enter a Post Only order, and if such an order would execute against a contraside hidden order, it would get repriced up or down a tick.  This repricing notifies the sophisticated trader about the existence of hidden order interest.  The sophisticated trader is alerted on NASDAQ’s private data feed that their order has been repriced (and that there is contraside hidden interest).

As a follow up to Friday’s note, we want to spend a bit more time on NASDAQ’s proposed solution to the bad behavior it had allowed for seven years.

NASDAQ intends to fix what it had created by allowing the Post Only hidden order to lock its own book without re-pricing.  For example, it wants to allow member to now enter a 51 cent hidden bid, and instead of it trading with a resting 51 cent offer, allow it to simply lock said offer. NASDAQ wants to allow bids and offers at the same price, without a trade – without a clearing price.

Let’s ask a few more questions:

1)      Will allowing bids and offers to exist at the same price on the Nasdaq order book without a trade help or enhance Price Discovery?  Will the public market for stocks (bids/offers/and trades) be more or less likely to reflect equilibrium supply and demand, and true asset value, at any point in time if bids and offers can exist at the same price and time and not trade?

2)      Retail and institutional investors take for granted that at any point in time, the public market of bids/offers/trades reflect the true price of an asset. Will allowing such non-clearing-price behavior – locking behavior – make a mockery of this important assumption? What is the value of a stock if bids and offers can lock and not trade? Is the value of the stock 50 cents? 51 cents? 74 cents? 23 dollars?

3)      If the SEC allows such behavior, is it promoting markets with better price discovery – or worse price discovery?

4)      If the SEC allows this behavior, is it a litmus test for the removal of the ban against locked and crossed markets?

The time has come for the SEC to examine in detail every single exchange order type and ask whether it serves investors first. The time has come for the SEC to create a yardstick for approving any new exchange rule filings:

–          Will the proposed rule maintain fair and orderly efficient markets?

–          Will the proposed rule facilitate capital formation?

–          Will the proposed rule protect and serve investors?

–          Who will benefit from the proposed rule filing?

Our markets today have morphed so that technology instead is leveraged to bring the maximum amount of intermediation between natural investors.  The time has come for the SEC to acknowledge this, and reverse it. They can begin by not allowing a scratch for a seven-year itch that will create another seven-year itch. They can begin by eliminating all post-only order types, instead of allowing them to continue to wreak havoc on the simple price discovery mechanism.