The Cost of Parity
A newly revised academic paper about NYSE parity caught our attention. The paper is titled “Deviations from Time Priority on the NYSE” and was written by Professors Robert Battalio and Bill McDonald from the University of Notre Dame and Professor Robert Jennings from Indiana University. You might remember Professors Battalio and Jennings from their 2013 paper “Can Brokers Have It All?” which suggested that retail brokers were routing to the venue that paid them the highest rebates and not necessarily the venue with best execution. Their new paper is the first of its kind to empirically address NYSE’s parity rule and to actually quantify the cost of parity orders.
As you all know, floor brokers and Designated Market Makers (DMMs) on the NYSE have the advantage of trading “on parity” with other limit orders that were entered before the parity orders. This means that fills from incoming market orders are allocated between the public book, the DMM and floor brokers. While this may have been a good model prior to Reg NMS when NYSE had an 80% market share and the floor was the place to be, the authors of the paper question the role that parity plays in the fully electronic, fragmented post Reg-NMS world. They believe that parity is a “vestige of the traditional floor-based trading model and favors floor-based traders”. The question they attempt to answer in their paper is: How much is parity worth? Or in other words, what does parity cost traders who are not using it?
The authors find that parity allocations are more likely to occur in these situations:
(1) the trade is in a low-priced stock
(2) the market is less volatile on the day and/or the stock itself has low volatility
(3) the bid-ask spread is at the minimum variation
(4) the quoted depth on the relevant side is large
(5) the trade occurs at a price that is less advantageous for the liquidity demander than the price of the prior trade.
Up until recently, it was very difficult for academics to distinguish between regular orders and parity orders but the authors were able to use the TAQ NYSE XDP Integrated Data Feed which is time-stamped to the nanosecond to identify parity orders. This data feed includes information on all open NYSE orders and also includes changes to those orders through modifications, replacements and deletions. That level of granular data allowed the authors to rebuild the NYSE book which we believe is what makes this academic paper special and groundbreaking.
Now let’s get to the authors conclusion:
“On an annualized basis, our results suggest potential profits to floor-based traders of between $22.7 million (executed bypassed orders and the opportunity cost of deleted bypassed orders) and $61.1 million (executed bypassed orders and assuming that deleted bypassed orders become aggressive) are generated by parity trading in 2017.”
These numbers suggest that parity orders are indeed very profitable for those that use them and also for those brokers that allow customers to use their pipes to gain parity position in the queue. So, who is using parity orders? Are institutional algos posting orders to NYSE with parity? Are floor brokers renting their pipes to HFT’s so that can then use parity to disadvantage an institutional or retail order that was previously posted on the NYSE limit book?
Bottom line here is that in a world where millions are spent on gaining an extra nanosecond of speed, the NYSE is still rewarding their member firms with an unfair trading advantage. While some could argue that DMMs have trading obligations and should be rewarded with perks like enhanced rebates and higher queue position for providing liquidity, what is the argument for a floor broker to continue to receive parity benefits? It might be time for the SEC to revisit the NYSE parity rule.