Friends of the Court

Ever since IEX proposed the D-Limit order last year, it has been contentious. Citadel and the legacy stock exchanges have voiced considerably opposition to the proposed order type, and Citadel has filed a lawsuit to force the SEC to overturn its approval. While the D.C. Circuit Court considers the lawsuit, three amicus briefs have just been filed in support of the SEC approval. Amicus briefs, or sometimes called “friend of the court” briefs are filed by people who are not part of the litigation but can assist the court by offering their expertise on the issues of the case. The three briefs that were filed all take a different perspective and all contain convincing arguments for why the D.C. Circuit should uphold the SEC approval of D-Limit.  We read through the briefs and pulled out what we feel are the most important parts:

Better Markets

Better Markets explained to the court how the “arms merchants” otherwise known as the major stock exchanges sell colocated space in their data centers and proprietary data feeds to HFTs which make latency arbitrage possible. 

Successfully deploying a latency arbitrage strategy is easier said than done, chiefly because of technological and financial hurdles that only a privileged few high-frequency traders, such as Citadel, can overcome

High-frequency traders purchase both connectivity services and depth of book data from multiple exchanges to ensure they have superior access and information, which increases the already prohibitive cost.

Predatory latency arbitrage trading practices also inflict broader harms by discouraging trading, and particularly the use of resting limit orders, on the lit exchanges.

In short, latency arbitrage hurts investors in the most concrete way by taking money out of their pockets. When an order is picked off as a result of a latency arbitrate strategy, an investor receives a price that is less favorable than the price they could and should have received a split second later, a price that the stock was inevitably moving towards. As the D-Limit order protects against this predatory trading practice, it benefits investors.

Better Markets cites reasons why the SEC acted appropriately with their D-Limit approval

The SEC was able to cite ample support from a remarkably diverse set of market participants, including a broad sampling of the most prominent institutional investors, asset managers, investment banks, and brokers in the world.

It considered all the “relevant factors” (and none that are off-limits under the Exchange Act); it drew “rational connections,” avoiding any clear errors of judgement; and it provided a lucid and persuasive explanation for its action.

The SEC…accepted the most straightforward, logical explanation for the data IEX provided. The reason such a relatively high proportion of marketable orders arrive during the relatively small periods of price instability, causing loss to the resting limit orders with which they interact and accruing profits for themselves, is that high-frequency traders like Citadel are in fact deploying their core trading strategy.

Better Markets explains why they think Citadel challenged the SEC’s approval of D-Limit

Ultimately, this challenge to the D-Limit order type is about protecting Citadel’s golden goose. Citadel spends a tremendous amount of money for superior speed, access, and information, allowing it in effect to see price changes before they can be seen by investors and to profit at the expense of those investors. 

As the record shows, the D-Limit order type neutralizes these advantages and places all investors on a more equal footing with Citadel. The SEC correctly approved its use under the applicable Exchange Act standard, in furtherance of its duty to protect investors rather than safeguard the fundamentally unfair and anti-competitive business model of a market participant.

XTX Markets

As a proprietary trader, XTX is very familiar with market structure plumbing and has first-hand knowledge of latency arbitrage. They provided the Court a very detailed explanation of latency arbitrage and the negative consequences it has on markets.

Definition of Latency Arbitrage

As a liquidity provider, XTX can attest to the need for regulators and exchanges to address latency arbitrage. At its core, latency arbitrage is a simple and intuitive trading strategy. It involves exploiting a trading-speed advantage to process real-time price changes affecting a financial instrument and trade on that instrument in the split second before professional liquidity providers, like XTX, and other market participants can update their prices.

Latency Arbitrage is Real

Contrary to Citadel’s repeated suggestion, however, there is nothing “amorphous” about the concept of latency arbitrage, nor anything “purported” about its existence.

The key to latency arbitrage is that information can travel only as fast as technology allows; the time it takes for a professional liquidity provider, other market participants, and exchanges to send and receive market information (including orders to an exchange to buy or sell securities, or to update the prices of orders “resting” on exchanges) is known as “latency.”

With the aid of costly market data and network infrastructure optimized for speed, certain traders can process real-time price movements and trade on a stock before professional liquidity providers, other market participants, and exchanges can act on that information, often “picking off” orders at the expense of slower professional liquidity providers and retail and institutional investors.

The entities carrying this strategy out—latency arbitrageurs—are a select group of high-frequency trading (HFT) firms with the financial means and engineering resources to build sophisticated systems of telecommunications and networking infrastructure (including microwave towers, hardware, and algorithms) to shave off every last microsecond (i.e., a millionth of a second) of latency…Virtually all other market participants lack the technological capability to exploit such fleeting opportunities. 

Even professional liquidity providers who may be sophisticated enough to update prices as fast as the fastest latency arbitrageur will still lose the “speed race” on average 50% of the time—more than enough to cause harm to overall market quality.

The practice is so palpable, in fact, that when weather events foil latency-arbitrage efforts by disturbing microwave transmissions, trading costs on the markets noticeably decline—to the benefit of all other market participants.

Most immediately, latency arbitrage imposes monetary losses on individual trades for market participants—including retail and institutional investors—who lack the speed advantages that latency arbitrageurs cultivate

What are the negative consequences of latency arbitrage?

Less displayed liquidity from a shallower pool of providers means less known supply, or fewer displayed orders for trading. That dynamic, in turn, weakens a fundamental function of the market: public price discovery—that is, the process by which buyers and sellers negotiate a mutually agreeable price that helps to set the market price.

In addition to reducing the amount of displayed liquidity, the latency-arbitrage tax prompts liquidity providers to post wider bid-ask spreads: To counteract the losses they incur when their displayed liquidity orders get picked off at stale prices, liquidity providers lower the price at which they are willing to buy a stock (the bid) and raise the price at which they are willing to sell it (the ask)

The burden of the latency-arbitrage tax gets passed on to retail, institutional, and other ordinary investors.

How does D-Limit help offset the negative consequences of latency arbitrage?

The D-Limit order simply allows liquidity providers to submit displayed orders that also continue to track current market prices while the NBBO is in flux. It gives any liquidity provider the option to select an order type that, during only the few seconds the CQI is on, automatically adjusts displayed orders to maintain their relationship to the NBBO. 

The extensive data that IEX submitted, and the Commission evaluated, demonstrates that without the protection the CQI provides, displayed orders are sitting ducks for latency arbitrageurs. XTX’s experience as a liquidity provider confirms as much.

Correcting the information asymmetry present during those milliseconds is a feature, not bug, of the D-Limit order. The Commission’s decision to approve a focused solution to a rampant problem, regardless of one’s opinions on modest differential effects, was thus both “reasonable and reasonably explained.”

Healthy Markets 

Healthy Markets explained that Citadel Securities doesn’t trade “on behalf of” retail investors and clarified how IEX’s D-Limit order differed from CboeEDGA’s proposed rule.

Citadel doesn’t trade “on behalf of” retail investors

Citadel Securities trades “on behalf of” retail investors exactly and precisely to the same extent that a scalper transacts business “on behalf of” a sports or music fan.

Citadel Securities is a market maker that purchases order flow from brokers and then trades against those retail orders in arms’ length transactions in the same way that scalpers sets up shop on a street corner to trade against the buy and sell orders of fans.

Modern market makers like Citadel Securities, in contrast, do not have any relationship with retail investors, but instead have relationships with the brokers.

D-Limit is different from CboeEDGA asymmetric speed bump proposal

However, just like the long-permitted peg order types, the D-Limit order type works the same for everyone, doesn’t introduce any broker or exchange optionality, and is in line with order types that the SEC has permitted for decades. In contrast, the CboeEDGA proposal sought to impose an asymmetric delay on liquidity taking orders, which would have necessitated “a very unique regulatory treatment, including exemptions from several different existing SEC rules and interpretations.”

Our Thoughts

As you can tell from the summaries, these three amicus briefs contain a level of detail that clearly displays that the petitioners understand the issue.  The briefs do an excellent job of letting the Court know how investors have been harmed by latency arbitrage and how the D-Limit order will protect investors and help increase market quality.

We thought it was even more powerful that one of the briefs was written by a sophisticated proprietary trader.  The XTX brief essentially says that even sophisticated proprietary traders can’t compete with the likes of Citadel. This means that the equity market has been losing diverse limit order participants who have contributed to price discovery. It also means that its likely that most prices are being set by large market makers who spend hundreds of millions of dollars to set up the fastest systems. These market makers will likely scoff at this and say “if you don’t like it, then spend the same amount of money and build your own system”.  But is that the answer? Does that help price discovery? Or, would we rather have a market where all different types of investors were encouraged to submit displayed orders which would likely tighten spreads?  Of course, if this happened then those wide spreads in non-S&P 500 stocks that market makers currently feast off of would likely start to tighten as would market maker profits.

We would like to thank Better Markets, XTX Markets and Healthy Markets for their thoughtful comments and we hope that the D.C. Circuit Court heeds their words and upholds the SEC decision to approve the D-Limit order.