Exchange Wars II: The Empire Strikes Back?

| About: Nasdaq Inc. (NDAQ)


Nasdaq has asked the SEC for a new order - to be known as the one-second rule.

The order is Nasdaq's new entry in the struggle to provide the slowest execution.

Is this order going to change the fortunes of Exchange Wars combatants?

Or is it just an angry jab at the SEC?

I'm tired of fast moves. I've got a slow groove

On my mind.

- The Pointer Sisters

New professionalism in the Exchange Wars? Is the new Nasdaq (NASDAQ:NDAQ) one-second rule a competitive move or is it more like a baby throwing a tantrum?

The good news for investors continues to roll in, following the SEC's decision to approve IEX's request for securities exchange designation. As most investors know, IEX became an exchange to thwart the use of the speed advantages that the other major US exchanges sell to high frequency traders (HFTs).

Is this evidence of a dividend paid to investors from competition between IEX and its publicly-traded exchange management firm competitors, or is it something else?

The IEX application included a "speed bump" - 20+ miles of fiber optics cable that stand between orders arriving at the exchange and the exchange's order book. The purpose of the speed bump is to prevent HFTs from lifting resting orders that seduce buy-side traders into submitting "hidden orders" or "pegs" at what appears to be the midpoint of the bid-offer spread. At the other exchanges, the HFT speed advantage permits the HFTs to lift their resting orders on the side of the market opposite the peg, leaving the buy-side trader's order to be filled at a loss. This practice is a high-speed version of the ancient practice of placing orders a trader has no intention of executing, known as "painting a picture" of market conditions.

This IEX move is a threat to the fee income charged to traders by the old line exchanges; fee income which today is the life blood of the exchange management firms.

To make a long story short, the other exchanges went ballistic over the IEX submission. In particular, Nasdaq threatened to sue the SEC for violating its own rules if the speed bump got the green light. Thus, it is a welcome development that, instead of raining negativity on IEX's parade, as opening day for exchange-trading at IEX rolls around, Nasdaq went positive, submitting a new order of its own.

Nasdaq proposes to create a different kind of slowness, a resting order that must remain in place. This slow limit order informs the exchange that, once placed, the order won't be pulled for at least a second. To you and me, a second is not a lot of time. But an HFT can place and lift an order more than 100 times in a second.

In response to the Nasdaq move, Gerald Lam, spokesman for IEX, said:

We're encouraged to see that IEX has finally inspired other exchanges to better serve investors and we look forward to seeing if any new products can neutralize the advantages they currently sell."


Or not. Could this be simply a Nasdaq move to tie the SEC in knots? A cynic might question the sincerity of this proposal. How would a cynic see this Nasdaq order?

There is unfinished business between the SEC and the old line exchanges. The SEC's sudden confrontation of HFT-friendly rules was unexpected and unwelcome.

Furthermore, a number of comments during the process of IEX approval, including IEX's comment, were not completely comfortable with the SEC's rationale for the decision. The attempt by the SEC to find a satisfactory definition of "at the same time" amounts to an SEC attempt to repeal the laws of physics. The SEC's National Market Order System requires that all orders be released "simultaneously." There is a fundamental problem with the meaning of the word. Orders traveling from my location cannot arrive at the same time as a simultaneous order traveling from yours. Similarly, a data feed traveling from the New York Stock Exchange to traders can depart NYSE "at the same time," but cannot arrive at my location at the same time as yours.

The IEX solution to protecting orders from HFTs did not include a concern about the SEC's self-created problem - a requirement that the exchanges obey the SEC's impossible goal that the exchange's market orders arrive at the same time for each customer.

The SEC approved IEX's application, which the force of public opinion had forced the SEC to do - thanks to Michael Lewis's best seller, "Flash Boys," publicizing the abuses of HFTs, and IEX's attempt to ameliorate the negative effects of HFTs on buy-side orders that HFTs routinely picked off.

But stubbornly, the SEC did not concede that the laws of physics make its principle of simultaneity obsolete. Instead it attempted to compromise with nature by saying IEX's 350 millisecond delay of order arrival at the IEX order book was "de minimis." In other words, the SEC proposed to redefine "at the same time" to include a delay of 350 milliseconds.

It was duly noted by everyone involved in this high-stakes debate that 350 milliseconds had been an arbitrary choice by IEX.

A cynic might see Nasdaq's one-second rule as a ploy to force the issue raised by the SEC's lame hope that the whole question would go away. There are two SEC issues created by the Nasdaq one-second order proposal.

  1. The SEC's definition of "protected order" is challenged. The SEC requires the orders that arrive at the order book first to be "protected." The meaning is that the first order arriving at the market bid or offer must be filled first. But the Nasdaq rule assigns value to an order's willingness to wait. If you are on the bid at 5, say, and my order to buy at 5 appears later, but I promise not to lift my offer for a second, my order jumps ahead of yours for execution.
  2. The SEC's term "de minimis," the questionable re-definition of "at the same time," is challenged. The Nasdaq one-second rule exposes the slippery slope upon which SEC stands by declaring 350 milliseconds to be de minimis. Is one second also de minimis? How about five seconds?

A cynic might think, while this new order may be "new," it is doubtless just the beginning of the pain that the old line exchanges are likely to inflict on the SEC in spite. The SEC will be twisted in knots trying to decide how to word rules that don't oppose this new order. What is more, the new order seems to be benign since no one will use it.

Why? The first thought that comes to mind is this: Any human trader would presumably grab the chance to use this rule to jump the order queue since it is physically impossible for humans not to wait one second to lift an order.

Yet, is it human traders that this rule will affect? Of course, not. This order is about the balance between the buy-side and the HFTs. Neither party is going to leave orders in place for one second. HFTs don't leave orders in place for one second, by the definition of HFT. On the buy-side, if I commit to leaving an order in place at IEX for one second, I give up the protection from the HFTs that the speed bump bought me. I am wide open to be picked off once again.

But IEX will not pull the SEC's fat out of the fire. It will simply not add this order to its list. IEX's management has shown an unusual, for the stock exchange crew generally, reticence to pick a pointless fight.

How does the SEC resolve this dilemma? It is a forlorn hope that the SEC can simply approve a new rule that confronts the contradictions to laws of physics that the National Market System creates. Not even if that rule will never be used. The SEC, when it approved IEX, tried to have its cake and eat it too, and whether now or later, the SEC will pay the price for this mistake.

The SEC did not do an effective job of confronting the problems with HFT that were exposed during Exchange Wars I. Somebody smart is going to need to provide assistance to the SEC for it to create "fairness" by government mandate. Or, the SEC could get really crazy and just drop the entire notion of a National Market System, allowing competition among exchanges and trader discretion in choice of trading venues to rule once more.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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