Pegged Orders

While searching for the Financial Post report of today’s block trades – couldn’t find it, by the way, I can only hope they’re still publishing it – I serendipituously came across an essay by Jeffrey MacIntosh, the Toronto Stock Exchange Professor of Capital Markets at the Faculty of Law, University of Toronto on Pegged Orders.

It really is excellent. As Dr. MacIntosh explains, fragmentation of the marketplace into many exchanges has resulted in order books that may not necessarily be showing the same bid and ask. Regulators require that orders be routed to the exchange that will give best execution, which in turn requires that all exchanges post their Best Bid and Offer to the National Best Bid and Offer book (NBBO).

A downside of having multiple marketplaces, however, is that only price, rather than price-time priority can effectively be enforced given existing technology. Herein lies the problem. Exploiting the absence of inter-market price-time priority, some trading venues have created order types that pose a danger to the virtual single market.

Some marketplaces, for example, have allowed their customers to enter “pegged” orders that adjust automatically to match the NBBO. These marketplaces then allow these orders to be executed ahead of identically priced orders that were previously posted on another marketplace

Dr. MacIntosh believes that Pegged Orders should be banned:

Allowing pegged orders to scoop the NBBO does more than create the impression of an unfair market. It allows traders using pegged orders to effectively remove their orders from the price discovery process. It also imprisons liquidity within a single marketplace, reducing the extent to which orders on different marketplaces interact. If my bid on Market A is the NBBO, for example, I would normally expect that a matching offer on Market B will be forwarded to Market A for execution. However, if Market B permits pegged orders, an inferior bid in Market B’s order book will jump the queue, leaving my order unexecuted. If this happens often, I will clearly think twice before lining Market A’s books — or any other market’s books — with orders.

This is simply because pegged orders reduce the returns to posting limit orders. This constitutes a direct assault on what makes stock exchanges tick. Those who post limit orders are liquidity makers, since they offer other traders the opportunity to trade at the posted price. Those who hit these orders are liquidity “takers.” Since liquidity is a valuable commodity, a limit order thus has an “option” value to all potential traders. It is for this reason that most modern stock trading venues actually pay traders to post limit orders, charging only the “active” side on any trade that results.

Liquidity makers and liquidity takers exist because traders and trading strategies are heterogeneous. One cannot exist without the other. Harming the interests of one harms the interests of both.

I’m of two minds about this. Assiduous Readers will know already what my instincts are: NO MORE BLOODY RULES! Let better traders make lots of money at the expense of those who aren’t so good. However, his point that retail might take their money and go home if they perceive that the market is unfair is certainly a valid concern.

However, is banning really the answer? Pegged Orders represent a simple-minded trading strategy – and there is nothing a trader (particularly a bond trader) likes better than exploiting the inefficiency of a simple-minded trading strategy.

Say, for instance, I’m attempting to sell some XYZ, a thinly traded stock with a wide bid-offer spread, and I see that there are a boatload of Pegged Orders on the bid. I should then be able to cackle with glee and put in a bid very close to the offer on some off-beat exchange for, say, 100 shares. All the pegged orders will move up to match my price within microseconds, I’ll hit them within microseconds and cancel my bid within microseconds. Total time to set up algorithmic trading routine: five minutes. Execution time: Less than 1 second. Profits: enormous.

I am not an expert on the intricacies of order regulation and I suspect I could get into a lot of trouble for doing this, with regulators whining that my one-second bid wasn’t honest enough. That, however, is part of my point. In their attempts to change the shark tank into a wading pool, regulators are forced to create more and more intricate layers of rules, which ultimately serve no purpose other than reducing the penalties for incompetent trading, getting honest traders into trouble if they forget subparagraph 14(a)(ii)(7)(z)(b) and, of course, providing steady employment for regulators.

Update: Pegged Orders have been allowed on NASDAQ since 2003, but the question of inter-market time priority is not addressed in the linked document. Dr. McIntosh’s full article was republished on the UofT Faculty of Law Blog.

8 Responses to “Pegged Orders”

  1. beluga says:

    Wouldn’t the peg orders have limits? I doubt they can move up unbounded to whatever people are bidding.

  2. bitey says:

    I think time priority for trades is a major problem in the Canadian equity markets. I have had two limit trades in the past four months where other trades have jumped the queue. This forces me to either place market orders based on the bid/ask and volume at the time or look for alternative investments where the game is not rigged. I am doing both.

    Don’t worry about regulation to control time priority issues. A regulator has to understand the issue before they can create rules to control it.

  3. jiHymas says:

    Wouldn’t the peg orders have limits?

    The NASDAQ version of a Pegged Order can be set with a limit; I can’t say for sure whether any of the ATS versions have the same thing, but it seems probable.

    I have had two limit trades in the past four months where other trades have jumped the queue.

    I can think of two situations where this can occur on the Toronto Exchange:
    (i) Internal cross by a different dealer. Most (if not all) dealers have trade matching software whereby a client market order will be matched with another client’s limit order and presented to the exchange as a cross. A previously input limit order at the same price from another dealer will get jumped in the process.
    (ii) Market Maker Participation: Market Makers can elect to participate in trades at the BBO up to, I think, 40%. Thus, if you’re alone on the bid for 500 shares and a limit sell comes along for 500 shares, you might find that only 300 get filled; the Market Maker scoops 200.

  4. bitey says:

    What I read from the professors article and confirmed by TD is that an ATS is obligated to only ensure the order is visible by price not time. Therefore what you can get is traders front running visible limit trades by using a differrent ATS. Also, the article implies that if the brokerage can internally cross the trade they will do so without the bid/ask even making it to a NBBO. If this practice continues, I think you will end up with the majority of trades taking place off a centralized exchange. This can easily lead to an easily manipulated “straw man” market.

  5. jiHymas says:

    Therefore what you can get is traders front running visible limit trades

    I’m not sure what you mean by front-running. I understand front-running to involve holding back an agency market order for the purpose of executing principal trades on the same side of the market prior to placing it. This violates the agent’s duties to the customer.

    This can easily lead to an easily manipulated “straw man” market.

    This may surprise you, but (subject to some limits!) I don’t have a major problem with that. I will sell stuff that’s manipulated to be expensive and buy stuff that’s manipulated to be cheap, outperform and make a lot of money for my clients.

    I have thought of good reason – consistent with Dr. McIntosh’s objectives – for retaining pegged orders: they provide the market maker with a lot of leverage.

    Say the extant bid/ask spread is $0.50, with 10,000 shares of pegged bids. A market maker can then place a bid for 100 shares $0.10 below the offer, the pegged bids will follow, and the market maker has levered up his 100 shares of exposure into 10,000 shares of liquidity.

  6. […] fascinating fields of research in the financial sector is market design. I’ve posted about Pegged Orders, proposed regulation of the retail bond market and the BoC’s analysis of bond auction […]

  7. […] an essay by Jeffrey MacIntosh of the UofT Faculty of Law (and a director of Pure Trading) on Pegged Orders. Canadian regulation could be improved by the endowment of professorships at the universities who […]

  8. […] Orders were first discussed on PrefBlog in a review of Jeffrey MacIntosh’s essay in the Financial Post. A discussion paper published by IIROC, Dark Pools, Dark Orders, and other Developments in Market […]

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