PrefBlog

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.

This entry was posted on Saturday, May 2nd, 2009 at 12:39 am and is filed under Interesting External Papers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.