Increased voluntary disclosure on the horizon?

This past week, Reuters featured a piece about “retail brokers avoiding the regulators’ wrath and increasing disclosure”.  The announcement came in the midst of current SEC and FINRA investigations into broker dealer conflicts of interest and failure to deliver Best Execution on customer orders. The retail brokers, in conjunction with the Financial Information Forum, have been working to create standard uniform metrics, based largely off of SEC Rule 605, that will allow customers and prospective customers to compare execution metrics “apples to apples,” from one retail provider to the next. As part of the voluntary disclosures, brokers working through the FIF will publish information on their websites that details Enhanced liquidity, Price Improvement and average savings per order from 1-2,000 shares in S&P and non S&P stocks. The program is expected to kick off by mid year. Reform Rules 605 and 606

We applaud the firm’s efforts with some restraint. For the first time, information will be available on a 605 style basis for retail brokers rather than exclusively for internalizing firms such as KCG or Citadel. While any increased transparency is great, this information will provide only a partial view. The program will completely exclude limit orders which today comprise a significant portion of a firm’s order-flow.  Additionally, the program will provide information about the most vanilla of orders and will exclude stop orders, orders at the close or open, and the increasingly popular contingent orders.

Worse yet, the information will be based on dated Rule 605 information which is in dire need of modernization and expansion. We’ve been pushing hard through Healthy Markets to modernize Rule 605 and Rule 606. Thus, we were encouraged to see Bats Global markets seeking similar reforms in their market structure petition with the SEC. Modernizing Rule 605 and 606 is low hanging fruit for the SEC. The majority of infrastructure exists today to facilitate this undertaking and there has been little pushback on the matter.

Regulatory pressure can change behavior

The latest SEC 606 statistics for the fourth quarter of 2014 were just released on the 31st and we analyzed the latest metrics among the largest retail brokers. The move to disclose more and increased regulatory pressure is making an impact on Payment for Order-Flow, as it is in our sample universe, where payments for order-flow declined by as much as 22% for some brokers in the fourth quarter of 2014 compared to the previous quarter. This is, no doubt, window dressing to divert payment monies to price improvement instead, which shows regulatory rule-making is not always required to prompt behavioral changes in the market.  Imagine how much better execution quality might be if Rules 605 and 606 were modernized with proper regulatory balance.

Top 10 Market Structure headlines in 2014: A year in review & predictions for 2015

2014 will go down in history as an inflection point for market structure. The year’s headlines  signal the approach of momentous changes in the months ahead. Before we leap headlong into 2015, let’s take a look back, in no particular order, at the 10 biggest market structure events of the past year:

1.       Flash Boys – Ask any industry veteran and they’ll tell you that the single most pivotal moment of 2014 came on March 31, the day Michael Lewis published Flash Boys: A Wall Street Revolt. Initially, industry insiders perceived the book as a flash in the pan (pun intended) and believed that it would be summarily dismissed by the public. To the contrary, the book served as a constant catalyst in 2014 for public discourse and a growing quorum for change.

2.       Lewis/Katsuyama/O’Brien CNBC Interview – Undoubtedly one of the most watched and most heated segments on CNBC in years, this television encounter ultimately forced O’Brien to correct his own misstatements and make an abrupt departure from Direct Edge.

3.       FINRA ATS disclosure – What began when Credit Suisse announced that they would cease publishing their Dark Pool volumes (a move that rankled both FINRA and the SEC), ultimately climaxed with FINRA’s ATS disclosure of ATS volumes.

4.       Mary Jo White Speech – One of the most pivotal speeches by any SEC Chair in recent history, White’s June 5th speech at the Sandler O’Neill Brokerage Conference was a landmark address. White broke new ground for the Commission by calling for the creation of a market structure advisory committee and a comprehensive, data-driven review of equity market structure.

5.       Levin Hearing – On June 17th, the Permanent Subcommittee on Investigations, chaired by Senator Carl Levin (D-MI) and Senator John McCain (R-AZ) as ranking member, grilled firms on inherent conflicts of interest, payment for order-flow and Best Execution in the market. The hearing also considered the impact such conflicts have on consumer confidence.

6.       Schneiderman Attacks Dark Pools – Hopping on the Flash Boys bandwagon in 2014 was New York State Attorney General Eric Schneiderman, who filed a lawsuit against Barclays on June 25th for falsely marketing the extent of HFT activity in its Dark Pool, LX. And while the suit lives on into 2015, the fallout thus far has been consolidation and closure, with Wells Fargo shuttering its dark pool and Citi announcing plans to close its ECN LavaFlow.

7.       Tick Size Pilot – Congressional pressure from the JOBS Act spawned the SEC sponsored experiment to draw more investors into trading smaller companies. The program seeks to expand the minimum tick size for certain small-company stocks to 5 cents and contains controversial subjects such as a “Trade-at” provision (See: KOR Comments on Tick Pilot).

8.       Adoption of Reg SCI – Regulation Systems Compliance and Integrity, or Reg SCI, was borne out of the aftermath of the Aug. 2, 2013 KCG trading fiasco. Designed to better insulate the market against technical failures, Reg SCI received unanimous approval in November. While the rule seeks to deter market infractions, it is interesting to note that KCG, which sparked the genesis of the rule, will be exempt from most aspects of it.

9.       SEC fines NYSE for data distribution – On Sep 14th, the SEC announced the first ever fine against an exchange operator for Improper Distribution of Market Data. NYSE agreed to a $5 million dollar penalty and to undertake significant reforms to settle the SEC’s charges that it provided improper early access to market data.

10.   ALS Ice Bucket Challenges – One part challenge, one part charity, the ALS Ice Bucket campaign swept the industry, clogging Twitter and Facebook feeds over the summer of 2014 and boasting the participation of notable industry veterans such as Joe Ratterman (Bats Global Markets), Gary Katz (ISE), Terry Duffy (CME), Mike Cahill (OCC), Remco Lenterman (IMC), Rich Repetto (Sandler O’Neill), Daniel Coleman (KCG) and many more.

 Volume Recap – Equities

2014 saw modest growth in equity volume, which rose 3% by year’s end.  Internalized volumes averaged 36% in 2014.

 2014 Equity volume

Volume Recap – Options

2014 Options Volume

OCC cleared contract volume reached 4,333,019,384 contracts in 2014, representing a 4% increase from the 2013 volume of 4,170,855,768 contracts. 2014 marks the second highest year for OCC cleared contract volume to date behind 2011's record volume of 4.6 billion contracts.


Predictions for 2015

While 2014 served to spark debate, 2015 will signify change and rollback.  Here are a few of our predictions:

1.       Rolling back Dodd-Frank – With Republicans taking over the Senate and retaining control of the House, Dodd-Frank rollback is likely and already underway. While we don’t see a full rollback, we do expect regulators to peel back some of the Swap rules and continue their push to water down certain aspects of the rule.

2.       Tick Pilot – The SEC is under tremendous pressure from Congress to roll out the Tick Pilot and with the comment period for the published rule having ended in December of 2014, we’ll see a finalized version of the rule in 2015, albeit a scaled back version.

3.       Continued ATS demise – Given increased scrutiny, the ATS consolidation and closure trend will likely continue into 2015.

4.       Best Execution – With FINRA and SEC investigations into Best Execution, we will see fines and censures on Best Execution for the first time in 6 years.

5.       Reduced Access Fees and scaling back Maker Taker – The announcement of ICE’s Grand Bargain and a BATS reform calling for lower access fees (see "A Grand Bargin, Not so fast") will both very likely come into play in 2015.

6.       IEX Exchange Application – 2015 could well be the year the Upstart ATS files to become an exchange operator.

7.       Sale of the NYSE – This is a very real possibility and could happen as early as this year.

8.       Proposed Trade-At in Active securities – In conjunction with a reduction in Maker Taker fees, there is high probability that the SEC may propose a “Trade-at” test in a handful of actively traded stocks.

9.       605/606 reform – Low hanging fruit for the SEC, we expect that reform of order disclosure rules 605 and 606 will be proposed in 2015 (See KOR 605/606 reform comments).

10.   HFT – HFT will be further defined in 2015. Likewise, definitions of what liquidity provisioning is will become clearer this year. We also anticipate increased disclosure from ATS operators.

A Grand Bargain? Not So Fast...

A Grand Bargain? Not So Fast… The news that the ICE and Credit Suisse reached agreement on a so-called “Grand Bargain” caught the attention of market structure observers this week. It would have been hard to miss it, of course, as the two firms have undertaken a major marketing and media push to promote it. At first glance, one might think that KOR and Healthy Markets would be strongly behind this effort, as it calls attention to the primary issues comprising our platform:

  1. Market data feed reform with a focus on fairness, consistency and clarity;
  2. Greater transparency for ATSs;
  3. Elimination of the maker-taker pricing model; and
  4. The implementation of a trade-at rule.

While it is clear why the ICE would support such a set of changes, it is, at first, much less clear why Credit Suisse would do so. Upon closer examination, it actually seems that neither firm is sacrificing anything here, and that the term “Grand Bargain” is nothing more than marketing mumbo-jumbo.

Before delving into this, let’s first examine the substance of the proposed reforms, as they appear to come directly from the Healthy Markets Platform. While we certainly appreciate the apparent intent, we have some significant concerns as to details and specifics, primarily because there are so few outlined in this proposal.

While it is great to talk about “market data feed reform,” we must remind ourselves that, in this case, said reform is coming from an exchange that, in addition to being a conflicted market data operator, continues to use the SIP feed to calculate the NBBO. This disadvantages many participants using order types that rely on this price (such as midpoint peg orders). We are hesitant to trust that ICE/NYSE are fully adopting the Healthy Markets proposals for market data feed reform, particularly when they continue to be negligent in how they treat orders entrusted to them.

This issue is further exacerbated by their September 1st fee change that specifically targeted ATSs and broker crossing networks. In that filing, NYSE increased the maximum cost for these venues to receive proprietary market data (quotes and trades) from $7,000 to $27,000, per-month. This is an explicit move to increase the burden on brokers to do the right thing, and match customer orders using direct feeds (and the most recent prices), rather than the SIP. The ICE/NYSE needs to explain their hostility toward the use of direct market data feeds to price the NBBO when matching orders.

The next item in their proposal is increased transparency for ATSs. This is like Grandma and apple pie – good luck finding somebody who would disagree with such a proposal. The devil is, of course, in the details. There are few that would disagree with the ICE proposal, but it does not appear to go far enough.

The elimination of the maker-taker business model is an important step in the right direction, and we fully support this effort. However, we are adamantly opposed to government price controls, and view the access fee cap as that. The elimination of rebates should remove the need for an access fee cap. Competition should be allowed to find the appropriate equilibrium, provided the incentives for executing trades on-exchange are sufficient and appropriate. Access fees will drop significantly once rebates are eliminated.

This brings us to the final recommendation – the implementation of a trade-at rule. You would think that there would be a huge party in the Healthy Markets offices when a major exchange and broker/dealer stand up and argue for eliminating maker/taker and implementing a trade-at rule. We have been passionately advocating for these positions in various forms for the past 2½ years. The tick size pilot proposal was an eye-opening experience for us though, and our comment letter is forthcoming. In that proposal, the SROs clearly demonstrated that they cannot be entrusted with the design of new market structure rules, and certainly cannot be allowed to write a trade-at rule. Instead of attempting to simplify market structure, their trade-at proposal was simply more of Reg NMS layered on top of the existing NMS structure.

The trade-at proposal that the SROs agreed to is an absurd example of what happens when you allow for-profit firms with perverse incentives to design regulation. It simply does not work, and opens the door for extreme unintended consequences.

While we fully support a trade-at rule, such a rule cannot exempt retail orders and must be simple. It must reexamine the need for Reg NMS restrictions within the context of the new market environment that would be created. And it must take into account technology and routing advances that did not exist in 2005 when Reg NMS was written. The rule written by the SROs in the pilot proposal does none of this.

So the substance of this so-called “Grand Bargain” is questionable, but it must be laudable that you have firms coming together from different parts of the industry to compromise and sacrifice for the greater good of the market and the public….right? Right?!

Isn’t that the whole point behind the Healthy Markets Initiative?

Of course it is, but here we question whether either firm is giving up anything. We further question the sincerity of the proposed regulatory changes – are these firms really ready to push for substantial changes to Reg ATS, Reg NMS and possibly even the Acts of 1933 and 1934? Are they ready to withstand the fight from the other side on this issue?

The ICE certainly is not giving up anything with this so-called “Bargain.” They currently earn the spread between the rebate and the take fee, which is hard to quantify because of fee tiers, but is probably somewhere around 7 – 10 mils. Moving to 5 mils per side (10 mils total per trade) would actually represent an increase in per-trade revenue (or at the very least would not be a decrease). The addition of trade-at would mean far more volume going to the exchange, so this would be a bonanza for the NYSE and their new owners.

In fact, consider this – ICE/NYSE has a history of raising broker fees for market data and derives the largest part of their revenue from market data fees and technology sales. Once these changes come in, they could easily drive ATSs out of business, and then open the door for ICE/NYSE to continue this pattern of driving up the cost to receive market data and to use their technology. Once again, the devil is in the details as to whether their supposed “market data feed” reforms would address any of these issues.

If the ICE is reaping such rewards, surely Credit Suisse is making a grand, selfless gesture by accepting trade-at, and most likely the end of the Crossfinder Dark Pool….right?

At the surface, this appears to be a reasonable reaction, but in this industry (and in general) we should always question why a firm would do something that negatively impacts its bottom line.

It is well understood that there is tremendous regulatory and enforcement scrutiny of ATSs by any government agency that has any kind of jurisdiction. This, along with the increased cost of operating an ATS (thanks to market data fee increases and Reg SCI) portend the end of the dark pool landscape as we know it. Perhaps Credit Suisse has already accepted the inevitable, eventual close of Crossfinder and is merely holding its pool as a chip for a future settlement with enforcement authorities.

Such a move would make sense, especially with the consideration that Credit Suisse also operates an ECN, LightPool. This ECN is laughably marketed as a buyside venue, despite an average trade size (147 shares) far below the industry average (204 shares on ATSs) and even below Crossfinder (175 shares). LightPool will be the big beneficiary here, when CS simply redirects the order flow that was previously flowing to Crossfinder. If Credit Suisse was holding this out as part of a settlement with enforcement authorities, this should be disclosed immediately. Credit Suisse’s support is being hailed as a major sacrifice (or “Bargain”) and clear vindication that regulators should push forward. But this may be a disingenuous maneuver. It may simply be that Credit Suisse has decided to close Crossfinder and has figured out a fantastic way of marketing the event.

It is important to understand that Healthy Markets agrees wholeheartedly with the principles behind these proposals, as we have made clear with our platform and advocacy work. We further believe that a coalition of industry firms is the only way to push these changes. That being said, the substance of these changes is as important as the credibility of the firms advocating them, and we question both in this case.

FINRA Announces Several Initiatives Aimed at Dark and HFT Trading

FINRA announces several initiatives aimed at Dark and HFT trading September 26, 2014

Like us at the KOR Group, many in the industry were awaiting the outcome of FINRA’s rulemaking initiatives following the September 19th meeting where the FINRA board considered a swath of rule proposals seeking to heighten the oversight of off-exchange and HFT trading and transparency. As expected, the FINRA board approved the several items specific to the equity markets, but what do they mean for the industry? Let’s have a closer look:

Expansion of ATS Transparency – FINRA seeks to further expand the ATS transparency initiative and will be proposing a requirement to require reporting of non-ATS OTC trades or internalized trades by the internalizing firm through their market participant identification (MPID).  Additionally, FINRA will be rolling out quarterly volume reporting, fee free in a machine readable format which is a welcome addition as FINRA currently charges as much as $18,000 per year for the data.

Supervision of Algorithmic Trading Strategies – FINRA plans additional guidance surrounding effective controls and practices to monitor for and prevent potential adverse impacts to the market, but Firms are already subject to oversight and supervision through FINRA Rule 3130 which requires member firms to have a supervisory control process and annual certification of compliance by the firms CEO.  Will added guidance improve market stability?  Highly unlikely as today firms covet their proprietary strategies and take great care with the implementation of these strategies in the market as doing otherwise generally comes at great cost.  Guidance is good; let’s hope FINRA’s guidance does not become an administrative burden and turns into a device for issuing fines rather than to promote best practices.

Clock Synchronization– Currently, firms are required to synchronize their computer systems for drift to a 1-second standard, which presents significant issues for regulators attempting to perform advanced surveillance, participants trying to make sense of data with uncorrelated timestamps, and participants and third-party firms attempting to measure execution quality. This is compounded by the fact that many firms still are coding to a 1-second interval when reporting to FINRA, though they are most likely not doing so internally. FINRA’s proposal will seek to reduce the current allowable drift to 50-200 milliseconds. KOR’s opinion on clock synchronization is strong and has been consistently publicly stated. FINRA’s change here seems like little more than lip service.

Nearly every firm in the industry uses the NTP protocol to synchronize their clocks, which achieves an accuracy measured in tens of milliseconds over the public internet and 1-2 milliseconds over a LAN or in a datacenter – FINRA’s stipulation here will have no effect on the broad majority of the industry. We believe they are doing this with that understanding in mind, in order to claim they are making progress while doing nothing substantive in reality.

For firms that must synchronize clocks over the public internet, KOR believes a 10-20ms drift is reasonable, and achievable with absolutely no additional cost or configuration. For any firm with servers co-located in a datacenter, the standard should be 1-2ms. Exchanges and SROs should be required to use specialized hardware to synchronize their clocks to 1us (microsecond). Either FINRA is so far behind the times that it is unaware of current clock synchronization capabilities and accuracy or it is deliberately doing as little as possible.

Registration of Associated Persons Involved in the Preparation of Algorithmic Strategies – FINRA will seek to require registration of individuals wo are primarily responsible for the design, development or for directing modifications of an algorithmic strategy or have responsibilities for supervising such functions. Registration is not a significant cost burden and doing so aids regulators in better understanding the firm personnel involved in running trading operations as the industry evolves.

These are a few of the bigger steps which FINRA plans to undertake over the coming months as they crack down on ATS and HFT trading. The expansion of ATS transparency is a fantastic step in the right direction and we applaud them for that. KOR urges FINRA to continue down this path, and to require quote consolidators to start reporting trade location for any trades being printed to a trade reporting facility. We also believe that transparency around Form ATS and additional details around order types, fee structures, participants and segmentation should be made available for all ATSs.



KOR Group to visit with Congressional and Regulatory Stakeholders

On September 17th & 18th, Chris Nagy & Dave Lauer will be meeting with Congressional staff and the Securities and Exchange Commission to discuss various market-structure related issues, including:

  • Modernizing SEC Rules 605 & 606 including adding metrics to the Options and OTC markets.
  • SEC proposed regulation S7-22-08
  • Best Execution
  • Release No. 34-72460 (Plan to Implement at Tick Size Pilot Program)
  • Healthy Markets

A full recap of the discussions will be available to KOR Group members.

What does IEX’s upcoming exchange application mean for market-structure?

On September 3rd, IEX announced that they had raised $75 million in funding to continue their rapid growth and, more importantly, to pursue registration as a U.S. exchange. But with IEX’s differentiated offering, what does this mean for market structure? There has been quite a bit of fracas in the twittersphere and among industry participants and analysts regarding IEX’s “unique” price/broker/time priority matching logic versus the price/time priority logic commonly found on existing U.S. Exchanges.

Is IEX’s priority logic unique?  Actually, not really. Broker preferencing has long been an established regime in Canadian markets. Not too long ago, preferencing also had its place in U.S. market-structure. Indeed, some readers may recall this preferencing on the Cincinnati “CSE” and Boston Stock Exchanges “BSE,” both with roots dating back to the late 70’s. Both the CSE and BSE exchanges had SEC approved rules permitting preferencing similar to that of the current IEX model. In those days, preferencing was an important component of the market, allowing the smaller regional exchanges to compete with larger exchanges.

With regional volumes growing, Congress requested, in 1996, that the SEC conduct a study on the practice of preferencing. The study found that preferencing did not have a deleterious effect on the national market system and that, to the contrary, market quality for preferencing exchanges is at least as good as that of other regional exchanges, and in some cases, better. Moreover, the SEC found that preferencing furthered the ability of CSE and BSE to compete in the national market system and that preferencing is not inconsistent with the best execution of customer orders. Both CSE and BSE were absorbed in the past decade and their models no longer exist, however variations of them do.

Nasdaq OMX PSX has approved rules that provide for a 40% allocation under the Price Setter Pro Rata priority structure. NYSE, in 2011, introduced the Retail Liquidity Program “RPI” that was later adopted by other exchanges. RPI preferences one class of participants over another for a small and typically insignificant amount of price improvement, thus subverting the price/time priority model which is much like the notion of customer priority contained within the options markets. The question many keep asking is, ‘will the SEC approve IEX’s price/broker/time model?’ Given current market structure and past history, it would be difficult to envision the SEC not approving IEX’s model.

What of other market structure issues? Notably, with IEX’s technology, matching engine updates are delayed for 350 microseconds. This begs the question, would IEX qualify as an automated market under Regulation NMS? Regulation NMS differentiates market centers based on manual or automated quotations. A manual quotation is one that is considered not immediately and automatically accessible and which does not receive protection against trade-throughs. On the other hand, an automated market center must, by definition, offer IOC functionality (which IEX does), and must also provide for automatic, immediate, ”no human discretion” in responding to the order. The SEC defines “immediate” as the fastest response possible without any programmed delay. In the case of IEX, there is no programmed delay, just a coil of fiber. Further, the SEC defines a material delay as a market center failing to respond to orders within a one-second time frame. IEX is not programmed to create a delay; rather the response time is merely a result of the coiled cable inside the “magic shoebox” to get to the matching engine where all participants are afforded equal access. This is, in many aspects, no different from a co-location center equally measuring connectivity cable to matching engines. In this regard, IEX would qualify as an automated market center under Reg NMS.

Finally, exchanges receive revenue from market data collected by the Consolidated Tape Authority and Unlisted Trading Privilege plans. Each exchange (SRO) is a participant in the plan and receives credits based on their quotes and trades. In order to collect a quote credit, an exchange must display a quotation for a minimum of one full second. Prior to Reg NMS, market data was paid to exchanges solely based on trading activity. This gave rise to the unintended consequence of tape shredding whereby a larger order would be broken down into smaller component trades to garner a larger share of revenue. The revised NMS formula sought to end tape shredding and to allocate revenues to those exchanges that benefit investors by contributing useful quotations to the consolidated data stream. With its proposed model, there is a high likelihood that IEX will be able to garner additional revenue through longer maximum quote life versus other exchanges.

Without a doubt, there are many sides to each of the issues posed above. There is, however, one item that will not draw much contention and perhaps this is the most important one. At present, the SEC and FINRA prohibit IEX from utilizing their full name, “Investors Exchange.” Attaining exchange status would allow unfettered use of the full name.

Healthy Markets Presentation at the KDD 2014 conference

August 24th, 2014 KOR Group's Director of Research Rajarshi Das, presented the Healthy Markets platform at the KDD 2014 "Data Science for Social Good" conference in NY.  KDD 2014, a premier interdisciplinary conference, brings together over 2,200 researchers and practitioners from data science, data mining, knowledge discovery, large-scale data analytics, and big data. KDD 2014 features 5 keynotes, 151 Research Track papers, 44 Industry & Government Track papers and 8 invited talks12 tutorials25 workshops including the KDD Cup challenge, theBroadening Participation in Data Mining program, and more.  Visit KDD 2014 to see more:

Healthy Markets Presentation:


Delving into Disclosure: An examination into routing trends

When we examine order routing disclosures and market quality under rules 605 and 606 on a quarterly basis alone, meaningful data points are a rarity. However, when we piece together quarterly and monthly statistics, a much clearer picture begins to emerge. At KOR Group, we compile 605 and 606 statistics that enable users to visualize data points in a multitude of ways.  This lets the user examine or challenge assumptions about market quality. 

With Q2 2014 Rule 606 data now available, we set out to examine routing behavior over the last quarter. We should note that the second quarter of 2014 has been an eventful one in terms of Market Structure-related events.  The quarter kicked off with the Michael Lewis bestseller Flash Boys, which marked a new level of public visibility for Market Structure issues.  What followed was Intensified media attention on market regulation and SEC Commissioner Mary Jo White’s groundbreaking speech on the subject. The focus continued with a series of House and Senate hearings examining everything from conflicts of interest to High Frequency Trading.  Finally, New York Attorney General Eric Schneiderman has inundated us with high-profile investigations on Dark Pools.

With so much scrutiny surrounding routing, Maker-Taker and Payments for Order Flows, we at the KOR Group were certain there would be heightened awareness of routing and payment issues. However, as we delved into the statistics and compared them to previous quarters, we actually found that quite the opposite was true. There has been little if any change in immediate behavior. While Barclays’ LX Dark Pool volumes fell nearly 80% since Schneiderman announced his suit against the operator, these lost volumes were an isolated incident.

Observation 1 – Direct Edge

Direct Edge X offers some of the highest maker fees by any exchange. The base rate for adding liquidity starts at .002 [Rates] and the schedule is complex and exhaustive. However, certain firms can earn up to .0035. In order to earn the “Mega Tier 1” of .0035, a firm must route at least 4m shares adding liquidity prior to 9:30am EST and after 4:00pm EST and add a minimum of 35M shares during market hours (39M shares daily).  A firm that meets these exact requirements would earn $2.8m monthly (21 trading days) as a result. A firm just missing the Mega Tier 1 would fall under the “Mega Tier 2” designation and would receive a payment of next lowest tier drops to .0032 (8% lower).  A firm routing 34M shares during market hours would forgo $300,000 in added revenue by missing the higher tier. Clearly, these tiers are designed carefully to captivate the bulk of a firm’s added order-flow.  Virtually all exchanges and Alternative Trading Systems operate in a similar manner.

As volumes began to drop off heading into summer, the 606 statistics illustrated that the firms we monitor, which comprise the bulk of 606 reporting, increased routing to Direct Edge X by an average of 270bp from the prior quarter.

Direct Edge has also been the subject of significant media attention this quarter, including a CNBC interview with Lewis & Katsuyama, a subsequent correction of statements regarding their matching engine, and a Senate hearing which questioned routing practices and limit order routing to Direct Edge. The hearing included testimony from Robert Battalio, who discussed the details of his recent study on limit routing.

Then there was the press release from BATS announcing the immediate departure of President William O’Brien. Any Best Execution committee addressing the issue of limit order routing should have accounted for all of these events. However, 606 and 605 data suggest that none of this news had an impact on routing during the quarter. This may imply that conflicts of interest are still not being properly disclosed or managed.

The chart below shows how routing has increased across many major retail brokers from Q1 to Q2 for NYSE-listed names - the same is true for Nasdaq-listed names as well.

2014 routing to DE - NYSE

Observation 2 – Routing to NOM (Nasdaq Options Market)

We also found it interesting, in reviewing the quarter’s 606 statistics, that there was an increase of routing added option orders to NOM. In our 606 group, routing increased by a whopping 475bp as compared to the prior quarter. Interestingly, there was only one firm in our peer group, Interactive Brokers, that reduced routing to NOM by 70bp.

NOM is a Maker-Taker options venue that boasts some of the highest rebates for adding liquidity of any options market. Large participants can garner as much as $0.50 per contract in rebate through NOM routing. How does NOM stack up on Best Execution?  This question is difficult if not impossible to answer as there is no 605 Data available to examine. This is true in spite of a movement created by SIFMA to bring qualitative reporting to options. Though this information is available on other options exchanges like BOX and ISE, a search for the data on NOM is only met with a “404 page not found.”  The obvious question, then, is how are brokers assessing Best Execution when routing to NOM.  Indeed, many of the traditional options exchanges such as the CBOE, AMEX and PHLX offer customer priority rules which state that any customer order will go to the front of the order queue behind a professional specialist order. As a pure “time-price-priority” exchange, NOM has no such provision. 

We do believe that disclosure helps with transparency and behavior in the market, but today those disclosures are limited and require a considerable amount of “reading the tea leaves” to ascertain data-driven results.  Improved disclosure could serve as an excellent arbitrator to dispel fact from fiction.

The chart below shows how three major options brokers route their orders, and has points showing the maximum make rebate they can earn and take fee they would have to pay. There are cases in which there is only one point for a market - in that case the rebate and fee in the highest tier is the same.

Routing and Rebates

This is a small sample of the level of analysis that KOR Members are able to perform with our web-based data visualization tools. They also receive monthly reports with full commentary and analysis on important industry, regulatory and Congressional developments regarding market structure. We encourage you to join today and realize the full benefits of KOR membership!

606 Routing Q2 2014


Broker Routing Conflicts: Payments and Best Execution

The US Senate’s Permanent Subcommittee on Investigations was introduced to me two years ago as “the most powerful Committee that nobody’s ever heard of.” Today that Subcommittee, which is part of the Homeland Security and Government Affairs Committee is convening a hearing to examine conflicts-of-interest inherent in various forms of compensation for order flow, whether that be Payment for Order Flow (primarily used by retail brokers to divert orders to wholesalers / internalizers) or the Maker-Taker business model employed by the overwhelming majority of stock exchanges. KOR Group has long advocated for a trade-at rule and a pilot eliminating rebates, and both of these issues are focal points of the Healthy Markets Initiative. Healthy Markets brings together various participants in the industry to advocate for a common set of goals and beliefs.

We’re also excited to roll-out a new feature on our website that helps the public understand how brokers are routing their orders. This is a Sankey Flow Diagram, and it shows how various brokers route orders. For example, here is an illustration of 3 brokers – E*Trade, TD Ameritrade and Interactive Brokers. E*Trade and TD Ameritrade accept Payment For Order Flow – high-frequency internalization firms pay the brokers to send all marketable orders to them so they can be traded against proprietarily. Interactive Brokers does not accept any payments. These diagrams show a dramatic, and intuitive, difference. All order flow from E*Trade and TD Ameritrade is routed to high-frequency internalization firms, while Interactive Brokers orders are routed directly to stock exchanges over 90% of the time.


Here’s another chart that shows Schwab’s routing practices. For a firm that believes that HFT “is a growing cancer that needs to be addressed,” they have a long-standing contract in place with UBS in which they route 95% of their customer’s orders to UBS’s high-frequency trading group.


Comparing PFOF routing practices from E*Trade, TD Ameritrade and Schwab to the non-PFOF routing practices of Interactive Brokers begs the question – how can all of them be meeting their Best Execution obligations to their customers? In today’s Senate hearing, Professor Robert Battalio from Notre Dame will spend time discussing his research on this exact subject. His paper, “Can Brokers Have It All?” calls into question discount broker routing practices for non-marketable limit orders by showing that while brokers favor venues that give them the highest payments for their order flow (rebates in the Maker-Taker model), those same venues have inferior execution quality compared to venues that do not provide such levels of payments.

The same may be true when comparing routing practices for marketable orders. While KOR and Healthy Markets believe that the market and the price discovery process is damaged by the practice of internalization, it may also be true that by inhibiting competition with backroom, off-the-record handshake payment deals for retail order flow, discount brokers are not getting the best execution possible for their customers. This may also be why these same brokers refuse to make their data available for independent analysis and study.

June 17-18 - KOR Group to visit with Congressional and Regulatory Stakeholders

On June 17th & 18th, Chris Nagy & Dave Lauer will be attending the PSI hearing followed by meetings with Congressional and Regulatory stakeholders to discuss various market-structure related issues, including:

  • The need to modernize SEC Rules 605 & 606
  • H.R. 3448 "Small Cap Liquidity Reform Act of 2013
  • "Trade-at" and the maker-taker model
  • Transparency of data

Link to the PSI Hearing:

A full recap of the discussions will be available to KOR Group members.  KOR Group will also be tweeting the PSI hearing live so please be sure to follow us on twitter.