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.
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.
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!