January 30, 2006

From the Jan-Feb 2006 issue of Advanced Trading

Every new regulation has unintended consequences, but it's difficult to know what they will be until the regulation is implemented. Advanced Trading asked three industry experts to predict one possible unintended outcome of Reg NMS. Here's what they had to say.

Order Jumping

Traders typically want to hit crowded bars after work and crowded market centers during the day. Going to the dominant "crowded" exchange instead of a lonely regional has a lot of advantages in today's world, one of the most important being protection from "trade-throughs." If a trader shows a 72-cent bid for 5,000 shares, the last thing he wants to see is a print go up at 71 cents while his bid sits unfilled at 72 cents. Going to the exchange where everyone goes largely alleviates this problem.

Under Reg NMS, the dynamics will change. The main driver will be the Top-of-Book Rule; only the best bid on each book is protected. So a 72-cent bid for 5,000 shares on the Philly may be protected at one moment - but if someone pennies it on the Philly, even for 100 shares, it is no longer the best bid and is therefore no longer trade-through protected. And here's where it gets interesting: Move that 72-cent bid to the Boston where it is top-of-book, and - poof - it's magically protected again.

Traders who like to leave limit orders dangling out there at prices a penny or two worse than the NBBO may disadvantage themselves if they just leave the order sitting in one place. Why leave your entire 72-cent bid unprotected on the NYSE when you can move some or all of it to INET where you'll be top-of-book? A likely result is that as soon as a limit order is pennied, the order will jump to a different book. Electronic systems and smart routing algorithms like AES Pathfinder will enable this behavior.

A strict top-of-book world may not come to pass; the buzz in the trading community is that the regulators will strongly encourage traders to sweep all books at each price, otherwise known as a depth-of-book approach. Depth of book has been opposed by dominant market centers, which fear that if your orders are protected in any marketplace, traders simply will migrate to the centers that offer the highest rebates. While posting liquidity in a depth-of-book world is straightforward, whacking bids on multiple books one penny at a time will require smart routing and a complex electronic infrastructure.

But, as the rule stands, it will be a top-of-book world, in which the more obscure a market center is, the more desirable it is as a place you can go and likely be top-of-book. And the most-liquid centers may turn out to be suboptimal places to post a bid, leading to limit orders being spread out more or less evenly among all the contenders. Formerly dominant market centers may end up best described by Yogi Berra: "Nobody goes there anymore; it's too crowded."

About the Author

Dan Mathisson
Head of Advanced
Execution Services
Credit Suisse