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Complex Order Types, Fragmentation And Dark Pools, Oh My!

Traders agree that market structure and some complex order types are not benefiting investors.

“Flash Boys”, the book by Michael Lewis is obviously turning up the heat on high frequency trading, a controversial practice that has been going on for several years. But so far the book is raising more questions than answers about whether HFT is good or bad. The real story in the book, however, is about how various order types and an extremely complex and fragmented marketplace may actually be detrimental in the long run.

Let's start with order types. Investors get a glimpse into the complex order types with weird names such as "Post Only" and "Hide Not Slide" used by high frequency traders to collect rebates from exchanges or dark pools, as well as to jump ahead of institutional orders. So as not to get bogged down in these order types, I will cover them in a separate story.

The focus of the book is squarely on Brad Katsuyama, then head trader at RBC Capital Markets. Katsuyama forms a group inside his new company, IEX, called the Puzzle Masters to decipher these order types. “Most of the order types were designed to not trade, or at least to discourage trading,” said Katsuyama in the book. Some of these orders are planted as way to obtain information, “as cheaply and risklessly as possible about the behavior and intention of stock market investors,” he explains.

Whistleblower Haim Bodek. exposed the secret order types -- specifically, Hide-not -Slide, that prevented his orders from getting executed. So some professionals view Flash Boys as old information, or that it's stretching the truth.

But the real story and the reason why Lewis continues to get a platform for his views is that it exposes the structural complexity of the markets with its excessive fragmentation with 13 public exchanges and 43 dark pools, the make or taker rebates, convoluted order types designed for HFT to jump the queue and proprietary data feeds and colocation.

Should the market be this complicated? Maybe the real message to come out of “Flash Boys” is that we have lost sight of the purpose of the stock market, as a place for companies to raise capital and as a place where investors and asset managers go to invest.

“Rather than saying it’s the order types that are the problem, I almost think it’s the whole market structure that could be the problem,” said Ryan Larson, Head of Equity Trading, U.S., RBC Global Asset Management (U.S.) Inc. in Chicago.

Those who use these order types are operating “within the context of the law and within the context of the current market structure and they are using the rules that are in place to the best of their ability,” emphasized Larson. Like many sophisticated institutional traders who utilize algorithms to execute orders in dark pools and exchanges, Larson has known about such order types for a while. In fact, he says, there are only about 10 to 15 basic order types commonly used, and the rest are tweaks, not thousands as reported in the media. [In the book, Katsuyama's Puzzle Makers worked on deciphering 50 orders.]

But Larson questions whether it’s okay if a HFT firm is putting a post-only order out there, and if an institution looking to sell stock, goes to interact with that offer, and that offer disappears.

HFT’s are also known for their high cancellation to trade ratios. For every 100 orders they put out, they may execute one of them, noted Larson. If messages are sent out in the thousands, if not millions, of times a day, then this can strain the plumbing of the exchanges and lead to bottlenecks or outages as evidenced by the SIP crash with Nasdaq.

What we really have now, it seems, is a quantitative, casino operating at high speeds, one that brings excessive message rates through networks and microbursts of quote activity and flash crashes in large companies.

Critics have suggested that a financial tax on messages that exceed a certain threshold will curb the problem, but some fear it will dampen liquidity.

While these order tactics are deemed legal — after all “they are happening under the SEC’s watch,” Larson questions whether it’s right. “If that’s not right, I would hope that the regulators, in terms of the SEC, and FINRA would step forward and say if this is illegal and we shouldn’t allow it.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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