Academic journal article Financial Management

The Quote Exception Rule: Giving High Frequency Traders an Unintended Advantage

Academic journal article Financial Management

The Quote Exception Rule: Giving High Frequency Traders an Unintended Advantage

Article excerpt

Under the Securities and Exchange Commission (SEC) Rule 611 exchanges that have not matched a new National Best Bid and Offer (NBBO) can trade at the old NBBO for one second. In 2008, this rule allowed fast traders to earn estimated revenues of $233 million at the expense of slow traders. Furthermore, we find that when the NYSE decreased latency by 600 milliseconds on March 10, 2008, execution quality improved markedly for fast liquidity demanders, but improved only minimally for slow liquidity demanders. However, we find a decrease in volume executed at adverse prices under the faster market conditions.


"By the time the ordinary investor sees a quote, it's like looking at a star that burned out 50,000 years ago." Sal Arnuk, Partner, Themis Trading (Adler, 2012).

High frequency traders (HFTs) use fast computer algorithms to open and then close trading positions within milliseconds. A number of studies examine HFTs and conclude that HFTs benefit markets by providing liquidity and dampening volatility. (1) In contrast, we examine a specific case in which the structural problems created by latency and the trading of individual assets in multiple markets simultaneously, and attempts by regulators to level the playing field across these markets, may have created the unintended consequence of allowing fast trades to gain revenue from trading with slow traders. Specifically, we use data from US equity markets in 2008 to investigate the US Securities and Exchange Commission's (SEC) "Flickering Quote Exception" to the Regulation National Market System (Reg NMS) Order Protection Rule that defines the benchmark price for evaluation of trade throughs and provides a one second look back exception. (2)

For heavily traded companies, at least one exchange is always at the market wide best bid (National Best Bid and Offer [NBBO] Bid) and the market wide best ask (NBBO Ask) (definitions of terms are presented in Table I). Thus, the Benchmark Quote Exception implicitly defines the market wide reference price for the evaluation of a trade through as the least aggressive NBBO Ask and NBBO Bid (together the NBBO) over the previous one second of trading. We call these reference prices the Benchmark Ask and the Benchmark Bid, respectively, or taken together the Benchmark Quote. Prices equal to or better than the Benchmark Quote, but inferior to the NBBO Quote, are called Benchmark Compliant Prices. Any trades that execute at Benchmark Compliant Prices are not trade throughs under Rule 611. However, prices inferior to the Benchmark Quote may be accessed with the use of an Intermarket Sweep Order (ISO) (Chakravarty et al., 2012).

We document several behaviors of liquidity suppliers that indicate an active strategy to exploit the Benchmark Quote Exception. We find that as the distance in cents between the NBBO Ask (Bid) and Benchmark Ask (Bid) increases, relatively more exchanges quote at Benchmark Compliant Prices. When the distance is $.01,2.26 exchanges offer liquidity at NBBO prices, but only 1.73 exchanges offer liquidity at Benchmark Compliant Prices. When the gap is $.03, 1.68 exchanges offer liquidity at NBBO prices, but 2.19 exchanges offer liquidity at Benchmark Compliant prices.

In addition, Benchmark Compliant quotes are found on all exchanges, but are more prevalent on the smaller exchanges. Given a price change that initiates a Benchmark Event, the National Stock Exchange offers liquidity at Benchmark Compliant Prices 60% of the time and NBBO prices 40% of the time. The NYSE offers liquidity at NBBO prices 46% of the time and Benchmark Compliant Prices 53% of the time. For the NASDAQ, liquidity is offered at NBBO prices roughly 60% of the time and at Benchmark Compliant Prices 40% of the time. Substantial volume is executed at Benchmark Compliant Prices. For our sample of 100 thick stocks, we find that there are 107,878 trades per stock at Benchmark Compliant Prices on a typical stock day. …

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