November 1, 2011
Elizabeth Murphy, Secretary
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090
Dear Ms. Murphy,
On October 24, 2011, NASDAQ filed a proposal with the SEC to get approval for a new minimum life order type for their PSX exchange. Before we get to this new order, lets just review all the exchanges that NASDAQ owns. First, there is the traditional NASDAQ which has been around since 1971. Most of NASDAQs transaction business is done here (they have a 19% matched market share of the US equity market) Then there is NASDAQ BX. This was the old Boston Stock Exchange which was bought by NASDAQ in 2007 and later launched as BX in 2009. BX is considered a cheaper alternative since its access fees are lower than NASDAQ classic. In fact, they employ an inverted fee structure where they charge users to add liquidity and pay users to take liquidity. It enjoys a 2.5% matched market share. Finally, there is NASDAQ PSX which was launched in October 2010. The PSX was the old Philadelphia Stock Exchange that NASDAQ bought in 2007. PSX is a U.S. equities exchange featuring a pro rata allocation model . They allocate trades based on the size of orders posted. PSX enjoys a 1% matched market share.
These are just three of the thirteen exchanges that contribute to the US fragmented equity market. As frequent readers of our blog know by now, the more market centers that there are, then the more chances for a profitable arbitrage exist. We are not talking about a Coke vs Pepsi arbitrage, we are talking about trading the same stock but on two different exchanges/dark pools.
Anyway, back to the new NASDAQ PSX order type. They are proposing a voluntary minimum life order. The proposal states:
"Once entered, a Minimum Life Order may not be cancelled for a period of time established in advance by the Exchange...The initial no cancel window will be 100 milliseconds...the Exchange expects to propose to offer an enhanced liquidity provider rebate of $0.0026 per share executed for Minimum Life Orders that provide liquidity after posting to the book."
We think that a minimum order life is a good idea. In fact, we recommended it almost three years ago in our Toxic Equity paper. The problem though is that the minimum order life cant just be a voluntary order offered by just one exchange. In order to be effective, a minimum order life must be mandated by the SEC and all orders, regardless of which market center they are entered on, must participate.
We did find a few statements that NASDAQ made in their minimum order life proposal supportive of our stance on this. NASDAQ stated:
"Market participants that seek to interact with orders that are cancelled before they can execute may ultimately achieve less favorable executions than would have been the case if the order had not cancelled or if they had directed their own order elsewhere."
"The Exchange believes that the order type may also enhance price discovery by allowing a market participant to signal its commitment to trade at a particular price."
We do have one more issue though with this new minimum life order. We hope that broker smart routers and algorithms will not just use it to obtain the enhanced rebate that PSX has proposed (the filing states this will be $0.0026/share). We also hope that users of these smart routers and algorithms are monitoring their order flow and ensuring that their order isnt being tipped off as a minimum life order just so the algorithm gets a few extra mils rebate. As we have seen many times in the past, predatory traders have many tools at their disposal. They will now know when an order has a minimum life attached to it since a new flag in the data feed (Minimum Life Flag -U) will be attached to that order. They can then use this information to further model price behavior.
To summarize, we are encouraged that an exchange has proposed a minimum life order. But we are concerned that only one exchange has made the proposal and it is not an SEC rule. We are even more concerned that by itself, this order may increase the potential for predatory behavior.
Themis Trading, LLC
November 1, 2011