Haim Bodek Consulting SM Copyright © 2012-2013 Decimus Capital Markets, LLC Highly Confidential - Do Not Redistribute Without Permission D ECIMUS C APITAL.

Haim Bodek Consulting SM

Copyright © 2012-2013 Decimus Capital Markets, LLCHighly Confidential - Do Not Redistribute Without Permission

DECIMUS CAPITAL MARKETS, LLC

FOWThe Problem of HFT

December 10, 2013Haim Bodek

Decimus Capital Markets, LLC

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4/3/12: “SEC Probes Ties to High-Speed Traders Links to Exchanges Scrutinized, New Types of Trades, Too”Jean Eaglesham, Jenny Strasburg, and Scott Patterson, Wall Street Journal

“One order type, called "Hide Not Slide" and offered by the exchange operator Direct Edge Holdings LLC, is among those being scrutinized by the SEC, according to people familiar with the matter. The agency is also looking at a similar order type offered by computerized stock exchange BATS Global Markets Inc., the people said.”

“The SEC is examining whether such order types unfairly allow high-speed traders to jump ahead of other investors in an exchange's "order book," or the queue of buy and sell orders that are typically ranked by price and when they were received, according to people familiar with the matter.”

March 2012


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9/19/12: “For Superfast Stock Traders, a Way to Jump Ahead in Line”Scott Patterson and Jenny Strasburg, Wall Street Journal

“At issue is whether exchanges sometimes allow high-speed trading firms to trade ahead of less-sophisticated investors, potentially disadvantaging them and violating regulatory rules. The inclusion of Nasdaq and NYSE in this high-profile probe, and the role Mr. Bodek has played in it, haven't previously been reported”

“Among questions the regulators want to answer is whether exchanges have at times misled them in seeking approval for certain order types or mischaracterized to investors how the orders work, those familiar with the probe say.”

September 2012


HFT Scalping Strategies

• The dominant form of HFT in equities markets• Lean on order book depth & capture a micro-spread• Requires price-time priority market structure• Low-latency electronic trading environment• Subsidized by maker-taker market model

– Sometimes referred to as rebate arbitrage

• Facilitated by HFT-oriented market structure – Primary HFT activity on lit market venues– NASDAQ, NYSE ARCA, BATS, DIRECT EDGE

• Algorithmic tradition evolved from future markets– The “0+ Scalping Strategy” is an early example


HFT Scalping Strategies - Features

• High Frequency Turnover – passive scalping of a micro-spread

• Queue Position – a dependence on order rank and order book depth

• Low Latency – precise and timely reaction to market microstructure events


HFT Scalping Strategies - Features

• Exchange Microstructure – usage of special order types and order matching engine features

• Rebate Capture – subsidized costs through “post only” orders and tiered rebates

• Low Risk Tolerance – avoidance of risk and usage of market book depth to reduce risk


Regulation NMS

• Formulated in 2005, established in 2007. • “…a series of initiatives designed to modernize

and strengthen the national market system for equity securities.“

• The adoption of REG NMS coincides with a period of intense HFT volume growth

http://www.sec.gov/rules/final/34-51808.pdf



Rule 610 – Market Access Rule

• Rule 610 – Banned locked marketsA trading center must “prohibit its members from engaging in a pattern or practice of displaying quotations that lock or cross any protected quotation in an NMS stock”

• Critical constraint impacting HFT strategies• Order handling – actively adjusts order to comply

with the ban on locked markets often interfering with aggressive limit orders which improve the NBBO




What is REG NMS Price Sliding?

Price sliding occurs automatically on a REG NMS compliant exchange when an incoming order would lock or cross a protected quotation at an away exchange.

NASDAQ: “Price sliding allows orders submitted at impermissible prices to be booked in a sensible and convenient way. The particular behavior varies by order type and port configuration.”

http://www.nasdaqtrader.com/content/productsservices/trading/PriceSliding_factsheet.pdf

http://www.nasdaqtrader.com/content/productsservices/trading/PriceSliding_factsheet.pdf


What is the Impact of Price Sliding?

• Price sliding is a key element in exchange order handling that in part:– Governs when a new national best bid and offer

(NBBO) can be accepted and displayed on regulatory price feeds

– Determines which orders are placed in favorable or unfavorable queue positions

– Determines when and what price orders are booked, thus defining eligibility for maker rebates and taker fees

• Effectively picks winner and losers in the context of HFT scalping strategies


The Dark Side of REG NMS Price-Sliding

• Order can be disadvantaged by being kicked to the back of the queue

• Orders can be promoted to the front of the queue• Maker/taker fee allocation can be attributed in an

opaque and unusual manner• Creates unexpected collisions between sophisticated

participants and unsophisticated participants that otherwise would not have occurred

• The impact of price-sliding on order type precedence is not properly disclosed by exchanges


Order Matching Engine Practices

• The complex sequence of microstructure events tied to price moves dictate HFT profitability

• Exchange order handling is now a primary factor impacting execution performance and slippage

• Exchanges order handling decisions effectively pick winner and losers– Significant differences between order handling

treatment of HFT-oriented order types and “vanilla” professional order types commonly used by institutional investors

• HFT-oriented special order types avoid and in fact benefit from disadvantages that frequently impact traditional order types


Exchange “Innovation”

"We created all these different order types to accommodate how they wanted to trade,” recalls one former Archipelago employee. “We tweaked how the order would interact with our book according to what they wanted. A lot of the unique orders were created at the request of a customer, typically a high frequency customer. You had to be a sophisticated customer to learn how to use it. They'd send it in and we'd respond. It was a happy little circle."

- Dark Pools, Scott Patterson, page 237.


Special Order Types

• The VIP door to each exchange – but only if you know how to unlock it!

• The undocumented features of special order types :– Enable HFTs to leap ahead of customer orders– Permit HFTs to dump toxic trades upon customer orders– Force customer orders eligible for rebates to pay fees to HFTs– Provide HFTs information on the buy and sell intent of

customer orders– Assist HFTs in gaining speed advantages over customers


Orders that “Hide & Light”

• BATS: “eliminates the need for traders to retry orders multiple times in rapid succession trying to be high in priority at the next NBBO price.”

• Orders that lock the NBBO are hidden instead of rejected or price-slid

• Important:– Hidden orders exempt from prohibition against

locking protected quotes• When the NBBO unlocks, the special order type is

displayed (i.e. lit) and becomes the best price

http://batstrading.com/resources/features/bats_exchange_pricesliding.pdf



Flavors of “Hide & Light”

• BATS: BATS Only Post Only (BOPO)• Direct Edge: ALO + Hide Not Slide • NYSE ARCA: Post No Preference ALO Blind (PNP

ALO B)• NASDAQ: Post Only + “Automatic Re-Entry”

These are the “vanilla” professional order types that HFTs utilize in place of non-routable day limit orders.Non-routable day limit orders are typically used by smart order routers servicing retail brokers.




Queue Jumping: “Hide & Light” vs. Non-Routable

• Assume the market for XYZ is 20.01 20.02, 1,000 up and an institution sends a NON-ROUTABLE order to buy 10,000 for 20.02 that locks an away market

• Institution buys the 1,000 at 20.02 and wants to pay 20.02 for another 9,000 but is price-slid to 20.01 upon locking the away market

• The trading firm sees the 1,000 trade at 20.02 and sees the new price-slid bid for 9,000 at 20.01.

• The trading firm then steps ahead of the institution by posting a “Hide & Light” hidden order, locking the market at 20.02 ahead of the institutional order (complies with Rule 610).

• Meanwhile a phantom order is displayed at 20.01, seemingly behind the institutional order

• Then as the offers have all cleared at 20.02, the “Hide & Light” is rebooked as a displayed order at 20.02. The institution’s original order is then rebooked displayed at 20.02, placed after the trading firm.


Lighting Unfairly Advantages HFTs

• Limit prices of all orders came in at same price• To comply with the ban on locked markets, these orders

were modified by price sliding treatment dictated by order type

• These modified orders would be posted on the SIP in price-time priority on the SIP (phantom order posted also for “Hide & Light” orders)

• When the market unlocked, the modified orders were canceled and then rebooked as displayed orders (i.e. lit)

• Exchange unfairly lit HFT-oriented orders ahead of orders commonly used by institutions and smart order routers


Classes of Order Matching Engine Abuse

Queue Jumping – unfair order handling practices that permit HFTs to step ahead of investor orders

Cannon Fodder – unfair rebooking and repositioning of investor orders that permit HFTs to flip out of toxic trades

Fish Food – unfair conversion of investor orders eligible for maker rebates into unfavorable executions incurring taker fees

Bait & Switch – unfair insertion of HFT intermediaries in between legitimate customer to customer matching

Catch Me If You Can – unfair and discriminatory order handling of investor orders during sudden price movements


Classes of Order Matching Engine Abuse

Queue Jumping – unfair order handling practices that permit HFTs to step ahead of investor orders

Cannon Fodder – unfair rebooking and repositioning of investor orders that permit HFTs to flip out of toxic trades

Fish Food – unfair conversion of investor orders eligible for maker rebates into unfavorable executions incurring taker fees

Bait & Switch – unfair insertion of HFT intermediaries in between legitimate customer to customer matching

Catch Me If You Can – unfair and discriminatory order handling of investor orders during sudden price movements


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11/19/12: “Exchanges Get Closer Inspection”Scott Patterson and Jean Eaglesham, Wall Street Journal

“ The SEC has expanded its scrutiny of order types from its enforcement division to its Office of Compliance Inspections and Examinations, or OCIE, which oversees how exchanges, brokers and other securities firms comply with regulations.”

“OCIE's involvement indicates that regulators are looking beyond specific order-type concerns into long-standing procedures at exchanges involving how they craft order types, who they give information about order types to, and whether their public disclosures adequately explain how order types work.”

November 2012


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11/19/12: “Exchanges Get Closer Inspection”Scott Patterson and Jean Eaglesham, Wall Street Journal

“The order-type probe was a "come to Jesus moment" for regulators about how exchanges appear to have systematically developed trading advantages for certain sophisticated clients, often with insufficient regulatory oversight or understanding of products, the person said.”

“Enforcement officials are looking at why exchanges offer certain order types and whether they were adopted at the request of certain clients, according to people familiar with the probe.”

November 2012


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2/22/13: “SEC Examining How Exchanges Develop Order Types” Traders Magazine, Tom Steinert-Threlkeld

“Each of the exchanges has been sent documents seeking details on how they develop ideas for new order types…The examiners will be looking at how methods of governing order creation and approval at each exchange are similar and how they differ. … Among the most concerning are hidden orders, which do not, in some cases, get activated until the price of a given stock slides or some other action takes place.”

February 2013




[email protected]: @haimbodekwww.haimbodek.com

Market Structure Matters

http://www.haimbodek.com/




IMPORTANT INFORMATION This presentation has been prepared by Decimus Capital Markets, LLC (“DCM”) exclusively for the benefit and internal use of the DCM client to whom it is delivered (such client hereinafter, “you” or the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions, including but not limited to the provisioning of DCM’s services and products to you. The information in this presentation includes certain statements, opinions, and analyses that are based on information that is proprietary to us. It has been produced solely for your use and should not be reproduced or disclosed, in whole or in part, to any other person without our prior written consent. This document remains our property, and at our request this copy and any copies that you have made must be returned to us and/or destroyed. This presentation is for discussion purposes only and is incomplete without reference to, and should be utilized solely in conjunction with, the oral briefing provided by DCM.

The information in this presentation reflects our views as well as prevailing conditions as of the date of this presentation. The information in the presentation is subject to change without notice and DCM assumes no duty to update the information. DCM’s opinions, interpretations, and estimates (with regard technological, financial, regulatory and other areas of domain expertise, and including but not limited to information based upon or provided by third parties ) constitute DCM’s judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of certain information available from public sources or which was provided to us by third parties . In addition, our analyses are not and do not purport to be appraisals or forward looking statements with regard to any of the assets, securities, or businesses of the Company or of any other entity. DCM makes no representations as to the value., which may be paid or received in connection with any particular transaction, nor the legal, tax and/or accounting effects of consummating such a transaction.

Nothing in this presentation should be construed as regulatory, valuation, legal, tax, accounting or investment advice and it does not constitute a recommendation, solicitation, offer or commitment to purchase, sell or underwrite any securities to you, from you, or on your behalf, or to extend any credit or provide any insurance to you or to enter into any transaction. Unless otherwise agreed in writing, we are not acting as your financial adviser or fiduciary. Before you enter into any transaction you should ensure that you fully understand the potential risks and rewards of that transaction and you should consult with such advisers, as you deem necessary to assist you in making these determinations including but not limited to your accountants, investment advisors, legal and/or tax experts.

Haim BodekManaging Principal

[email protected]

Decimus Capital Markets, LLC | 11 Sea Beach Drive | Stamford, CT 06902 | 203.286.4470 | www.haimbodek.com

Haim Bodek Consulting SM Copyright © 2012-2013 Decimus Capital Markets, LLC Highly Confidential - Do Not Redistribute Without Permission D ECIMUS C APITAL.

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