CHX and Four Types of Speed Bump

Speed bumps, the latest fad in market structure, are proliferating. The Chicago Stock Exchange (CHX) recently proposed a new type of speed bump in the US equities market, called the “Liquidity Taking Access Delay” (LTAD). [1] The SEC’s decision whether to approve the LTAD could have a big impact on market structure, possibly more so than the IEX decision.

To understand the consequences of approving LTAD, I think it’s helpful to consider four types of asymmetric access delay: [2][3]

1. An exchange applies a delay to orders that are accessing resting liquidity. Resting orders themselves may be modified or cancelled without delay. This is the LTAD.
2. The same as #1, except only resting orders that are non-displayed avoid the delay.
3. The delay applies to all client messages to the exchange, including cancellations and marketable orders. But the exchange operates algorithmic order-types which adjust their attributes without delay. In particular, a displayed order can be pegged to undelayed price data, while its potential counterparties are subject to the delay.
4. The same as #3, except only non-displayed algorithmic order-types avoid the delay. This is the IEX speed bump. [4]

Here’s a table of the speed bump combinations, split by which types of resting orders have functionality similar to last look:

Last look	Can apply to displayed quotes	Can apply to non-displayed quotes only
At discretion of resting order-sender	#1 (LTAD)	#2
At discretion of exchange algo	#3	#4 (IEX)

In my opinion, all four types do more harm than good to market end-users (in the context of Reg NMS) — each allows resting liquidity to fade in some way. But many end-users disagree, and asked the SEC to approve #4. So, now that speed bumps exist and non-displayed peg orders may elide them, which of the other three asymmetric delays should be allowed?

One school of thought is that exchanges have a duty to protect their peg orders to the maximum extent possible. Combining this principle with the new “de minimis” interpretation may imply that speed bumps of types #3 and #4 should be allowed. Healthy Markets takes this view. [5] I think it’s a bad idea for exchange algorithms to have a time-advantage that isn’t offered to traders. Exchanges have neither the incentive nor the expertise to optimize their pricing algorithms. [6] The traditional role of the exchange is to provide a meeting place for buyers and sellers, allowing them to transact at prices of their own choosing. Exchanges offer algorithmic order-types (like pegs) mainly for convenience, and I don’t think there should be any illusion that these order-types are as good as the techniques used by sophisticated brokers and traders. Providing exchange algos with a time-advantage will mean that they out-compete traders, who are otherwise superior in terms of their pricing accuracy, stability under stress, and diversity. Traders and their algorithms do make mistakes, but it’s hard to believe that an exchange algo monoculture can do better. Subsidizing inferior business methods reduces an industry’s productivity, and giving exchange algorithms a structural advantage would be no different.

In my view then, if #4 is allowed, then #2 should be allowed. And, if #3 is allowed, then #1 should be allowed. Since #4 is already approved, the only thing to consider is whether it should be permissible for delays to have asymmetries in how they apply to accessing displayed quotes. The comments mostly do a good job explaining why asymmetries are problematic for displayed market structure. [7] In short, if displayed orders are given extra time to decide whether to consummate a trade, a large number of quotes will be practically inaccessible, even though it’d be prohibited to lock, cross, or trade-through those quotes. [8] Even in markets without these regulations, such as FX, last look causes difficulty. [9] The consequences of combining last look with order protection are unpredictable, but they seem unlikely to be good for long-term traders.

So, if we don’t want Reg NMS order protection to apply to quotes eligible for last look, only options #2 and #4 should be permitted. There is a tradeoff, though. Giving only hidden orders a time-advantage will incentivize dark trading. I doubt that the major exchanges would become as dark as IEX, but the equities market would probably become less transparent.

IEX’s approval is already inspiring a dramatic increase in complexity. CHX might not be the most important exchange, but like IEX, any precedent it sets applies to other exchanges. [10] Restricting speed-bump-asymmetries to hidden orders has drawbacks, but it might be the only way Reg NMS can keep limping on.

[1] Technically, it’s not really new. The LTAD is similar to an old proposal from Nasdaq’s PSX, which was rejected by the SEC.

[2] In order to highlight the essential elements, I’m leaving out some details.

[3] There are other speed bump types of course. For example, an exchange could delay traders from cancelling resting orders, but allow incoming marketable orders to execute without delay. That sort of delay could be used to address complaints about “fading liquidity“, and is similar in some respects to Nasdaq’s tentative “Extended Life Order” and EBS’s “Minimum Quote Life“.

Delays in market data are speed bumps of an entirely different class. These are prohibited (I think) in US equities markets, which require quotes and trades to be published to the SIP without delay. Though perhaps this requirement doesn’t apply to “de minimis” delays?

[4] Algorithmic order-types may also use their undelayed data feeds to trade aggressively with resting orders which can’t be cancelled without going through a delay. IEX’s DPEG does this via its “book recheck” mechanism.

[5] From their comment letter:

Time delays should not apply to an exchange’s ability to price orders on behalf of all participants (i.e. Pegging).

Dave Lauer clarified on Twitter that this principle also applies to displayed peg orders.

[6] CHX’s justification for the LTAD evokes a useful thought experiment. CHX argues that its ETF quotes are victims of “latency arbitrage,” and that the LTAD will prevent this. If the SEC rejects the LTAD, CHX might propose another type of speed bump, where CHX manages displayed orders in ETFs (e.g. SPY, QQQ, etc) by pegging them to undelayed CME market data. Will CHX understand the relationship that these ETFs have to futures markets as well as professional traders do? And these ETFs are just the simple cases — imagine what kind of pegs an exchange might come up with to prevent market makers from being “picked off” on XOM when the price of crude or CVX moves. I’m sure exchanges can think of peg algos that market makers would find very useful, but is that really what we want exchanges doing?

[7] No discussion of the LTAD would be complete without mentioning CHX’s market data revenue sharing program. This post, though, isn’t intended to be a complete discussion. Many of the comment letters (and Matt Hurd’s playful summaries) address this issue.

I found it interesting that Virtu publicly supported the LTAD as soon as it was announced, presumably before they had time to review the filings. Was the LTAD proposed at Virtu’s request? Could Virtu’s CHX profitability rely on market data revenue sharing?

[8] Without using ISOs, that is. If enough displayed orders were granted a last look, then the market would be clogged with inaccessible quotes. Only traders with the legal infrastructure to submit ISOs would be able to navigate the equity market.

[9] This opinion isn’t unanimous. Some long-term traders appreciate last look, like Norway’s SWF, NBIM.

[10] James Angel’s letter argues that CHX should be given the benefit of the doubt just like IEX was. I’m not a lawyer, and I think the LTAD could hurt long-term traders, but some of his points are persuasive.