To satisfy these concerns, the SEC carved out an exemption to Rule 611, providing a special exception -- the Intermarket Sweep Order (ISO) -- for institutions that need to sweep through multiple levels of the order book. To quote the filing: “The intermarket sweep exception enables trading centers that receive sweep orders to execute those orders immediately, without waiting for better-priced quotations in other markets to be updated.”(See above link.)
While normal orders routed to a venue not displaying the best price would create a trade-through and force an exchange either to reject or to reroute an order, ISOs are executed without any requirement to check away market pricing or to apply trade-through protections. The stipulation to using ISO orders is that the broker-dealer is required to access all Protected Quotations across all markets that are covered by the trade-through rule and to assume all liability for compliance with Rule 611. In other words, to use an ISO order, broker-dealers need to trade across all protected trading venues and absorb liability for the exchanges’ trade-through compliance requirements.
While ISOs are meant for large institutions sweeping through the book, in practice they are really leveraged by HFTs and sophisticated proprietary trading desks to get ahead of slow SIP data feeds during price moves. Especially in the early period, very few broker-dealers recognized the importance of using ISOs as a primary order type for smart order routing to protect against the adverse impact of slow SIP feeds. In fact, due to liability concerns of broker-dealers, even sophisticated direct market access (DMA) customers that wanted to use ISOs often were not permitted to use them, a constraint that continues to impact smaller HFTs to this day. Thus the competitive dimension of ISO activity was and is constrained to a subset of HFTs when compared with the much more widespread use of orders that “hide and light.” (See Part 2 of this series: “Hide & Light”)
The simplest form of ISO is the Immediate-or-Cancel (IOC) version of the ISO order type. This class of ISO order instructs the exchange either to immediately execute an order at a specific price or to cancel it, with no requirement to check if the order trades-through any “protected” price at an away exchange. To use an IOC ISO, a broker-dealer needs to affirm that it is also sending orders to any market showing a more advantageous price. The trade-through test, however, is not dictated exclusively by the slower aggregated SIP feed; if a broker has a faster direct feed, it can limit the cases in which it has to send orders to hit SIP prices that, given the fast nature of U.S. equity liquidity provisioning, in many cases are stale and no longer exist.
When the SIP feed slows down (which can happen in a fast market as a result of delays on as few as one of the 13 exchanges), customers that use traditional orders can be disadvantaged, as they are rejected or unsuccessfully rerouted due to phantom SIP quotes created by race conditions and latencies. HFTs and other sophisticated participants that are able to use IOC ISOs suffer no such burden. In other words, while traditional orders based upon slow SIP data and trade-through routing chase SIP quotes that don’t exist, HFTs using ISO orders and fast data feeds can access rapidly diminishing liquidity on price moves and thus outflank the latency-prone tactics.
[Larry Tabb asks: Is This the End of High-Frequency Trading as We Know It?]
In fast markets, HFTs benefit from the slow SIP feed in a manner that may exasperate rapid price movement as they maneuver to avoid adverse flows -- they are able to pull their unexecuted orders on venues before they trade against customers using marketable non-ISO orders that are rerouted or rejected due to phantom SIP prices. Thus, for a portion of order flow, HFT scalping strategies are in essence protected by the exchanges’ implementations of Rule 611 -- implementations that in effect provide a shield against an onrush of public orders in fast market conditions, as such orders are rejected or rerouted.
The impact of the widespread use of ISOs upon the marketplace, the potential for significant dislocation associated with “sweep events,” and the problem of “phantom liquidity” have far-ranging repercussions. as (See: BlackRock managing director Ananth Madhaven’s excellent paper relating the use of ISOs and fragmented liquidity to the flash crash.)
In summary, brokers unfamiliar with the necessity and nuances of accessing HFT-oriented markets with ISOs in fast moving markets limit the liquidity available to their clients and leave many orders unfilled, a practice that effectively shields HFTs from toxic marketable order flows and subsidizes the profits of HFT scalping strategies.
In the next two articles in this series, Haim Bodek will discuss the further evolution of ISOs, including the introduction of the DAY ISO, which has the powerful ability to “light” a new aggressive price and step ahead of orders that “hide and light,” and the Post-Only ISO, one of the most powerful order types in the HFT arsenal.