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The Great HFT Debate

29 October 2012

Why HFTs Have an Advantage, Part 3: Intermarket Sweep Orders

Though ISOs were meant for large institutions sweeping through the book, an unanticipated consequence has been that HFTs leverage the order type to get ahead of slow SIP data feeds on price moves. Brokers that don’t use ISOs in fast market conditions disadvantage their clients and subsidize the profits of HFTs.

Part 3: Intermarket Sweep Orders

Rule 611 of Regulation NMS is called the Order Protection Rule, more commonly known as the “trade-through rule.” Its goal is to prevent orders on one exchange from being executed at prices that are inferior to those “protected” quotes at another exchange. This rule forces exchanges to either reject marketable orders or route them to the exchange displaying the best price. In conjunction with Rule 610, Rule 611 provides a key protection that prohibits exchanges from executing trades that can be filled at better prices at away markets, a crucial property for binding markets in a single, unified national best bid and offer.

In theory, this rule should help investors get the best price in the market, regardless of where an order initially is routed. In practice, however, high-frequency traders have undermined the ability of others to secure the best price by exploiting an increasingly fragmented market.

In 2005, when the Reg NMS framework was being developed, decimalization in the U.S. equity markets had already resulted in a thinning of size available at the top of book, a general reduction in available market depth, and the deployment of sophisticated broker routing technologies to trade across the fragmented U.S. equities marketplace. With the threat of impending trade-through regulation, institutional traders were understandably concerned that Rule 611 would interfere with a broker’s ability to serve an institutional investor when trading in parallel across execution venues as exchanges attempted to fulfill their trade-through requirements across a fragmented marketplace. The problem is that if the client needs to access liquidity across all markets instantaneously but is prevented from doing so, the market impact of the trade could lead to rapid withdrawal of liquidity by market makers and/or situations in which the broker is unnecessarily forced to chase liquidity with orders that are denied by exchanges in an effort to comply with Rule 611. In fact, the resulting race conditions between market centers creates technological pandemonium in the price feed that frequently interferes with access to instantaneous liquidity by institutional investors in a variety of conditions.

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.

Spotlight-white-trans For more stories in the The Great HFT Debate Spotlight Series click here.

Comments | Post a Comment

9 Comments to "Why HFTs Have an Advantage, Part 3: Intermarket Sweep Orders":
  • Comment_salarnuk

    29 October 2012

    I think the real juice comes from Day-ISOs and Post-only ISOs. "So many loopholes to pervert - so little time." - Exchange Executives

  • Comment_l

    29 October 2012

    Haim will address DAY ISOs and Post-Only ISOs in Parts 4 and 5, which should be coming in the next weeks.

  • Anon_avatar

    30 October 2012

    I'm not sure how your conclusion about HFTs being protected from toxic orders is warranted.  Wouldn't market participants who use ISO orders pick off those HFTs?

  • Comment_10x29_mackie_headshot

    30 October 2012

    Looking forward to parts 4 and 5 because part 3 leaves me unconvinced.

  • Missing
    Shawn Kaplan

    31 October 2012

    Do you have any statistics on this? What are the percentages of trades which are routed to other exchanges? What are the effects of latency on re-routing of orders? If exchanges use the SIPs for routing, aren't they inherently behind the market? Perhaps this is one of the key strategies employed in HFT? This is fascinating, but only scratches the surface on the micr structure of the market.

  • Comment_haim_linkedin

    31 October 2012


    I don’t typically use routable orders, but I have measured differences in execution quality between traditional IOC and IOC ISOs. For my execution strategies in particular (trading in moving markets), transaction fill rates of standard IOCs were commonly reduced by 30% compared to using IOC ISOs. The distribution of the rejected IOC orders was weighted heavily towards missing favorable trades.

    This bias makes sense when one considers the conditions in which Rules 610/611 constrain price moves.  Especially in penny wide names, the higher incidence of marketable orders that are rejected due to SIP phantoms, the more likely the market is rapidly moving away from the current price point (as opposed to the away market having a better price). Also, if you consider how the mechanics operate, in a fast moving market, the slow SIP will catch up to the fast feeds at stability points that have persisted long enough for the SIP to catch up. The non-ISO orders are more likely to execute clustered at these price-points where the SIP converges with the fast feed. This unintended consequence of Rule 611 can result in a dramatic difference in executed time/price when comparing ISO and non-ISO execution performance.

    I encourage measuring the opportunity costs of unfilled marketable non-ISO orders, as the cost will differ depending on the conditions in which orders are typically sent. For traditional IOCs, you can extract all orders rejected due to the trade-through rule using a condition code on the exchange response message. Look for orders that are not executed due to “regulatory restriction” or “trade through restriction.” For unfilled orders you might want to test for any re-attempts that were filled at a worse price, though they were originally rejected due to better prices available. I tend to look at 1 second post-trade mark-to-market metrics. I should also note that the issues described in this article are much more pronounced in the ETFs.

  • Missing

    03 November 2012

    Shawn - statistics on trades routed to other exchanges & latencies are now available in monthly rule 605 reports on exchange websites. Do read the definition of covered trades that the report pertains to.

  • Comment_l

    05 November 2012

    Industry Officials Call for Talks On Order Types Is the really interesting stuff in what they didn't say about proliferating order types?

  • Comment_matt_samelson

    07 November 2012

    I need to come back and read this series more thoroughly.  However, I think it is important to point out that some research we have done suggests orders routed among exchanges (including ISOs) are less than 10% of the total printed share volume in the market.  More on this later when I have time.

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