Originally, the DAY ISO was intended for institutions that wanted to sweep to a particular price level and then post at the best price – for example, clear the offer, then bid aggressively for more at the old offer price (buy all you can at the offer, then post a limit to buy the remainder at the old offer price). To use a DAY ISO, a broker-dealer is required either (a) to show it isn’t locking or crossing away markets, or (b) to sweep markets displaying prices it would otherwise lock or cross. Thus the DAY ISO order addresses conditions in which Regulation NMS puts constraints upon an order to simultaneously satisfy the ban on locked markets stipulated by Rule 610 and the trade-through rule stipulated by Rule 611.
However, the DAY ISO also provides a way to step ahead of orders that are already resting on the book -- orders that were originally submitted at the same price but were price-slid or hidden to comply with Rule 610 and the ban on locked markets. This advantage -- the remarkable ability to step ahead of orders resting on the book at the same price -- gives DAY ISOs a unique edge over the bulk of order types, including orders that “hide and light.”
(See: "Why HFTs Have an Advantage: Part 2: Hide & Light”)
Like orders that “hide and light,” the DAY ISO can be used by HFTs to lock away markets that are in fact stale phantom prices on the SIP feed that are no longer present on the away exchange. Unlike “hide and light” orders, though, the DAY ISO enters the market as a protected quotation and is eligible for immediate display on the book, whereas the “hide and light” order must remain in a hidden state until the away market unlocks. When sending a DAY ISO in such conditions, the burden of liability is on the HFT to demonstrate that the direct feeds used indeed show that away markets have truly faded and that there isn’t a pattern of locking protected quotations on away markets or any violation of Rule 610. If, for any reason, an HFT desires to lock an away market that displays a firm quotation (and not a phantom quotation) with a DAY ISO, the HFT would also have to take out the away market with an ISO. The other option in such a scenario would be to simply use a “hide and light” order.
DAY ISOs, like “hide and light” orders, avoid conditions that would normally result in rejection, rerouting, or disadvantaged price-sliding of aggressive orders -- unfavorable order treatment that typically occurs when an exchange employs a slow SIP feed to assert compliance with the ban on locked markets and the trade-through rule. Not only do HFTs exploit DAY ISOs to get ahead of slow SIP feeds while avoiding the disadvantaged exchange order handling treatment described above, HFTs also use DAY ISOs to step ahead of “hide and light” orders already resting on the book. What is most remarkable about DAY ISOs is this ability to queue jump orders that arrived at the exchange at the same price as, but prior in time to, the DAY ISO.
(For another example of price-time priority corruption, where orders that “hide and light” are permitted to queue jump orders commonly used by institutional investors, see “For Superfast Stock Traders, a Way to Jump Ahead in Line.”)
To appreciate the significance of DAY ISO queue jumping, it is key to understand that among all the special order types, only the DAY ISO can light a new aggressive price on an exchange that locks an away market. In practice, this lighting capability provides an alternative end-around to Rule 610 and the ban on locked markets and provides HFTs a backdoor to the top of the queue.
Lighting an aggressive price with DAY ISOs is a winner-take-all sport. The first DAY ISO that arrives to set a new NBBO will light the new price when it is booked. The new price will be displayed whether or not the order is locking an away market. HFTs often leverage DAY ISOs to get to the top of the queue on an NBBO change in cases where there is a slow SIP or when there are race conditions between prices disseminated on direct feeds. Hence, the fastest firm gets the top-of-queue and controls the actual “lighting of the market.” Indeed, HFTs are dictating the timing of an NBBO change on the SIP when using DAY ISOs.
After the DAY ISO is lit, all such “hide and light” orders that were resting on the book are then displayed, triggered by the ISO lighting event. It needs to be clarified that DAY ISOs, due to their status as protected quotations, are ranked ahead of all “hide and light” orders that exist in the subordinate hidden state at the same price. Thus DAY ISOs have the special ability to step ahead (i.e., queue jump) orders that previously arrived at the exchange and were resting on the book in a hidden state.
What about the case when two DAY ISOs are sent by competing HFTs? In this case, the second ISO coming into an exchange would fall behind all such lit orders, including “hide and light” orders that were queue jumped, even if the second DAY ISO arrived only microseconds later. Hence, when there is HFT competition to light a new price with a DAY ISO, second place really is the end of the line (the back of the queue). Especially in highly competitive and actively traded names, the HFT might as well cancel any DAY ISOs that fail to light the market rather than be posted at the back of the queue.
In summary, DAY ISOs were originally intended for large institutions that needed to sweep the book and post unfilled quantity at their most aggressive price. However, such orders became the mainstay of HFTs, which use them to post liquidity ahead of slow SIP feeds in order to light aggressive new prices. DAY ISOs assist HFTs in gaining a favorable queue position by queue jumping ahead of orders that “hide and light” as well as order types commonly used by institutional investors. Execution service providers that route aggressive orders to HFT-oriented exchanges yet fail to effectively utilize the primary features provided by such exchanges in the correct usage cases, including the appropriate usage of DAY ISOs and “hide and light” orders, are unnecessarily subsidizing HFT scalping strategies and disadvantaging their customers.
In the final article in his series on Locked Markets, Priority and Why HFTs Have an Advantage, Haim Bodek will discuss the further evolution of ISO orders in the context of the maker-taker model, including the Post-Only ISO and related order types.