Micro-Structure & Exchanges: The Relationship Is "Complicated"

This past Tuesday night news hit that BATS Global Markets was in the process of settling with the SEC on the claim that Direct Edge provided unfair perks to certain high frequency traders (HFT), a development that might set a pivotal precedent in the market structure debate. News of the possible settlement was preceded by the departure of William O’Brien who ran Direct Edge with its twin exchanges before selling it to BATS in early 2014, becoming the second-in-command of the combined entity.

In an effort to challenge Brad Katsuyama of the Flash Boys fame live on TV, O’Brien stated that his exchange’s matching engine (used to match buy and sell orders) used direct feeds provided by other exchanges. However Direct Edge’s matching system used staler data from the SIP (securities information processor) - not the direct feeds - for several important housekeeping tasks. In a spectacular public relations failure, the NY Attorney General forced BATS to publicly correct O’Brien’s statements.

One person in the mix who may have not been remembered is Haim Bodek. After coming out publicly in Scott Patterson’s Dark Pools as a critic of exchanges that cater to HFT, Haim was on a one-man crusade to save his reputation by making a convincing case against the HFT industry. In the end, he wound up triggering SEC investigations that (so far) led to an exchange head being forced to step down. For those unaware, Haim was also the real star of the VPRO film Wall Street Code. In the film Haim used the example of skipping in line while buying Metallica concert tickets:

In a phone conversation with Benzinga, Haim noted this (yet to be announced) settlement would set precedent for future concerns about abuses taking place on securities exchanges.  Direct Edge wasn’t the only exchange nor the first exchange to do what it did, which was the creation of symbiotic relationships between exchanges and HFTs.  

 

In the 114-page document the exchange wants those orders redefined to be “characteristics”. That’s a major change, and, interestingly, the announcement about William O’Brien stepping down as President at BATS came less than a week after this proposal was filed with the regulators.  It is odd that his exchange would wait so long to clarify what order-types are and what characteristics are. But there’s more.

 

Just a few days later, the SEC approved the rules submitted by all eleven equity exchanges chiefly addressing the usage of data feeds, a pivotal issue that is exemplified by the televised clash between Katsuyama and O’Brien. The regulators explicitly requested these rules in the first place, which explains this flurry of filings and their immediate approval via the “immediate effectiveness” option, but the fact that this ambiguity had lingered on for so long is significant.

 

KOR Trading Visualization of Filings With Descriptions

 

Kor Trading offers statistical analysis an visualized breakdown of key filings from exchanges and brokerages.  The Group covered the complexity of Direct Edge’s routing structure in an article published on August 7. KOR addresses the retail broker routing growth to Direct Edge for NYSE listings in Q1 and Q2 of 2014:

 

 

In 2012, while appearing on Pimm Foxx’s show, O’Brien said he “actively embraced greater government regulation”.  One must wonder how many other exchanges went - and to what extent - to please their HFT clients only to file documentation clarifying what goes on their exchanges only months after Flash Boys made headlines.  Something smells fishy.