Streetwise Professor

August 10, 2013

SLOB vs. CLOB

Filed under: Economics,Exchanges,Politics,Regulation — The Professor @ 1:00 pm

I just read Haim Bodek’s “The Problem of HFT.”  It reinforced my belief in what I’d long concluded, namely, that the problematic aspects of HFT result from the decision of the SEC to create a Simulacrum Limit Order Book-a SLOB-rather than a true Central Limit Order Book-a CLOB-when it promulgated RegNMS.  As I noted at the time, the SEC chose an “information and linkages” approach to create a National Market System that consisted of interconnected competing exchanges, rather than to create a single CLOB.  In achieving competition, it was hugely successful.  Whereas NYSE dominated trading in its listings pre-RegNMS (with a market share in the low-to-mid 80s), now executions are divided rather equally among a handful of exchanges.  There are few rents in securities execution in the US anymore, in contrast to the old floor days.  NYSE’s equity business contributed relatively little to the price paid by ICE for NYSEuronextLiffe.

Part of the decision to  was political economy: politically, the SEC couldn’t have realistically favored one venue, or displaced existing exchanges by creating a new national CLOB.  Part of this decision was predicated on a defensible and understandable desire to encourage competition in securities trading, in fees, rules, liquidity, and technology.  However, the SEC didn’t anticipate how the market structure would evolve, and in particular, how HFT would transform securities trading.  I can’t say that anybody did.  I certainly didn’t.  I thought that automated trading would link markets, but I didn’t see it playing out like it did.

I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB.  Price priority is for top of book only.  Time priority (or other secondary priorities) are not enforced across trading venues.  Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically.  Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB.

Because it links multiple execution venues, the SLOB has many seams.  And one thing we know is that traders traders look for and exploit seams like Tom Brady looks for and exploits the seams in a zone defense.  Bodek’s little collection of essays goes into considerable detail on how traders have worked the seams, and how their methods have changes in the last 6 years.

The most critical seam in the SLOB, in Bodek’s accounting, is the rule on locked and crossed markets.  The SEC rules state that an order on exchange A that locks or crosses an order on exchange B cannot be displayed.  This complicated the task of quoting aggressively: an HFT that submitted an order that locked or crossed a market would not be able to establish position at the head of the queue.  To address this, traders first used spam and cancel: repeatedly sending orders that were canceled if they locked or crossed, but which would go to the front of the queue as soon as the quote in the away market changed.  Exchanges had implemented algorithms that re-priced orders that locked or crossed away markets, and put them at the end of the price queue.  HFTs circumvented this using hidden order types that were not displayed if they locked or crossed, but which were displayed-and crucially went to the head of the queue at the new price-the instant their price would no longer lock or cross an away market.  HFTs also used sweep orders to establish priority.

The common features behind all of the things Bodek criticizes are that (a) they are all intended to establish priority, and facilitate aggressive quoting, and (b) they can happen in a SLOB, but not a CLOB.  They give an advantage to HFT firms that invest in the technology and in understanding the order types, to the detriment of those who don’t (including many institutional investors): this is Bodek’s main beef.  They are an artifact of the prohibition on locks and crosses, and this can only occur in a fragmented market structure that precludes locks and crosses.  If locking and crossing orders were matched against one another and executed, as would happen in a true CLOB, much of the gaming of order types Bodek laments would go away: I suspect, however, that latencies across a system of linked exchanges would make this impractical.

This relates to, and complicates, points I made in my writing on exchange competition in the late-90s and early-00s.  Competition between privately operating CLOBs with no obligation to route orders to markets displaying better prices is likely to result in the survival of a single dominant platform that exercises market power.  This is arguably the case in futures markets.  A CLOB utility that is regulated to mitigate this market power problem raises myriad difficulties.  Who will operate it?  How will rates be regulated?  How will access be regulated?  (One way to exercise market power is to limit access to the CLOB.)  How will the CLOB utility be governed?  How is capture (by major intermediaries, for instance) to be avoided?  How can the CLOB be incentivized to be technologically innovative, rather than a lazy monopolist (especially since some technological changes may be very disruptive to the business models of important market participants)?

Socializing order flows by requiring exchanges to route orders to other markets displaying better prices encourages competition, and seemingly avoids the problems posed by private CLOBs and utility CLOBs, but raises its own difficulties.  Indeed, these are the problems that we are experiencing today, and which Bodek identifies.  This raises the question: can we clean up SLOBs so they are more truly CLOB-like, while retaining interexchange competition that mitigates market power problems?  The answer to this question has both technological and political components.   A system of linked exchanges necessarily has seams and latencies and inter-market coordination issues absent in a true CLOB, and these are vulnerable to gaming and breakdown, and even during normal operation represent a more complicated and error-prone way of allowing all orders to interact with one another than a true CLOB.  The political components arise from the fact that interested parties, most notably exchanges, major sell side intermediaries, and big buy side institutions, will strive to shape the system’s design and rules to advance their interests.

The trade off is therefore pretty stark: it’s a pick-your-poison kind of thing.  Don’t socialize order flow and live with market power, or socialize order flow to facilitate competition, and grapple with the technological challenges of creating a virtual CLOB, and fighting the never ending battle against attempts to exploit the seams.  I don’t claim to know the right choice, but I think that framing the issues in this way will permit far more constructive debate than the one currently ongoing.  This debate has become Manichean: good vs. evil: black hats vs. white hats.  It is oddly ahistorical, in its failure to recognize the problems with the previous system.

Perfect is not an option here.  Which is why debates over securities and derivatives market structure have been raging for as long as securities and futures have been traded.  The debate would be more productive-less sterile-if the choices were framed more clearly.  I’ll keep trying.

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8 Comments »

  1. @Professor I recall reading a few months ago Bodek admitting that what he is labeling as “hidden” is not hidden at all and with due effort anyone could learn these order types. The question is if they did find it worthwhile learning something new…

    On another note one of the remarkable statements of Bodek in the book referenced by and which I totally agree with is the following:

    “Many exchange features introduced as innovations were in fact features designed to assist HFTs in “regulatory arbitrage” activities that circumvented Regulation NMS to get an edge over other traders in the marketplace.”

    Bodek, Haim (2013-01-15). The Problem of HFT – Collected Writings on High Frequency Trading & Stock Market Structure Reform (p. 65). Decimus Capital Markets, LLC. Kindle Edition.

    Comment by MJ — August 11, 2013 @ 12:43 am

  2. I meant “referenced by you”

    Comment by MJ — August 11, 2013 @ 12:43 am

  3. And another note of his:

    “HFTs weren’t the “quant” savants they claimed, but were in fact masters of “regulatory arbitrage.”

    Bodek, Haim (2013-01-15). The Problem of HFT – Collected Writings on High Frequency Trading & Stock Market Structure Reform (p. 65). Decimus Capital Markets, LLC. Kindle Edition.

    Comment by MJ — August 11, 2013 @ 12:46 am

  4. […] SLOB vs. CLOB I just read Haim Bodek’s “The Problem of HFT.”  It reinforced my belief in what I’d long concluded, namely, that the problematic aspects of HFT result from the decision of the SEC to create a Simulacrum Limit Order Book-a SLOB-rather than a true Central Limit Order Book-a CLOB-when it promulgated RegNMS. https://streetwiseprofessor.com/?p=7530 […]

    Pingback by The week that was (aka Dazzling Derivatives; issue of 12th August 2013) | The OTC Space — August 12, 2013 @ 9:19 am

  5. I saw this early on in electronic trading. The NASDAQ had no ban on dual trading, and brokers routinely would run the electronic market prior to executing a paper or flashed order they received in the pit. This was a form of creating arbitrage opportunity. As trading evolved, we saw that the fragmentation was putting some traders at a disadvantage.

    In CLOB, co-location is the way they are able to arbitrage against the rest of the market. Having access to actual market and order book data milliseconds ahead of everyone else means profit and arbitrage opportunity.

    The SEC side of the market is more screwed up than the CFTC side. But, both have problems. I am NOT for getting rid of electronic trading, or HFT-just want the playing field to be level. No more pay for order flow, dark pools, internalization, trading against customer flow.

    The industry also needs to enforce rule 514 out of the CME rule book. For example, creating ficticious trades happens a lot with HFT (quote stuffing, flashing etc). It needs to be severely penalized by the industry, and more importantly by the HFT shops themselves. They are the best ones to police the bad guys-of which there will be some. We had bad guys on the floor, and eventually, everyone knew who they were.

    Comment by Jeff — August 13, 2013 @ 6:01 am

  6. […] The Streetwise Professor, reviewing Haim Bodek’s The Problem of HFT, makes an important point about true central limit order book markets (CLOB markets) vs. those where a poor simulacrum of a central limit order book (SLOB) is created via market linkages: I call what the SEC wrought a “simulacrum” order book because although it incorporates some aspects of a central limit order book, specifically price priority across exchanges for the top of book, it lacks several crucial features of a true CLOB. Price priority is for top of book only. Time priority (or other secondary priorities) are not enforced across trading venues. Markets can cross or lock-which can’t happen in a CLOB, where locked or crossed orders execute automatically. Moreover, latencies, particularly in the public feed of the NBBO create behaviors and incentives that diverge from a CLOB. […]

    Pingback by Deus Ex Macchiato » SLOBs and CLOBs — August 15, 2013 @ 2:34 am

  7. […] and CLOBs, here. The Streetwise Professor, reviewing Haim Bodek’s The Problem of HFT, makes an important point about true central limit […]

    Pingback by Two From Deus Ex Macchiato « Pink Iguana — August 19, 2013 @ 6:24 am

  8. […] Craig Pirrong wrote a little about market structure a short time ago and concluded that a central limit order book for markets might be better than what we have […]

    Pingback by The Mainstream Media Is Waking Up on Exchanges | Points and Figures — August 24, 2013 @ 7:12 am

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