High frequency trader 3-Way ambush

High frequency trader 3-Way ambush opens the door to market rigging

The fundamental shift of both exchange operations and structures changed how markets work. Those changes included a key shift in the priority of who markets work for. Such changes were made with no fanfare, announcement or warning. However, the outcome remade stock markets. That remake delivered new stock exchange operating fundamentals.

Exchanges made 3 changes to the core operating technology to open the door to rigged markets. By making those changes and adopting new technology and policies, both data quality and markets themselves changed.

Parts of the high frequency trading 3-Way ​ambush:

               1. Rebates for Volume - buying trading volume

               2. Premium Data Sales - price and trade data

               3. Colocation Services - favored processor access

1st
High frequency trader 3-Way ambush

The first of the 3 way fixes began as fee rebates offered to attract HFT volume. It began with exchanges wanting to show trading in volume. That volume, management hoped would attract trades from real investors. And those real investor were the fee paying users.

That is ironic! HFT trading action happens after real investors place orders. Only then do HFT begin to generate their orders. In fact, all HFT action depends on and builds on, orders of real investors. Certainly, not the other way around.

Those fee rebates pay HFT to play and began the tilt of markets against investors. Prior to that, and for many years, exchanges, other than NYSE, offered trading fee rebates. However, it was only following the 2008 financial crisis that the NYSE adopted them. That became a watershed event.

All aboard the high frequency trading 3-Way fix gravy train!

As always there are consequences of decisions made in any crisis. In this case, the NYSE decision acted like a seal of approval for all exchanges to embrace HFT. It was the arrival of the HFT gravy train! HFT firms lined up to get aboard the ride to billions!

For HFT players that became a declaration of open season on markets. That open season was not only an opportunity to get paid to play, it was endorsement by the management of the biggest board anywhere! That quickly resulted in a torrential flow of money from HFT related fees. It was a new NYSE money deluge! What could possibly be wrong with that!

Once HFT firms delivered, promised trade volume and rebate profits soared. This scheme was named, Supplemental Liquidity Providers (SLP). In this case, NYSE fee reduction rebates were $0.00015. As a result, to profit from such a fee reduction scheme, a SLP must deliver huge trade volumes. Consequently, as generating volume was no for HFT computers, millions of transactions were quickly produced. Magic volume in a NY blink or perhaps a HFT flash!

New rebate effect changes markets

The need to generate massive volume to profit from the rebate fee structure has another effect. That effect includes making sure the program remains out of reach of even the largest real investors. As a result, with real investors, even large funds, trading nowhere near such volumes, only massive HFT volume pumping qualified.

In theory, three sources of liquidity add volume to real investor volumes. First, volume also comes from SLPs, DMM (definitions listed in Lesson 1) and Floor Trading Brokers. All those players deliver real liquidity. Their orders are real trades. But that changed because, in fact it is now algorithm controlled computers that deliver the high trade volumes. In effect, the machines have arrived and taken over trade for profit around all markets!

Exchange managements view SLP volume as computerized liquidity. As a result, they justify the related volumes as contributing liquidity in the same way as any provided by a DMM. However, that such volume rides on the backs of real investor orders gets ignored!

They give no consideration to any need for transparency or fairness. In fact, the scheme pays far too well for anyone inside the game to be concerned about fairness. Thus anyone questioning or complaining about this new volume magic is considered a boat rocker! And because all insiders are happy to have rebates serve up investors, nothing will change.

High frequency trading profits playing rebates

This is an amazing HFT profit making strategy! In the case of rebates, rebates alone can generate HFT profits! Now that is magic volume! Even when HFT can’t make money from trading on price movements, they can feed on rebate fees alone!

This is indeed magic numbers from computers! That happened once they began collecting rebates to generate order volume. To do that, the bright HFT wizards came up with another scheme that plucked money from the market. That scheme uses technology and speed to simply generate many thousands, or even millions of orders. The result...they collect rebates.

Consider this new age number magic! As they collect SLP volume fees, even trades without price movement can be profitable! Obviously, for most people, buying and selling at the same price could never make money. But these are not most people. Rather, they get paid for trade volume just to produce volume, so, when you get paid for trade volume it can and does pay!

Getting paid to produce volume ensures there is no need for profit from a trade to make money. In that case, the new bizarre reality of HFT, simple volume production wins the prize! And that prize includes taking profits!

One-Two rebate punch knocks investors to third place

Unlike investors, HFT, brokers and dealers can collect rebates. Consequently, that has the effect of hitting investors with a one-two punch! Therefore, investors get knocked back in third place. And that third place puts them well behind the inside players.

1st Punch - Rebates pay HFT to feed on investor orders.

2nd Punch - Broker rebates with no best trade assurance.

At one time exchange revenue came from two sources, listing fees and trading fees. In the first case, companies paid listing fees as part of the capital raising process. In the second case, investors paid trading fees to place capital with those companies. Both sides thought those fees were fair compensation paid to exchanges as fees for service. That was then, now things have changed

Exchanges discovered two new revenue sources. First new fee source were fees for the new data services. They quickly realized data and data feeds had great value and managed data could be milked for much more value yet.

Second new fee source was selling access. Access fees became a new exchange gold mine! ​Now, high fees charged for feed of rich data provides huge amounts of revenue. And millions more in new revenue was added by the astronomical colocation fees.

As the new fees payers could bare high costs, the new fees quickly came to rank as the first and second greatest sources of exchange revenue. That knocks investors big and small back to third place as exchange revenue producers.

Has your broker joined the rebate greed feed?

And does your broker play you order against you? Are they using your own orders to work against your interest? If so, their firm may be among the many who are in on the rebate greed feed. In fact, your financial advisor may not even be aware that this particular greed feed is happening. It is more inside dealing.

That greed feed, gets cloaked in a liquidity cape, for presentation as providing adding liquidity. Any liquidity gain is minimal as the focus of HFT, like your broker, remains on making money. That is profit for then, not necessarily profit for you. Still they focuses on profit not liquidity.

The possibility your broker plays against you has now gotten built into markets. It comes from the complex tangle of fee and rebate programs. Exchange rebate programs include stock quote posting payments. As a result, exchanges pay to attract quotes offering deals to large order sources. Like your broker.

It works for exchanges to attract quotes from many sources. They make it up on the other side by charging fees to access those collected quotes. All that is normal. The costs are part of the fees we investors pay to trade.

It changed when an alert broker firm manager realized an order flow could make money. The firm could profit by directing their client order flow. Now firms chase fee streams for quote posting and for trading volume.

The stream of payments go into the firm account, not to client accounts. Clients get nothing including any information that such possibilities even exist. That can work for the firm but may not be in the client's best interest.

Payments to brokers not necessarily the best for clients

That scheme benefits broker firms over investors. In such cases, rather than ensuring the best possible trade for investors, brokers get volume payments. Under such a scheme, brokers seek the best combination of fees and rebates for themselves. But that does not always get the best client trade.

Such payment schemes are a conflict with client interests. That conflict is another reason financial service firms want the lowest standard of client care. As they successfully hide behind the low standard of suitable trade, changing this standard will be fought every inch of the way. But that is another story for another day.

Low suitable trade standards fall far short of any fiduciary obligation. That low standard and the scheme putting money in the accounts of broker firms without compensating the client meets the low bar. And gives nothing to the investing client, the reason for the trade with the client capital and at a cost to the client. Most glaring, in such schemes all involved in collecting the benefits and fees, ignore any need to ensure clients get the best trades.

2nd
High frequency trader 3-Way ambush

We know data is the most valuable asset on Earth. And managements of stock exchanges certainly know that as well. As a matter of fact, they exert precise control of the data and data feed because of this great value. As well, HFT know that data feeds has great value. That value includes revealing to anyone gaining access,  all investor behavior and market data. Doing that reveals all buying and selling action before the trades even get completed. Imagine, looking into the future for guaranteed trading opportunities! And all that information puts every investor at a disadvantage. In effect, guaranteeing HFT profits from all our trades.

That data access gives every investor unfair competition in a race we did not know we were in. And, when it started,  we did not even know it existed. Now, HFT, the competition for a trade, knows all about every investor order.

Yes, that includes your order, or any order placed but even before it gets filled. In fact, they know of all orders before anyone actually can buy or sell stocks. After all, HFT get the information directly from the exchange. And they get the advantage by seeing all exchange trade and order data before anyone else. Definitely, we are talking about a market sharply tilted to favor HFT!

By selling that data, exchanges give HFT a view of all investor orders before any fills happen. For the privilege, HFT pays millions to feast on the rich data of investors and markets. After the rich data scheme began, markets radically tilted. Indeed the stock market got rigged.

And because HFT technology can put any order they wish in front of any investor order they want. Obviously all investors are at a disadvantage. That includes your, my or any other investor’s order! Even the largest professional fund managers in control of billions are put at such a disadvantage!

Exchanges make millions selling data and news

Investors know news and data have great value. The more information the better and the sooner you know, the better. Exchanges and HFT also knows the high value of this data. That value includes giving themselves a huge advantage over all investors. Now, their only competition is another HFT. All HFT now build the purchase and use of investor and market data into their systems.

High frequency traders get an inside information track

Exchanges sell this inside track information to HFT by supplying:

1. Rich Data, big data, structured data, all data for sale!
2. Order Access to all investor orders large or small!

Rich Data Sales:

Exchanges sell HFT high speed rich data feeds. At the same time or actually behind that time, regular investors less data, later, at lower speeds. That time differences begin as mere milliseconds. But a head start of milliseconds is all it takes for HFT to win every time.

Milliseconds can put all investors at both a time and information disadvantage. It lets HFT act before investors even see their own or any other market or trade data! That deals an information advantage to HFT over investors.

Investor order access:

Exchanges sell access to real investor orders. That lets HFT read, react, clip, remove or place orders ahead of investors. It lets HFT see and seize opportunities from every investor order. As a matter of fact, it happens after the investor order gets placed but before it gets filled. At that in between milliseconds of time, they get to look at your order and place their order in reaction. And they can do that with every other investor order large or small. In other words, they can look at them all!

Huge revenue producer moves investors to the back

For a price, a high price, exchanges deliver far richer markets and exchange data feeds to HFT. In our millisecond world investors get relevant market information. But they see less information, later, and yes at a far lower price.

It is not like investors, even very large investors, have a real choice to buy those data feeds. Since the prices are astronomical. Because the prices are so high, only HFT using the data to prey on millions of orders, can hope to make enough to cover costs and profit. Therefore the arrangement of data feed and high fees clearly makes the exchanges in effect, partners with HFT. That partnership is aligned against the interests and pockbooks of investors.

Those rich data feed prices are out of reach for anyone not able to place thousands of trades or more day after day. Only HFT can produce a daily revenue stream from such a strategy. But, for HFT that profitable stream of trades justifies paying the premium data feed prices.

From the exchange point of view those rich data fees are also very important. In fact, those premium data prices produced huge revenue flow for exchanges. Morever, that data fee flow is new, occuring only after the arrival of HFT. So the high cost tie exchange profits directly to what has become a tax on investors by HFT to benefit HFT. And while that fee flow is exchange profit an d HFT profit, not everyone wins. At the same time investors get used and lose while paying the higher costs imposed by HFT.

Investor order information sold

HFT uses the rich information feed to take profitable advantage of investor orders. They can take advantage of any large or small investor order. That means when you place an order HFT algorithms see and react to it before your order gets filled.

Faster than a blink, HFT reacts to buy, sell, create, cancel or change an order to profit. By seeing your order they know what reaction makes it pay for them. That happens in the brief instant after you place an order but well before even a market order gets filled!

HFT speeds ahead of investors and seems to be well beyond the speed of trust. At least this investor wonders what is the exchange speed of fairness, truth and transparency? Or are profits for the gang on the inside all that matter to exchange management?

And talk about an inside track! So much for fairness, truth and transparency! The HFT data feed includes all investor in-play orders. Because of that, it is no surprise that exchanges find a ready market for such valuable data feeds!

We can understand why HFT firms are eager to buy that valuable data. With the cooperation and support of the exchanges, they access the data. That data gets run into their systems and algorithms do the rest.

Data sales now produce significant portions of exchange revenue. Now discovered as a rich revenue source for exchanges, data helped the spread of HFT. Now with feed of inside information HFT activity spread across most markets.

3rd
High frequency trader 3-Way ambush

Then we come to the 3-Way crowning glory of inside fixes built into exchanges. Namely, a real estate play! However, not much real estate. Amazingly, we are talking about a few square inches costing millions! And that is just the rent! Therefore, these few square inches must be some of the most expensive real estate anywhere!

HFT firms pay huge fees to locate their servers right next to the exchange matching engines. Most importantly, those matching engines are the computers at the heart of the exchange. In detail, that computer heart is actually the device that makes all trades on electronic exchanges. As a result, being as close as possible puts HFT computers at the very front of the line. That way, right inside the exchange data center server room, HFT gets and stays ahead of all investor trades.

That server room now houses both the matching engines and the servers for HFT active on that exchange. As exchange matching engines match the buy and sell orders and process all those transactions, every trade, every order on the exchange goes through a specific matching engine. As a result, HFT servers located right next to those matching engines have an advantage over all other traders and certainly over every investor. Instantly, HFT get the messages, the data, first.

Occupying that space is called colocation. Further, selling colocation services generates many millions in fees for exchanges. And paying those fees, HFT gain access to data and opportunity to generate many more millions for themselves.

Colocation the front row seats for stock market access

Colocation provides the ring side seats to all exchange action. Because that desirable space attracts keen interest, prices are high. Consequently, for very high rent, exchanges give access to that location. Doing that is like selling an inside passage to the very front of the trading line.

Since connecting HFT computers right next to exchange computers is the front row seat, millions in fees are paid. In fact, it is like selling the front row of a box office ticket line access to first choice on the most desirable seat or every seat to every show!

That nanosecond access puts HFT closer to the action. And that puts HFT far in front of any investor. While that valuable real estate costs millions, access to the data and trading on it can be worth billions! In that case, intimate data access for HFT before anyone else gives this inside gang a look before anyone else even knows it exists!

Colocation guarantees HFT gets and keep the front of the line. by selling that advantage, exchange revenue streams grew by millions. But that inside win-win spreads a thin layer of costs across markets. In that case it is investors the bare the costs of what amounts to a tax imposed by HFT.

Technology evolved into front line processor access

Exchanges centered on trading floors recorded deals made between face-to-face traders. In such circumstances colocation would have limited value. That all changed when electronic trading became accepted and universal across exchanges.

Once exchanges switched to electronic trading everything was subject to change! Secure purpose built data centers became the new heart of every exchange. Locating next to the computers used to process exchanges became very valuable.

Trading floors became history. Exchange data processors are miles from any former trading floor. Spaces next to exchange data processors are now the prime stock market real estate! Exchanges sell HFT firms those locations for their data processor access. No investor needs to apply. The price occupy this real estate begins in the millions! This costly game is only for the inside high volume market trading crowd.

Those high costs aren't too much for HFT firms. Colocation gives them opportunity. They can nip a penny or fractions from millions of real investor orders. The totals clipped from millions of investor orders equals big time HFT pay!

Ever more high frequency trading secrets

Like the rest of the HFT scheme, this part of the story also began in secret. In fact this was the biggest HFT secret. Favorable data center colocations were the billion dollar secret! Market insiders did their best to keep this well away from investors.

It was the shift to electronic trading from human floor trading that set the stage for the HFT blitz. That opened the doors and access to exchange data processing. It provided the most important fix for HFT. Those changes made certain that the fix was in.

High frequency traders 3-Way ambush changes markets

The fallout from the 3-Way fix changed exchanges and stock markets. While some changes were minor, others very significant. At the time of the financial crisis, exchange management was desperate for solutions. Because of the pressure to do something and driven to find liquidity, HFT volume seemed like a good idea. Still, they needed to keep bottom line profit which remained their biggest concern. Going with deals for HFT seemed like a good solution. After all, to make markets work, they had to find trading volume. At least in theory any volume could provide the market with liquidity. How could volume from any source be a problem or change markets? Perhaps an example of careful what you wish for!

3-Way fixes give high frequency trading superpowers!

Technology promised the fastest way to find both volume and profit. As a result making three key structural changes gave HFT firms a huge edge over investors. In each case, the fix gives HFT an advantage.

Used together the 3-Way fixes give HFT firms superpowers over all other investors. And for HFT the triple header of a 3-Way fix remade markets. Another result was the changes happened fast. And those changes delivered an instant effect on investor orders.

Profit production flips tables on old values

In lesson 4 we learned new o wners took over the NYSE. The change in ownership brought new values to effect deep changes. Rather than efficient operations, new owners wanted more profit for more sources. And they wanted them now. The desire for more profits from more sources drove change. That brought internal stock market changes.

Exchanges hooked by new revenue and profits

Lesson 4 also discussed NYSE exchange management began shifting focus with new owners. As a result they pursued more and new revenue and profit by developing new services.

Management expanded the fee for service business. The new services include data products and preferred access to exchange operations. These became the inside tracks to HFT success.

Rich data production turned into rich profits

Stock exchanges are rich data producers. Management turned that flow of data production into gushing revenue. Exchanges also discovered huge access fees. They sold inside access to data processing. That was colocation. Colocation services placed HFT servers right next to exchange data processors.

For exchanges, the relentless pursuit of revenue and profit became their new priority. The former prime role of raising and placing capital mattered but less. Making more money by any means became the driver. Data and colocation customers became the top priority for exchange management. The exchange served the new top dogs.

Exchange revenues grew for 400 years:

For centuries stock exchanges had two major sources of revenue:

1. Listing fees

Paid by companies wanting to raise capital by selling shares

1. Trading fees

Paid by investors and traders for access to buy and sell shares

High frequency trader 3-Way ambush brings revenue:

With the 3 fixes in exchanges feasted on new rich revenues:

          1. Data fees

Paid for more and faster pricing and trading data

          2. Colocation fees

Paid for close access to exchange trading engines

New revenue sources turned the tables

New revenues changed everything. A major result came from the new flood of fees. In a New York minute the new revenue became the new king of the stock exchange hill. Data access and colocation fees became the most important sources of revenue and profits.

The old listing and trading revenues fell to 3rd and 4th place. The fundamental priorities of stock exchange managements changed. That ensured HFT became the stock market top priority user.

Mass orders created, executed or cancelled

HFT algorithms place, execute and cancel huge volumes of orders. They act and trade shares at incredible speeds. HFT operates at trade frequencies well beyond what any human can see. These speed, technology and inside fixes all favor HFT. That means HFT operates well beyond the ability of you, me or any other human.

How high frequency trader 3-Way clips investors

It only gets better for HFT firms! Speed and technology advantages get a further boost. The triple header of build-in exchange cement them inside the exchange. With all these parts working together HFT has huge advantages over any real investor.

First, it begins with HFT paid to deliver huge trade volumes. That meets their promise to provide liquidity. Second, HFT firms get preferred data feeds. That lets them see all real investor orders. Third, their colocation advantages give them more speed and position advantages. Those advantages let them step in front of any investor order.

Their process begins by seeing data from real orders. Then knowing what an investor wants to do, they use their technology and speed advantages. Those advantages let them take profit making action. They can beat any investor to any real opportunity.

After reading any investor order, they can place a new order in front of the investor order. That happens before any investor order gets filled. When those new orders get taken by investors, HFT collects guaranteed profits. When the HFT orders are not taken by investors, the order gets canceled. Their technology play is a one way no lose deal!

High frequency traders see your cards before you do!

Like players in a card game, after you bet but before HFT places a bet the dealer lets them see your cards and bet! Then they can place their sure thing bet. And they can get it in front of you.

Seeing investor orders first gives HFT a virtual guarantee they can profit. The cost gets paid by the investor that does not even know they are in the game. All real investors pay costs to benefit these few market insiders. And all developed, done and continued in secret. Not cool, not fair, not transparent!

Trading is arcane, highly technical and bewildering which is the way financial services like it just fine. All the better if they manage to leave you confused and intimidated. Financial services would like you to simply give them your money, pay them well and scoot.  But that is not in your best interest. To get the most for you out of your money requires learning how to invest well. Begin by building your own investor mind.

Later lessons give techniques and strategy to counter the HFT advantages. The next lesson considers the roles played by regulators. SEC and exchange regulations and actions continue to enable HFT. That is a key to the HFT market rigging scheme.

Wrapping up technical bits and pieces: NMS, SIP and NBBO

Understanding HFT requires knowing the importance of latency. Latency is delay, the amount of time it takes for something to happen. Some things in some places take longer to happen than they do in other places.

That applies to your fast food order or placing a phone call. It also happens in stock markets when a stock can trade on several markets. Some price and trade fast, others have slower responses.

Distance is also a factor affecting communication speed. As a result we expect nearby exchanges to receive and return communications first. Most often before exchanges located far away or across the continent.

Latency, data and distance issues are all well known. Both the Securities and Exchange Commission (SEC) and exchanges responded.

First came the National Market System

A consolidation of rules became Regulation National Market System (NMS) June 29, 2005. NMS requires exchanges to give buyers and sellers the best possible bid and offer price. That means the best price from all markets. So, all markets must connect and display all bids and offers. That includes your modest order and the largest fund orders.

But, displaying large orders was a set up for predatory trades. Traders reacted to large order displays by racing ahead buying any desired inventory. HFT predators win that race every time. After buying, they immediately resell to the institution at a markup. That adds no value but does add cost for that institutional buyer.

The data flow between each market has a tiny communication time difference. At the same time, regulations permit exchanges to provide customized market data. Those feeds provide customers with a fee for service service feed. For a fee, paying customers get more, better or faster service. That is a fee to tilt the table.

Combine data flows and colocation services put investors at the bottom of a large pile. And HFT goes to the front of that line or any other line they choose. That puts HFT ahead of the public and ahead of all investors large or small in the ultimate inside data play!

The combination of data feed time delays gets large. Feeds between markets vary and customized data feeds increase those differences. That is the perfect operating base for HFT. Talk about unintended consequences of regulations! From the beginning of HFT, it feed on data flow time differences. The combination of data flow time differences and blazing fast technology produced billions. That is the core of the HFT issue.

Going dark avoids predators

To avoid exposing orders to HFT, institutions turned to private exchanges. Those private exchanges were the first dark pools; private exchanges created for institutions. Dark pools grew from a few to soon outnumber public exchanges. These were the secret members only clubs of stock markets.

In response to HFT algorithms also lead to the development of Smart Order Processing (SOR). SOR software breaks a large institutional order into many small orders.

SOR orders get distributed as many smaller orders throughout several markets. They seek the best total results. But the HFT wizards were quick to program automated responses. They could then counter the counter attack. Soon they again feasted on these large investor orders.

Dark pools soon grew to outnumber the public exchanges. That produced more competitive pressure. And wouldn't you know it but pressure opened the dark doors to HFT!

NMS - Regulation National Market System

Requiring the best possible price for buyers and sellers first happened in 1975. That was the beginning of the SEC National Market System (NMS). It also set a one penny increments and the trade through rule. Trade through requires giving the best price irrespective which exchange has it.

The NMS rules seek to make the display of price and data information fair and available on U.S. exchanges. As outlined below, SIP and NABBO are parts of NMS.

SIP - Security Information Processor

Security Information Processor (SIP) links U.S. markets. SIP real-time trade and quote data intends for everyone to have it all. But, then we meet the real world. Like any technology network every day it becomes more dated. It works but the newest and fastest technology can deliver selective data faster.

Following the rules, data gets released to everyone at the same time. But in a nanosecond world there is no rule that all receive it at the same time. As a result data gets released to SIP and colocated HFT servers at one time. While small investors wait for the SIP feed, colocated HFT players can speed ahead.

Colocated HFT servers can read any investor order and place their own in front of any investors! That all happens long before we even see our order displayed on our own screen, let alone get executed. Colocated HFT players have hit, run, profited and moved on. All before we blink.

The SIP feed is key to that. It produces the NBBO (see following) but doing so takes time. Even the few milliseconds taken matter. That latency or delay, gets used to trade ahead of investors. This is the core predatory HFT activity.

NABBO - National Best Bid and Offer

National best bid and offer (NBBO) became the regulatory standard. NABBO required all exchanges to connect and share pricing information. It requires brokers to execute customer trades at the best available price.

But in the market, the first trade was truth and transparency. Volume and profit came out as the winners on that trade. And the real winners are those willing to pay more for the privilege of preying on investors. Regulators and lawyers performed the needed gymnastics to allow market predators free reign.

Accessing data first, allows HFT to run free over markets and investor orders. NBBO data is old. Before the public or all exchanges see it, HFT has used data gleaned from colocation to move to the front.

They get and use the information before anyone else! Astronomical fees get paid for that colocation advantage. Those fees produce a large part of exchange profits. Now the vast majority of NYSE volume comes from the HFT feeding on exchange proprietary data.

Resting orders spur legal battle

Then a stir of regulatory movement! In 2018 the SEC announced the exchange broker rebate programs were under review. In Dec 2018 SEC announced approval of a test of restrictions. The restrictions limited the amounts exchanges could charge for trade executions. They also proposed to limit rebates paid brokers. Payment restrictions were set for orders others can trade against called resting orders.

Resting orders are limit orders priced to buy below the market or sell above the market. Buyers and sellers can trade against these orders as a backstop. They act as a fall back position when trading. HFT use resting orders to profit and manipulate trading in their favor. See order types and strategies explained in the Starting Small course. Lessons in that course give a full explanation of the various stock market order types.

Conflict testing starts legal conflicts

The SEC proposed making restrictions as a test of the rebate issue. The issue is a big deal because it involves payments of about $2.5 billion per year! Those bucks are mega incentives!

But do they create conflicts of interest? The trial was to run for one or two years. The payments to brokers provide an incentive for those brokers. We expect they would send client orders to exchanges paying the biggest rebates. That may mean the client of the broker does not get the best result. Were brokers ignoring this or taking the easy way and not looking for a better client outcome?

Exchanges traded well and very profitably for HFT and themselves. They wanted no pesky or disrupting regulations! So, in Feb 2019 the industry responded. ICE, NYSE, Nasdaq and Cboe (owners of 13 of 14 U.S. exchanges) all filed notice to sue the SEC.

Announcing the suits, they called the SEC move overreaching. The tired liquidity argument also got dragged out. In other words, they floated the rebates attracted order that provided liquidity. That implies those orders would not otherwise exist if the exchanges did not pay the rebates. Questionable stuff but a fair question.

Perhaps more of a problem, the SEC had not shown the rebates harm the market. That argues the SEC must determine there is a problem, not undertake a mission to shed light on the issue. In any event, the issues are legal matters so they will not bother with common sense.