SEC Brings Action Against Exchanges Centered on Order Types

There was a time when orders for securities were straight forward – buy, sell, limit and perhaps a few variations. Now, however, there is a multiplicity of order types as Michael Lewis points out in his book “Flash Boys.” Just what each of those order types is and does is probably unknown to most investors and traders and perhaps even to many very sophisticated traders.

Now the SEC has brought its first action principally focusing on stock exchange order types. Two exchanges, formerly owned by Direct Edge Holdings and now owned by BATS Global Markets, agreed to pay $14 million to resolve charges tied to price sliding order types that were inaccurately disclosed expect to a few. In the Matter of Edga Exchange, Inc., Adm. Proc. File No. 3-16332 (Jan. 12, 2015).

Respondents Edga Exchange, Inc. and Edgx Exchange, Inc. are currently registered with the Commission as national securities exchanges under Section 6(a) of the Exchange Act. The exchanges were acquired by BATS Global Markets in 2013 as part of the acquisition of Direct Edge. Prior to their 2009 application to become exchanges, Edga and Edgx were ECNs.

ECNs and exchanges offer different categories of order types, including those which are displayed and undisplayed or hidden. The access rule, Rule 610 of Regulation NMS, requires that exchanges establish rules requiring members to avoid displaying quotations that lock or cross any protected quotation in a NMS stock. A crossed market exists when a protected bid price exceeds the protected offer price. A locked market exists when a protected bid price is identical to a protected offer price.

Under the access rule the Direct Edge ECNs developed an order handling procedure known as price sliding for non-routable orders – those that had to be executed in that venue – that would otherwise lock or cross a protected quotation, a National Best Bid or Offer. Under their procedure such an order would be ranked for execution at one minimum price variation away from the locking price. The venue would un-slide and re-price the order to its original locking price when market conditions permitted it to be displayed at the original price. When this occurred the order would receive a new time stamp. The ranking and time stamping determined execution priority for orders for the same security. The ranking reflects the price at which the submitter was willing to trade. More aggressively priced orders were ranked higher. If the orders were equally priced then the one with the first time stamp typically was executed first. This was a default position for each ECN for non-routable orders.

In late 2008 a high frequency trading firm encouraged Direct Edge to develop an alternative to its existing price slide functionality that would permit the order that would lock or cross a protected quotation to retain its priority or queue position. For the firm, this would permit it to generate profits from its trading strategy which was designed to capture certain spreads and/or collect rebated offered by trading centers for providing liquidity.

Direct Edge adopted this order type because of the possible benefits to other similar market participants. It was known as hide not slide or HNS. In early 2009 Direct Edge began a phased roll-out of HNS and amended its technical specifications for subscribers. When the specifications became outdated Direct Edge modified the operation of HSN but did not provide members with further communications on the modified operations.

As Direct Edge created a new technology platform in 2009 it made modifications to HNS. Under one HNS orders would no longer be ranked and hidden at the original locking price but rather would be re-priced, ranked and hidden at the mid-point of the NBBO and could execute at that point. These were called MPM orders. They were originally intended to have execution priority over HNS orders.

Two high frequency trading firms expressed concern regarding the modifications and the impact on their trading strategies. Direct Edge ultimately agreed that HNS orders should have execution priority over MPM orders as sought by the two HFT firms. Accordingly, modifications were made to the system.

Eventually the exchanges adopted three price sliding functionalities — Single Re-Price, Price Adjust and Hide Not Slide. These variations were not accurately reflected in the rules approved by the Commission. As a result EDGA and EDGX violated Sections 19(b) and 19(g) of the Exchange Act. They also violated a prior Commission order based on the same Sections.

To resolve the action each Respondent agreed to adopt an extensive set of undertakings. In addition, each consented to the entry of a cease and desist order based on the Sections cited in the Order, to the entry of a censure and to jointly and severally pay a $14 million penalty.