Today, the Securities and Exchange Commission fined the Direct Edge stock exchanges $14 million for violations involving their “Hide Not Slide” order types. Here’s a 2012 Wall Street Journal article that comes with basically a graphic novel devoted to how a “Hide Not Slide” order works, and I refer you to there if you want to know how it works. The thing is that you probably don’t want to know how it works. But here’s the basic idea, without the cartoon of a jumping man in a suit:
- The national best bid and offer for a stock are $10.00 / $10.01.
- For reasons of your own, you want to bid $10.01 for it, but you don’t want to just buy the stock offered at $10.01 on, say, Nasdaq.
- Instead, you want to put up a standing buy order at $10.01 on a Direct Edge exchange (EDGA or EDGX) and wait until someone hits your bid.
- You can’t do this, because the SEC has rules against “locked markets” — if the national best offer is $10.01, you can’t bid $10.01, you gotta just lift the offer (or bid $10.00).
- But the name of the game is customer service, so the exchanges come up with ways to let you enter orders that would otherwise lock markets.
Simplifying enormously, Direct Edge offered two ways of doing this:
- A limit order: You enter a $10.01 bid at 1:00 p.m. Because it locks the market, Direct Edge “slides” it back to $10.00 and displays it as though it’s a $10.00 bid. But at 1:05 p.m., the market becomes unlocked: There’s no more $10.01 offer, the national best offer is $10.02, so you can display your $10.01 bid. So Direct Edge changes your order back to a $10.01 bid, with a 1:05 p.m. time stamp.
- A Hide Not Slide order: Same, except your order is changed back with a 1:00 p.m. time stamp.
Earlier time stamps get priority in execution, so you get a better chance to actually buy stock at $10.01 if you choose option 2 rather than option 1. So why would you choose option 1? The short answer seems to be, roughly, that you didn’t: Option 1 was the default option, and you could only choose option 2 if you thought about it.
That is of course an insurmountable barrier for many people, but just in case, Direct Edge put up another barrier, which is that they did sort of a rotten job of describing how Hide Not Slide works. Not necessarily worse than I just did, but still pretty bad. For one thing, Direct Edge’s rules did not describe Hide Not Slide at all: “Displayed price sliding” of limit orders — that is, option 1 above — “was the only price sliding functionality provided for in EDGA and EDGX’s rules.” Hide Not Slide was never mentioned.
That sounds terrible, though it wasn’t quite as terrible as it sounds; Hide Not Slide was described in a “trade desk notification” sent to Direct Edge subscribers by e-mail and posted on the website, and was at least hinted at in the technical specifications, so Direct Edge’s customers could find out about it if they wanted to. Direct Edge just forgot to put it in the rules. But, separately, the description on the website was wrong: It was right for a little while, but “became outdated shortly thereafter,” due to technical changes to Hide Not Slide that are — you will have to trust me on this — even less interesting than what we’ve talked about so far. And the website was never updated for those changes.
That’s bad. You should update your website! Here’s Andrew Ceresney:
“This is a serious violation with serious implications,” Andrew Ceresney, head of the Washington-based agency’s enforcement division, said on a call with reporters on Monday afternoon. “The idea here is that if you’re going to have order types, you need to specifically, completely and accurately disclose the nature of those order types.”
A good heuristic is that if an enforcement official says that something is “a serious violation,” he doesn’t really mean it. If someone steals a billion dollars from widows and orphans, you can just say, “This guy stole a billion dollars from widows and orphans! Come on!” and everyone will understand that it’s serious. But when someone doesn’t fully update its rule filings to describe the time priority of order display in locked markets, you have to just be like, “Trust me, guys, this is super serious,” because if you actually say what happened no one will pay attention through the end of the sentence.
So is it important? I mean, obviously people should update their websites. But my stupid little story above started off with you wanting to lock a market. That is the hinge on which all of this turns: There is stock for sale at $10.01, and you want to pay $10.01 for that stock, but you don’t want to buy the stock that’s for sale at $10.01. You want to buy some other stock for $10.01, later. But not much later — you want to be the first person to buy it at $10.01 after it stops being available for sale at $10.01. I know, I know. This can actually be a perfectly reasonable desire, for a lot of reasons, but it is a niche desire.
It is of course a desire that is felt mainly by high-frequency traders. Unlike many market-structure issues, there are clear and identifiable victims of Direct Edge’s, um, hiding of its Hide Not Slide rules. Those victims are not widows and orphans, though. They’re robots. Specifically, they’re trading machines. Even more specifically, they’re Trading Machines LLC, a high-frequency trading firm started by Haim Bodek. From that 2012 Journal article:
His firm did well at first, Mr. Bodek says, but in 2009 its performance worsened on several trading platforms, including Direct Edge, a computerized market based in Jersey City, N.J. Trading Machines’ profits fell by more than $10,000 a day, Mr. Bodek says.
He suspected a bug in his trading code and talked with officials of several trading venues. Then at a holiday party hosted by Direct Edge on Dec. 2, 2009, Mr. Bodek says, he spoke with the company’s sales director, Eugene Davidovich. Mr. Bodek says Mr. Davidovich told him his problem wasn’t a bug — he was using the wrong order type.
Mr. Bodek had been using common “limit orders,” which specify a price limit at which to buy or sell. Mr. Davidovich, according to Mr. Bodek, suggested that he instead use an order type called Hide Not Slide, which Direct Edge had introduced in early 2009, about the same time Trading Machines’ performance started to suffer.
Mr. Bodek says Mr. Davidovich told him Direct Edge had created this order type — which lets traders avoid having their orders displayed to the rest of the market — to attract high-frequency trading firms.
And so Bodek brought the order-type controversy to the SEC’s attention, and the SEC looked into it. And its investigation bore out Bodek’s claims: Hide Not Slide seems to have been created at the request of, and with continuing advice from, two high-frequency trading firms (“Trading Firm A” and “Trading Firm B”); Firm A actually said that it would send more trading Direct Edge’s way if it implemented Hide Not Slide.
Unsurprisingly, the Direct Edge exchanges talked more with these firms about Hide Not Slide than they did with the people who didn’t help create it. Andrew Ceresney again: