08.29.2013
By Terry Flanagan

Nasdaq and Bats/Direct Edge Provide Market Insights

The Nasdaq outage and the Bats/Direct Edge merger, while unrelated, provide insights into the market structure changes that have come about as a result of automated trading.

“Bats should be applauded as being one of the most disruptive agents in the U.S and European exchange space and this deal gives it the operating scale to become one of the major global players,” said Steve Grob, director of group strategy at Fidessa.

It also signifies another important dimension to the simultaneous fragmentation and consolidation that is taking place around the world.

“While it’s true that exchanges and alternative venues are consolidating, the actual number of order books among them remains roughly the same,” Grob said. “This plays into the hands of the HFT community which thrives on market complexity and yet reduces their co-lo and other exchange connectivity costs.”

As for the August 22, 2013 Nasdaq outage, liquidity in some Canadian stocks was significantly impacted, and trading venues with inverted pricing models experienced a greater loss of order activity, according to a report by Investment Technology Group.

Due to interlisted trading strategies, a trading halt in the U.S. dramatically reduces intermediary order flow on Canadian markets, and the demographics of orders for venues with inverted pricing models is heavily skewed towards intermediary order flow.

During the outage period, order flow distribution from TMX Select, CX2, and Omega fell from over 20% to below 5%, according to ITG. “This reveals that venues with an inverted pricing model receive a substantial level of their order activity from intermediary trading,” said Doug Clark, managing director at ITG, in the report. “Without a hedging destination, intermediaries for the interlisted symbols shut down their strategies.”

Over the last few years, Canadian exchanges have experienced their share of system outages, such as the Chi-X outage on August 31, 2011, and the TSX Trading disruption on November 30, 2011, according to ITG.

“As market participants, we have first-hand knowledge of the downstream effect on equities trading on the other venues,” said Clark.

After technical interruptions in the Securities Information Processor (SIP) data feed, a national consolidated tape of all U.S. exchanges, Nasdaq experienced a technical problem that halted trading for three hours on August 22.

ITG used this “natural experiment” to examine what happens in Canada when a major U.S. trading venue shuts down by analyzing order flow characteristics, quoted spread, and quoted volumes.

“The Nasdaq outage provided a rare opportunity to gain a variety of insights into interlisted trading on Canadian lit venues,” said Clark.

As for Bats/Direct Edge, “it will be interesting to see what happens with this deal as, for example, Bats Europe continues to run both its original order book and the one it inherited from Chi-X separately,” Grob said. “Just to be clear though, Bats is not alone in this and pretty much every venue operates a variety of both lit and dark order books. The real question is whether this is in the interest of end investors or the market making community.”

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