To Lock Or Not to Lock?

Terry Flanagan

U.S. equity exchanges are subject to outmoded rules, such as the ban on locked markets, that stifle innovation and prevent them from fulfilling their primary mission, says a prominent market structure commentator.

“We have a regulatory framework controlling our market structure that requires exchanges to do things exchanges were not ever meant to do,” said Peter Nabicht, adviser to Modern Markets Initiative, a high-frequency trading advocacy group. “An exchange’s number one business priority was, and I think should become again, how do you match an order? That’s what lit venues do. But instead, we’ve given them a regulatory regime where they actually have to monitor whether or not they’re allowed to match people.”

Peter Nabicht, Modern Markets Initiative

Peter Nabicht, Modern Markets Initiative

Nabicht will appear on a panel on market structure at Markets Media’s Summer Trading Network In New York on Thursday, July 10.

The current ban on locked markets, which was created under Regulation National Market System in 2007, is detrimental to market efficiency and should be scrapped, Nabicht said.

“[Exchanges] might have a new order to rest at a new best price, and they’ve got to say ‘that would lock the book with another market,” Nabicht says. “So they might slide it, or reject it, or route it with a chance of it missing. This doesn’t contribute to public price negotiation. If you get rid of the ban on locked markets, you should increase the amount of lit trading you see and the amount of displayed quotes.”

A locked market occurs when there are multiple marketplaces trading the same security and a bid (offer) on one marketplace is posted at the same price as an offer (bid) on another marketplace. Had both orders been entered onto the same marketplace the bid and the offer would have matched and a trade would have been executed.

Those in favor of maintaining the ban on locked markets say that allowing locked markets would result in an increase in crossed markets, where bids on one exchange are at a higher price than offers on another exchange.

In her June 5 speech on equity market structure, SEC chair Mary Jo White took note the of the large number of complex order types offered by the exchanges, most of which are designed to deal with the SEC’s rule against locking quotations.

White has asked the exchanges to conduct a comprehensive review of their order types and how they operate in practice. As part of this review, the exchanges will consider appropriate rule changes to help clarify the nature of their order types and how they interact with each other.

Nabicht said that the number one market structure issue is trading in the dark. “Whether it be dark pools, internalization, payment for order flow or hidden orders on lit venues, we’ve reached the tipping point where I don’t think we have nearly enough size displayed in the book in terms of size that gets traded,” he said.

Requiring exchanges to route order flow to other exchanges sends the message: “Don’t do what you’re good at, instead allow your competitors to do what they’re good at, and help them with it,” said Nabicht. “That makes no sense.”

“By saying you can’t have a locked market with another exchange and you’ve got to be able to route orders out to other exchanges, we introduce a ridiculous amount of complexity for the market,” he added. “I think those are the two biggest issues: dark trading, whether it be on or off exchange, and a set of rules that cause exchanges to have to build complex systems to do something they’re not good at.”

Featured image via Alexandr Bakano/Dollar Photo Club

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