SIP On This Idea: The NASDAQ Freeze Didn't Cause A Brain Freeze
The Nasdaq “Flash Freeze,” that halted the entire US equity and US equity option markets for roughly three hours last Thursday, August 22, has been a lightning rod for anyone and everyone that has been chomping at the bit to attack both the US regulatory system and high frequency trading (HFT).
Is this inquisition justified? The answer is not as clear cut as the pundits tried to make it out to be in the aftermath of Thursday's debacle.
At approximately 12:14 pm on Thursday, the US equity market began to crash. As an independent options trader, Sang Lucci noticed the problem early, as the Level II stock ticker froze for a few Nasdaq symbols. Thinking that this was a problem internal to my trading system, a server request was made, but that did not work either.
Soon enough, it was announced that Nasdaq had crashed. This was the opportunity of a lifetime for anyone waiting to attack the current state of affairs of electronically traded US equity markets, and they took full advantage. The big voices in this space include Themis Trading and Nanex. The founder of Nanex, Eric Scott Hunsader, tweeted on Sunday, August 25, 2013 at 11:26 am that “Exchanges collect $500M/year for the SIP, then pay rebates to #HFT who compete against those using/paying for the SIP.”
There's a trend here. Experts are linking the SIP and HFT issues together.
SIP stands for the Securities Information Processor. This Processor constructs a National Best Bid and Offer (NBBO) from all the US equity exchanges, whereby subscribers (HFT, Dark Pools, ETNs) trade upon and vendors and other and news services distribute this market information. Nasdaq was given the sole responsibility of fulfilling this function on a daily basis through the Nasdaq UTP (Unlisted Trading Privileges) Plan and is funded by a small fee collected from each executed share in the marketplace.
The UTP was developed by the following Participants (the term used in the Plan): BATS, BATS Y, CBOE, Chicago Stock Exchange, EDGA, EDGX, FINRA, ISE, NASDAQ OMX BX, NASDAQ PHLX, The National Stock Exchange, NYSE, NYSE AMEX, NYSE Arca and The NASDAQ Stock Market. The argument is that because Nasdaq is a for-profit exchange, and, as pointed out by Mr. Hunsader, receives a fee for the SIP duties, it should not be given said function.
Themis Trading, in its August 23, 2013 article, made an interesting claim that since NASDAQ's profit is based upon volume and HFT comprises over 60% of average daily volume, there is a conflict of interest in the UTP Plan's model.
HFT firms profit from latency arbitrage, as they construct a faster NBBO than the SIP and take full advantage when discrepancies arise. Therefore, it is in the best interest of NASDAQ to remain slightly slower so as to allow for HFT to trade more.
Themis makes a great point, but it is not without its flaws.
Regardless of who maintains the SIP, whether an exchange or an independent organization, technical errors are always going to exist. Trading companies experience glitches, as seen from the Knight Trading debacle and last week's Goldman Sachs options blunder, and therefore exchanges do as well.
Glitches occur because there are programming errors or bugs when a new upgrade is released internally, or in the case on Thursday, between systems. According to NASDAQ's CEO Robert Greifeld, there was a connection issue with NYSE Arca that prevented quotes from being reported, whereupon a chain reaction of events occurred causing the US markets to shut down for almost half the trading day.
What this really boils down to is the quality of work in the system upgrade process. The programmers and developers that maintain and upgrade the systems at both the SIP and the other Participant organizations must be scrutinized. Why did the Flash Freeze occur around noon?
Well, coincidentally it is known to be the slowest period of the trading day and someone at either NYSE Arca or NASDAQ decided to release a system upgrade when it seemed like the safest time of the trading day. This upgrade obviously had a bug in it and caused, what some people speculated to be, a national security issue.
So the issue was not, in fact, due to NASDAQ being a for-profit SIP, but rather some internal chain of command at either NASDAQ or NYSE Arca releasing a system upgrade at an inappropriate time. Maybe system upgrades regularly occur during the day, but obviously Thursday's events show how risky this can be.
The anti-HFT/regulatory reform pundits that argue that the SIP should be a non-exchange, independent organization are missing some additional points.
As the Flash Freeze illustrated, the connectivity between exchanges is a vast and complicated animal. With all due respect to the programmers and developers that would be in line to take upon the massive project to create an independent SIP, more likely than not, the exchanges themselves are probably more capable of managing and understanding price data than an independent SIP.
Exchanges are natural participants in inter-market price feeds and would be aware of a system bug faster than an independent party. To make an analogy, the best way a trader can judge his/her open position is by watching its open pnl.
Furthermore, if the SEC was to remove the SIP responsibility from NASDAQ, it should also take away the Self Regulatory Organization (SRO) powers from US equity and option exchanges. They should not be able to govern themselves and other trading institutions in this event, as there are obvious conflicts of interest.
Therefore, in reference to regulatory reform/anti-HFT I-Told-You-So references that swarmed the internet and social media as a result of Thursday's NASDAQ debacle, the real fix to future Flash Freezes or other system glitches is to regulate the internal systems and the actual human beings responsible for upgrades and maintenance. Additionally, the concern for NASDAQ's conflict of interest with respect to SIP latency could be subsided through a regulation of standards test versus HFT engines.
If NASDAQ is required to continue to improve its speed in processing and dissemination of quote and sale data regularly, the conflict of interest issue may be put to rest.
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