Nanex Research

Nanex ~ 21-Jan-2014 ~ Flickering Quote Credits

Subversion of a key U.S. stock market regulation


Read this bizarre twitter dialog between Nanex and an exchange CEO over this paper.
Link to document describing SIP allocation formula. It has been confirmed to be accurate!


A key rule in Regulation NMS (Reg NMS, the body of rules governing the U.S. stock market) may have been subverted in the implementation process, unknown to both the public and the SEC (Securities and Exchange Commission). Had this key rule been implemented as written, exchanges favoring tactics employed by high frequency trading (HFT) would have been at a disadvantage: they would have received a smaller share of the $500 million in exchange fees collected annually from 2.5 million subscribers to real-time stock quotes. The subversion of this key rule removed an important incentive placed by the SEC and the industry to ensure investors receive reliable stock quotes.

Executive Summary

Every year, the U.S. stock exchanges together receive approximately $500 million for providing real-time stock quotes to subscribers of the SIP (consolidated market data). The portion of this $500 million pie that each exchange receives is determined by the number of trades executed and quote credits earned using a strict set of rules specified in Regulation NMS (Reg NMS). Quote credits are earned when an exchange's quote is at the NBBO (National Best Bid/Offer) for at least 1 second. Quotes that change in less than 1 second are called flickering quotes. Flickering quotes are specifically excluded from earning quote credits because they are detrimental to the market (high frequency traders use flickering quotes to probe the market or to trick other algorithms and humans).
However, a recent document produced by the consulting group Tee Williams Associates, sent to us by people familiar with the matter, describes an elaborate set of rules and formula, apparently hatched behind closed doors, to allow flickering quotes to be eligible for quote credits. These rules involve things like changing the timestamps and prices of quotes. From these altered quotes, the "best" is selected using an elaborate scheme that uses a sliding window of time, sliced into 1/10th of a second intervals. The "best" of these altered quotes is called a RBBO (Revenue Best Bid/Offer), a term not used anywhere else in the industry. These altered quotes are then matched up to the RBBO for the sole purpose of awarding quote credits.

If this sounds a lot like gerrymandering, it is, except we can't find any public record of this process. The date of this document predates the final ruling of Reg NMS, and Reg NMS has no language offering clues of its presence: it doesn't appear that the SEC was aware of this RBBO/flickering quote scheme.

A recent letter from SIFMA to the SEC requesting an audit on sub-second (flickering) quotes provides additional evidence of this rule subversion:
.. In addition, the SEC should request an independent financial audit of SIP finances and, in particular, the implementation of the market data revenue distribution formula. This audit should include an analysis of how the revenue formula is accounting for sub-second quotes in the formula and how sub-second quotes are being provided to SIP by Plan participants vs. how they appear in direct feeds. All of these audit results should be made publicly available.

The acknowledgements section of An Introduction to Trading in the Financial Markets: Technology: Systems, Data and Networks by R. Tee Williams (of Tee Williams Associates) mentions the work of the aforementioned document, along with the names of those who worked on it.

Finally, among the many detailed rebate and fee schedules from the 14 different exchanges, we can't find any fee that specifically discourages flickering quotes. In fact, the word flickering doesn't appear even once. That seems highly unlikely, given that flickering quotes play a prominent role in a calculation involving hundreds of millions in annual profits.

Those of you who know all about flickering quotes may wish to skip straight to the discussion of this troubling document.

What are flickering quotes?

Flickering quotes are quotes that last for less than 1 second, making them inaccessible to millions of traders and investors who have elected not to spend tens of thousands per month in co-location costs for timely stock prices. Many of these flickering quotes are also inaccessible to people who collectively pay hundreds of millions of dollars for real-time data, but receive that data outside of the exchange data center in New Jersey. Flickering quotes are quite common - they are a hallmark of High Frequency Trading (HFT) - so examples are plentiful.

The charts below show what flickering quotes look like. The gray shading is the NBBO spread (best bid, lowest offer from all exchanges quoting this stock). The triangles show the best bid or ask price and are color coded by the exchange that submitted the quote. Best Bids use triangles pointing up, Best Asks use triangles pointing down. Each chart shows about 15 seconds of time on January 16, 2014.

1. Agilent Technologies, Inc (Symbol: A, market cap: $20 Billion).
The best bid flickers rapidly over a 20 cent range (60.02 to 60.22) and involves multiple exchanges. The best ask also flickers, but over a shorter range.

2. Varian Medical Systems, Inc (Symbol: VAR, market cap: $8.7 Billion)
The best ask flickers rapidly over a sliding 20 cent range and involves multiple exchanges. Several seconds have flickering best bid prices.

We've also created a number of videos showing flickering quotes.

What is the problem with flickering quotes?

Regulation NMS (Reg NMS) explains why flickering quotes are a problem on pages 259 and 260:

A specific type of gaming that concerned commenters was "flickering quotes" – quotes that are flashed for a short period of time solely to earn market data revenues, but are not truly accessible and therefore do not add any value to the consolidated quote stream.
Commenters also were concerned that such practices would increase quotation traffic and bandwidth costs, but with little or no benefit for the quality of the consolidated data stream.
Flickering quotes are behind the enormous increase in the number of stock market quotes leading to an alarming increase in bandwith, storage and processing costs for the millions of subscribers to the consolidated quote stream. In 1999, the peak number of quotes for U.S. stocks in 1 second was 1000. Today that number is 2 million.

What was Reg NMS's solution for flickering quotes?

The solution was simple: discourage flickering quotes by disallowing credit towards a $500 million pie.

The consolidated data feed (also known as the SIP) is comprised of a quote feed and a trade feed and is used by millions of traders and investors. It forms the heart of Reg NMS, as all references to stock prices are based on the SIP. The SIP collects over $500 million annually from about 2.5 million subscribers paying for real-time prices coming from these 2 feeds. This $500 million is split between the 14 exchanges using a formula that is based on the volume of shares executed, and more importantly, the number of quote credits earned by an exchange. In simple terms, a quote credit is earned when an exchange's quote is at the National Best Bid or Offer.

The SEC realized that they could encourage quotes that add value to the market place, and discourage quotes that are harmful, by tweaking the formula that awards quote credits. Since flickering quotes are highly undesirable, Reg NMS flat out denies awarding any credit for a quote that lasts less than 1 second.

From Reg NMS, page 260:
The Commission recognizes that abusive quoting behavior is a legitimate concern, particularly given that quotations have not been entitled to an allocation of market data revenues in the past. The adopted formula therefore incorporates a number of modifications to the reproposed formula to minimize the potential for abusive or costly quoting behavior.
First, the adopted formula modifies the language of the reproposed formula to clarify that a quotation must be displayed by the Network processor for a minimum of one full second of time before it is entitled to earn any Quote Credits. This one-second time period is consistent with the one-second time period included in the flickering quotation exception in the Order Protection Rule and is designed to assure that only quotations that are readily accessible can earn Quote Credits. The time stamps assigned to quotations by the Network processors will control this determination. Accordingly, subsecond flickering quotations are excluded from the formula.
Page 276 sums it up:
An SRO will earn one Quote Credit for each second of time and dollar value of size that the SRO’s automated best bid or best offer during regular trading hours equals the price of the NBBO and does not lock or cross a previously displayed automated quotation. To qualify for credits, the quoted price must be displayed for at least one full second, and the relevant size will be the minimum size that was displayed during the second

But flickering quotes have not abated, why isn't this working?

We obtained what we believe to be an accurate and detailed description for how quote credits are calculated. While reading the document, it became apparent that something happened along the way during the implementation of the part that removes flickering quotes. A complicated quote time/price adjustment was introduced which essentially ends up allowing some "types" of flickering quotes! Judging by a few examples provided, the types of flickering quotes that implementation allows, are the same, inaccessible, unreliable quotes that that SEC and industry wanted to discourage in the first place. And we should note that nowhere in Reg NMS or in any academic paper, is there any differentiation between types of flickering quotes: flickering quotes are quotes that last for less than 1 second, period.

This significant change appears to have occurred without public comment, or public knowledge for that matter - at least we couldn't find any reference (please let us know if you find otherwise: One exchange CEO, who ran the Tape C SIP during Reg NMS implementation, recently confirmed his belief that quotes lasting under 1 second (flickering quotes) are not eligible for quote credits. 

Here is the page (stuck way back in the appendix) that discusses the flickering quote removal process:

Example of how the implementation allows flickering quotes

The method of computing eligible quotes is very complicated, and involves adjusting quotes to arrive at what's called the RBBO - or Revenue Best Bid/Offer. The adjusted quotes are then compared to the RBBO to determine quote credits. To see an example of how the RBBO enables flickering quotes to be eligible for quote credits, toggle between the before and after images below, both taken from the same document.

Note the title of the second image - Quote Credit Goals. Whose goals? Certainly not the SEC nor the industry, in either the spirit nor letter of the law as it was written in Reg NMS.

Box Color Eligible For Credit Explanation
      Red        No Flickering Quote - last less than 1 second
  Light Blue   No Inferior price
     Green      Yes Best price and lasts 1 second or longer

Shouldn't this be public?

Most definitely. In fact, one page makes it very clear that all real-time subscribers of the SIP will have access to everything required to conduct the revenue allocation calculations. We presume this would include how flickering quotes get transformed into acceptable quotes. However, in reality, such information doesn't appear to exist.

Does Reg NMS favor high speed traders over investors?

Emphatically, no. While perusing Reg NMS (worth reading), we came across a few paragraphs relevant to this matter that must be emphasized. The decision to include "some types" of flickering quotes certainly appears to have been influenced by, or made to appease, high speed traders (or exchanges that catered to them at the time). Fortunately, Reg NMS makes abundantly clear how the SEC will decide on issues favorable to high speed traders but detrimental to long term investors.

Page 125:
..the Commission recognizes that the existence of intermarket price protection without an opt-out exception may interfere to some extent with the extremely short-term trading strategies of some market participants. Some of these strategies can be affected by a delay in order-routing or execution of as little as 3/10ths of one second. [..] This conflict between protecting the best displayed prices and facilitating short-term trading strategies raises a fundamental policy question – when such a conflict exists, should the overall efficiency of the NMS defer to the needs of short-term traders, many of whom rarely intend to hold a position overnight? Or should the NMS serve the needs of longer-term investors , both large and small, that will benefit substantially from intermarket price protection?

The Commission believes that two of the most important public policy functions of the secondary equity markets are to minimize trading costs for long-term investors and to reduce the cost of capital for listed companies. These functions are inherently connected, because the cost of capital of listed companies is influenced by the transaction costs of those who are willing to accept the investment risk of holding corporate stock for an extended period. To the extent that the interests of short-term traders and market intermediaries in a broad opt-out exception conflict with those of investors, the Commission believes that the interests of long-term investors are entitled to take precedence. In this way, the NMS will fulfill its Exchange Act objectives to promote fair and efficient equity markets for investors and to serve the public interest
Page 409:
..intermarket price protection will significantly benefit the more than 84 million individual investors in the U.S. equity markets by reducing their transaction costs and thereby enhancing their long-term investment returns. Price protection may, however, interfere to some extent with the extremely short-term trading strategies that can depend on millisecond response times from markets for orders taking displayed liquidity. It also may interfere with short-term trading strategies that benefit from volatile and illiquid markets. The dissent claims that the "length of time an individual owns a stock is not a relevant factor in distinguishing among groups of investors" and that the distinction between long-term investors and short-term traders is arbitrary and unreasonable. But in those limited contexts where the interests of long-term investors conflict with short-term trading strategies, the conflict cannot be reconciled by stating that the NMS should benefit all investors. In particular, failing to adopt a price protection rule because short-term trading strategies can be dependent on millisecond response times would be unreasonable in that it would elevate such strategies over the interests of millions of long-term investors – a result that would be directly contrary to the purposes of the Exchange Act
Page 410:
The dissent also argues that short-term traders often provide liquidity to the market and thereby benefit long-term investors. The Commission certainly agrees with this statement as a general matter, but believes that, in the specific context of an intermarket price protection rule, directly promoting the display of limit orders, which directly provide liquidity to the market, rather than promoting short-term trading strategies that require millisecond response times for orders that take displayed liquidity, is the most appropriate approach to protect investors and enhance market efficiency. Many commenters agreed with this policy decision. For example, T. Rowe Price stated that "we do not believe that speed of access considerations should drive market structure issues if to do so would jeopardize legitimate market linkage initiatives. Connected markets provide the opportunity for information gathering, block trading, and improved price discovery, as well as the legitimacy of the 'last-sale' price. While speed of access and execution are crucial, there is a limit to how fast such linkages need to be in order to protect and enhance our markets."


If this document does indeed accurately describe how quote credits are calculated, then the industry has lost a key rule designed to ensure accurate and reliable quotes. This document neatly explains why exchanges appear unconcerned about flickering quotes which significantly impact how $500 million is divided annually. We think it would be prudent for the SEC to find out exactly how quote credits are calculated. We also think this process should be made available to all real-time subscribers of consolidated data as mentioned in the same document..

Finally, we wonder if other aspects of Reg NMS were subverted during implementation. For more on that thought, we encourage you to carefully read SIFMA's recent letter to the SEC.

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