Has the time for widespread auctions in US equities finally come?
The US equity market trades in microseconds via hyper-fast computers and smart order routers. But there is a growing trend to slow down the market, amid an outcry that it may have gotten too fast and is unfair to certain participants. The IEX Exchange, which touts a 350 millisecond speedbump or slow down in processing orders, may have brought the issue to the forefront, but other participants also believe a slowdown in trading might help traders achieve best execution. Their argument – a market structure that includes more stock auctions.
The Chicago Stock Exchange has begun to adopt an auction structure, launching their SNAP auctions for securities. So has the London Stock Exchange, which has implemented a mid-day auction. PDQ ATS has also staked its market structure on the auction.
One subscriber to the theory of slowing down the market in the name of best execution and fairness, along with IEX, is Keith Ross, chief executive officer at PDQ Enterprises, operator of PDQ ATS. A long-time proponent of market auctions, Ross told Markets Media in an interview that the idea of taking time, gathering up best bids and offers for a security and then filling an order might be the right fix for the market right now. However, care must be taken when employing such a structure.
“We endorse Chicago’s SNAP actions as a wonderful idea,” Ross began. “But as an exchange, I think they have unique issues facing them. One is, the actual structure of their auction makes it very difficult for high speed traders to participate. So because of their timing and because of the inter market sweep requirement, I think it’s really hard for the high speed traders to provide liquidity in those situations.”
Secondly, Ross continued that given CHX’s limited reach, commanding only 0.2 percent or so of trading volume, the amount of bids and offers received at its auctions have been very limited.
“So while we endorse the idea, whether or not that’s actually going to be able to hunt down liquidity will be very interesting to us,” Ross said.
PDQ ATS has been employing an auction model for some years to help the buyside amass liquidity by building an order book first and then holding an auction. And due to its success at PDQ, he said now was the time to see more widespread adoption of this model. Ross explained that PDQ offers what its calls a “micro auction.” This type of auction is an “on demand” auction which is driven by the buy-side trader’s initiating order. As Ross explained, this “on demand” concept is the piece that’s is missing from the current auction ideas being circulated.
In general, the opening and closing time periods are essentially an auction on most of the exchanges where the opening and closing prices are set. And while Ross believes that the auction process works and is the most fair to investors, having a set or fixed auction time is not the way to help investors or improve trading.
“Yes, auctions are the fairest to the participants, but our take is that ‘why do you need to put a clock on it’,” he said, “Anyone who wants to initiate an auction at PDQ ATS can find the available contra-side liquidity.”
At PDQ, when an auction is initiated by a liquidity seeking order, the liquidity providers are given only the symbol of the stock to be traded, not the side, size or price.
“They don’t know if it’s a buyer or seller or how much volume is there,” Ross said. “It’s very similar to when a broker went into the crowd on the exchange floor and would ask the specialist ‘what’s the market’? Then the broker can use the information of the market status to get the best possible fill for the client.
PDQ newest auction model, AUCTION1, is targeted at buysiders who want to trade larger orders – blocks – and are willing to wait a longer time to execute an order. The new auction will wait up to a full second for orders to be gathered before filling an order against the order book.
An order initiated auction, through AUCTION1, can interact with passive natural liquidity, algorithmic liquidity and market maker liquidity, at the choice of the client. AUCTION1 requires a 2500 share minimum to initiate an auction and responding orders must be 500 shares or greater.
In its original auction model, introduced back in November 2011, PDQ held an order between one to twenty milliseconds to create an auction book. Then after the 20 milliseconds, an order is executed against the trade book.
Ross said that while the specialist model worked then, in today’s electronic world the auction model is much more efficient. As evidence, PDQ said it has executed 9.7 million shares a day in July via its auctions – up from 8.1 million shares a day a year ago. During the same time the external routing portion of PDQ’s business has grown about 17%.
“In the beginning, the old manual market was so inefficient. But for an institutionalized trader this new process – symbol driven – is best,” Ross said. “There is no information leakage and since you don’t know which side of the market the order is on until you get your result from the auction, the market maker has to commit first.”
Ross concluded by saying auctions, especially ones like PDQ’s that are symbol or order driven, not quote driven are best for the market and investors.
“The on demand auction reverses the markets from being quote-driven to order-driven so that in the auction, we can bring more liquidity to the contra side if there is any,” he said. “And I think that’s a piece people will become more aware of as time goes on. Also, they will find it to be much more interesting for those that are trading larger than the retail size.”
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