Nanex ~ 31-Jul-2014 ~ Retail Trades Disadvantaged by Direct Feeds

Internalizers buy at the direct feed price, sell to retail at the SIP feed price

Executive Summary

While internalizers matching retail trades claim they use direct feeds for pricing, there is overwhelming evidence that retail customers, in fact, are getting prices based on the SIP (Securities Information Processor also known as the consolidated quote). It may be that internalizers making this claim mean that they are using direct feed pricing for themselves to buy and sell stock on exchanges, but they give customers prices based on the SIP. Perhaps the question to ask the internalizers paying for retail customer order flow: what prices are you assigning to retail customer trades?

The Setting

During the first 30 minutes of the August 22, 2013 Nasdaq black out, a curious thing happened. SIP quotes stopped updating, but trades continued to print in stocks for at least another 30 minutes, and in stocks that had price movement, two clear price bands formed: one band contained trades priced at the last known (and very stale) NBBO (National Best Bid/Offer) sent by the SIP, while the other band contained trades priced on direct feeds that High Frequency Traders (HFT) pay exchanges princely sums for. Exchanges can legally sell direct feeds, as long as they make trade and quote information available to the SIP first or at the same time as direct feeds. With the SIP no longer transmitting quotes, yet trading seemingly unaffected, it's probably a good bet that the exchanges weren't providing the SIP with trade and quote information at the same time as the direct feeds. While that is clearly illegal, it's something we have already covered in detail.

The Evidence

This paper is about understanding which trades executed based on direct feed prices and which trades executed based on the stale SIP price. While we only show prices for the stock of Apple (symbol AAPL), many, if not all of Nasdaq stocks during the same time present the same evidence. Furthermore, we have seen this phenomenon during other times (e.g. September 4, 2013, and June 2, 2014) when the SIP had problems, but direct feeds did not.

Note, there are 4 main sources of trades reported to TRFs (Trade Reporting Facility, which handle trade reporting for unlit markets):

1. Retail trades, sent by internalizers, also called wholesalers. Internalizers pay brokers a fee for the privilege of matching retail orders. The claim they provide price improvement.
2. Alternative Trading Systems (ATS), sometimes called Dark Pools. Some ATS's (Lavaflow) publish quotes to FINRA's ADF, but this distinction is unnecessary for this paper.
3. "Upstairs trading", or off-exchange negotiated transactions outside of a broker dark pool, (High Touch).
4. Broker internalization engines that are not registered as an ATS.

This paper focuses on retail trades executed (matched) by internalizers.

• Red shading indicates a crossed NBBO (Best Bid price greater than Best Offer price) which is prohibited by Reg NMS, and often indicates a delay in the SIP.
• There was also brief outage between 12:00:08 and 12:01:16.
• The SIP stopped sending quotes in AAPL at 12:04:40 and did not resume until 15:25:00.
• The last known NBBO was 498.45 bid and 498.53 offered.

• The higher priced band (in the case of AAPL, in other stocks it may be the lower band) is from trades executed at direct feed prices. This is the true market price.
• The other band is from trades executed at of the last known SIP price. Note this second band contains only unlit markets (green squares).
• Trades at the stale SIP price are not the result of a reporting delay: the length of time, the presence of trades in both bands, and rate of reporting make it highly unlikely. 

• This is the same chart as above, but with trades from lit markets removed.
• Some Dark Pools (such as Credit Suisse Crossfinder) use direct feeds, while others (such as Goldman Sach's Sigma X) use the SIP.
• Even though the last quote from the SIP was at 12:04:40, trades from unlit markets continue to print until 13:13:47 (beyond the end of this chart).

To understand how we can identify retail trades, read this page (keep following links if necessary, as this rabbit hole is deep).

• This is the same chart as above, but includes only "retail" trades.
• Even though the last quote from the SIP was at 12:04:40, retail trades continued for 28 minutes (until 12:32:52).
• Internalizers are clearly giving retail customers prices based off of SIP data (directly contradicting this statement made to Congress).
• This is not an isolated incident: it is present in many stocks during the same period of time, as well during other events when the SIP had a problem, but direct feeds did not.

Conclusion