Candidly, I don't know what's going on here.

Photographer: Matthew Peyton/Getty Images for Direct Edge.

'Hide Not Slide' Orders Were Slippery and Hidden

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Today, the Securities and Exchange Commission fined the Direct Edge stock exchanges $14 million for violations involving their "Hide Not Slide" order types. Here's a 2012 Wall Street Journal article that comes with basically a graphic novel devoted to how a "Hide Not Slide" order works, and I refer you to there if you want to know how it works. The thing is that you probably don't want to know how it works. But here's the basic idea, without the cartoon of a jumping man in a suit:

  • The national best bid and offer for a stock are $10.00 / $10.01.
  • For reasons of your own, you want to bid $10.01 for it, but you don't want to just buy the stock offered at $10.01 on, say, Nasdaq.
  • Instead, you want to put up a standing buy order at $10.01 on a Direct Edge exchange (EDGA or EDGX) and wait until someone hits your bid.
  • You can't do this, because the SEC has rules against "locked markets" -- if the national best offer is $10.01, you can't bid $10.01, you gotta just lift the offer (or bid $10.00).
  • But the name of the game is customer service, so the exchanges come up with ways to let you enter orders that would otherwise lock markets.

Simplifying enormously, Direct Edge offered two ways of doing this:

  1. A limit order: You enter a $10.01 bid at 1:00 p.m. Because it locks the market, Direct Edge "slides" it back to $10.00 and displays it as though it's a $10.00 bid. But at 1:05 p.m., the market becomes unlocked: There's no more $10.01 offer, the national best offer is $10.02, so you can display your $10.01 bid. So Direct Edge changes your order back to a $10.01 bid, with a 1:05 p.m. time stamp.
  2. A Hide Not Slide order: Same, except your order is changed back with a 1:00 p.m. time stamp. 

Earlier time stamps get priority in execution, so you get a better chance to actually buy stock at $10.01 if you choose option 2 rather than option 1. So why would you choose option 1? The short answer seems to be, roughly, that you didn't: Option 1 was the default option, and you could only choose option 2 if you thought about it. 

That is of course an insurmountable barrier for many people, but just in case, Direct Edge put up another barrier, which is that they did sort of a rotten job of describing how Hide Not Slide works. Not necessarily worse than I just did, but still pretty bad. For one thing, Direct Edge's rules did not describe Hide Not Slide at all: "Displayed price sliding" of limit orders -- that is, option 1 above -- "was the only price sliding functionality provided for in EDGA and EDGX's rules."  Hide Not Slide was never mentioned.

That sounds terrible, though it wasn't quite as terrible as it sounds; Hide Not Slide was described in a "trade desk notification" sent to Direct Edge subscribers by e-mail and posted on the website, and was at least hinted at in the technical specifications, so Direct Edge's customers could find out about it if they wanted to. Direct Edge just forgot to put it in the rules. But, separately, the description on the website was wrong: It was right for a little while, but "became outdated shortly thereafter," due to technical changes to Hide Not Slide that are -- you will have to trust me on this -- even less interesting than what we've talked about so far. And the website was never updated for those changes.

That's bad. You should update your website! Here's Andrew Ceresney:

“This is a serious violation with serious implications,” Andrew Ceresney, head of the Washington-based agency’s enforcement division, said on a call with reporters on Monday afternoon. “The idea here is that if you’re going to have order types, you need to specifically, completely and accurately disclose the nature of those order types.”

A good heuristic is that if an enforcement official says that something is "a serious violation," he doesn't really mean it. If someone steals a billion dollars from widows and orphans, you can just say, "This guy stole a billion dollars from widows and orphans! Come on!" and everyone will understand that it's serious. But when someone doesn't fully update its rule filings to describe the time priority of order display in locked markets, you have to just be like, "Trust me, guys, this is super serious," because if you actually say what happened no one will pay attention through the end of the sentence.

So is it important? I mean, obviously people should update their websites. But my stupid little story above started off with you wanting to lock a market. That is the hinge on which all of this turns: There is stock for sale at $10.01, and you want to pay $10.01 for that stock, but you don't want to buy the stock that's for sale at $10.01. You want to buy some other stock for $10.01, later. But not much later -- you want to be the first person to buy it at $10.01 after it stops being available for sale at $10.01. I know, I know. This can actually be a perfectly reasonable desire, for a lot of reasons, but it is a niche desire.

It is of course a desire that is felt mainly by high-frequency traders. Unlike many market-structure issues, there are clear and identifiable victims of Direct Edge's, um, hiding of its Hide Not Slide rules. Those victims are not widows and orphans, though. They're robots. Specifically, they're trading machines. Even more specifically, they're Trading Machines LLC, a high-frequency trading firm started by Haim Bodek. From that 2012 Journal article:

His firm did well at first, Mr. Bodek says, but in 2009 its performance worsened on several trading platforms, including Direct Edge, a computerized market based in Jersey City, N.J. Trading Machines' profits fell by more than $10,000 a day, Mr. Bodek says.

He suspected a bug in his trading code and talked with officials of several trading venues. Then at a holiday party hosted by Direct Edge on Dec. 2, 2009, Mr. Bodek says, he spoke with the company's sales director, Eugene Davidovich. Mr. Bodek says Mr. Davidovich told him his problem wasn't a bug -- he was using the wrong order type.

Mr. Bodek had been using common "limit orders," which specify a price limit at which to buy or sell. Mr. Davidovich, according to Mr. Bodek, suggested that he instead use an order type called Hide Not Slide, which Direct Edge had introduced in early 2009, about the same time Trading Machines' performance started to suffer.

Mr. Bodek says Mr. Davidovich told him Direct Edge had created this order type -- which lets traders avoid having their orders displayed to the rest of the market -- to attract high-frequency trading firms.

And so Bodek brought the order-type controversy to the SEC's attention, and the SEC looked into it. And its investigation bore out Bodek's claims: Hide Not Slide seems to have been created at the request of, and with continuing advice from, two high-frequency trading firms ("Trading Firm A" and "Trading Firm B"); Firm A actually said that it would send more trading Direct Edge's way if it implemented Hide Not Slide. Unsurprisingly, the Direct Edge exchanges talked more with these firms about Hide Not Slide than they did with the people who didn't help create it. Andrew Ceresney again:

They also gave information about order types only to some members, including certain high-frequency trading firms that provided input about how the orders would operate.

There's a hint in that quote of, "Oh those high-frequency traders, what will they think of next," but, again, the victims here were the high-frequency traders who weren't in the room. If you're buying 100 shares at a time with market orders in your personal account, this is not your problem. If you're buying a million shares at a time for your mutual fund, it's probably not your problem either.

On the other hand, if you're a high-frequency trader, this is something you care about, and it really ought to be described clearly and fairly for everyone. So, good for the SEC for catching it and fixing it. But notice that the fix is purely about disclosure: "The SEC does not allege that there was anything inherently inappropriate about the order type functionality," says Direct Edge's current owner, and that is quite right. But it is also controversial: "I’m uncomfortable with having all these order types," the chief executive officer of the company that owns the New York Stock Exchange has told Congress. "I don’t know why we have them." I bet Trading Firm A knows, though.

You could have two views of the order-type debate: You could think that markets should provide the same simple tools to everyone, or you could think that markets should be free to provide specialized tools for specialized purposes. In the latter model, high-frequency traders who care about time priority and liquidity rebates should have access to tools like Hide Not Slide, and fundamental investors who care about maximizing execution size and certainty should have access to other tools that do different things,  and everyone can either work to figure out the tools or else constantly be taken advantage of by the people who understand the tools. This takes work, but then, everything takes work: If order types are simple, then you have to combine them in complex ways. The idea of complicated order types is that, instead of relying on your broker, or writing your own algorithms, to decide how to go about buying stock, you can outsource some of the decisions to the exchanges. Order types can be little pre-programmed algorithms offered by the exchanges to make decisions for you.

The first model is a lot simpler and more soothing to those who don't spend a lot of time on market structure, but you can see why the second is more appealing to the exchanges. Their customers come to them and say, "Hey you know what would be cool is [some new order type]." What are they going to do, say no? Why not make the customers happy and try to pick up more business that way? As long as, you know, you don't do it by keeping other customers in the dark.

Here's Haim Bodek's reaction today:

“I was quite impressed by the level of sophistication the SEC took towards this case,” Bodek said in a phone interview today. “It’s completely knowledgeable about the intricacies of the market. I’d be very surprised if that competency that they’ve shown was just limited to just this one case.”

This seems right; the SEC order is very much in the weeds of market intricacy. And yet in some sense the SEC's conclusion is not that sophisticated: It's just "keep doing what you're doing, but disclose it better." 

This fits with my general theory of the SEC's recent market-structure enforcement efforts. I think that the SEC understands how the stock market works, and is basically OK with it. (After all, it's largely the SEC's doing.) It's also aware that much of the public doesn't understand, and is not OK with it: "The market is rigged! High-frequency traders are evil!" Etc. And it's aware that there are real problems that give rise to that public impression, though the problems might be smaller than they appear.  

So the SEC keeps bringing cases like this one, which is pretty perfectly calibrated to that world view. This case fixes a real market abuse: Direct Edge really should tell people how its order types work. It satisfies the public demand to crack down on high-frequency traders and the exchanges that cater to them. But it doesn't actually change anything fundamental about market structure.

  1. The Direct Edges are now owned by BATS Global Markets. Also I describe them as "exchanges" here; they became exchanges in 2009, shortly after the Hide Not Slide stuff got started.

  2. I'm not kidding, the Journal's graphic novel really is the clearest description of the issue, and and also features a cartoon of a man jumping around in a suit, it is hard to beat.

  3. That's from paragraph 38 of the SEC order

  4. That quote is from paragraph 27. The principal changes, described in subsequent paragraphs, were about re-ranking at the NBBO midpoint, rather than the original price, and about being able to take liquidity up to the original price if it saved money net of the take fee. 

  5. The main ones might be:

    1. You don't want to buy the stock on offer at $10.01 at another exchange, because you don't trust that there's a lot of liquidity at that exchange, and you don't want to show your hand by lifting a small offer elsewhere and have the price move against you.
    2. You don't want to lift an offer because most exchanges charge you a fee for "taking" liquidity (trading at the offer), but pay you a rebate for "making" liquidity (putting in a resting bid that someone later trades with). So Hide Not Sliding lets you pay $10.01 minus a rebate (say, $10.008 per share), instead of $10.01 plus a fee (say, $10.013).

    You could imagine others. 

  6. In the sense that you're probably not using arcane order types and locking markets to optimize your maker/taker rebates: More realistically, if you want to pay $10.01 for a bunch of stock, you'll just go lift the offer at $10.01. This exaggerates because lots of mutual funds do trade using algorithms, and some of them, if their algorithms don't know all the exchange rules, might in fact run into problems where Hide Not Slide orders get in front of them.

  7. Dark pools are sort of nominally about large size and limiting price impact, though there's plenty of controversy about whether they work. Or there are tools like "Discretionary Orders" (see page 47 of this BATS specification), which let you buy more than your displayed bid, though at worse prices, if stock is available.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net