Benefits of a High Speed Electronic Auction Market
February 2011
By D. Keith Ross, Jr.
CEO, PDQ Enterprises, LLC
The introduction of an auction market in the high speed electronic trading environment is the key to solving the current problems of gaming ; fairness over speed and co-location access ; quote stuffing ; pennying ; visibility of markets ; leakage of order information ; small trade sizes ; lack of block trading capability and concerns over an unlevel playing field. This essay will analyze the benefits to the marketplace of a high speed electronic auction market in four sections: Structure, Fairness, Efficiency, Regulatory and a summary of benefits.
A key structural element that has been missing in the evolution of the electronic markets is the ability for a trader (or the trader's order) to ask the question ,What is the market?. In the days of the specialist, when a two dollar broker had an order of significance to trade he would go to the specialist post, and before showing his hand, the broker would ask the specialist what is the market?. The specialist would then give the broker a picture of the current book and other brokers in the crowd at the post would indicate if they were buyers or sellers of significance. The $2 broker would then be able to execute his customer's order against the known liquidity at the time of the execution. A high speed electronic auction recreates this structural element and will make the markets fairer and more efficient because of the improved risk profile for dealers and market makers.
In a high speed electronic auction the algorithmic traders will compete for the privilege of trading with customers by responding within 20 milliseconds with their best price and size. Using these responses, a price time priority book will be constructed for each order. At the 20th millisecond, the customer order will be executed against the assembled book with a significant potential for price and liquidity improvement. The best responses from the competing algorithms will earn the trade.
During the auction process the customer order will not be gamed or front run. Because the algorithms only know that a request for trade has been made, the side, size or price of the order is not disclosed. All algorithms competing for the order have the same information and respond with their best possible market in order to execute the trade. This process forms an electronic crowd where all orders can be represented; large, small, fast, slow, passive, and aggressive. There is no reason for restrictions or barriers to any market participants or their order types. This electronic crowd recreates the competitive floor market making which makes all trading fairer and more efficient.
Fairness
In a properly constructed auction, the actual order is only revealed to the responding algorithm if the confidentiality of the order can be assured. Otherwise the responding algorithm is shown only the symbol of the security to be traded. Since the algorithms do not know the nature of the order until they trade with it there is no opportunity for gaming or pennying. Also, in this format there is time available to create competition among the algorithms and create the best possible fill for the arriving order. In addition, customer orders can be represented by managed algorithms which will be located at the venue and compete pari pasu with the algorithmic traders. Therefore, collocation infrastructure is not required and becomes a moot point; no customer is disadvantaged because of speed constraints. In this environment all types of market participants can participate in a fair and effective manner.
Efficiency
An auction process will increase market efficiencies because the auction process reduces the risk for market makers. During the auction process the market-maker/dealer/algo trader is able to respond to a specific trade, at a specific time, under specific circumstances. They don't need to declare their market first (as with the display market where they can be adversely selected) and they know that there is a high probability of execution because they are responding to a marketable order. With the auction process a trader's algorithm can make tighter markets of greater size because of this improved risk profile. The electronic auction also dramatically reduces the need for cancel-replace messages and reduces bandwidth requirements
Regulatory
A high speed electronic auction also resolves many regulatory concerns. Gaming and quote stuffing become issues of the past because they are ineffective during a confidential auction process. The nature of the order is only revealed to the marketplace after it has interacted with the available liquidity at the moment of execution so the order is the beneficiary of interacting with all known liquidity at the moment execution (including newly created liquidity). Customers who are not in a position to embrace the expense of co-location can have their orders represented by a managed algorithm at the ATS and respond as quickly as a co-located algorithm thereby leveling the speed playing field.
There are two other regulatory benefits unique to an auction process. The time of the auction, i.e. the time to aggregate the liquidity from interested parties can be variable, say from 20 milliseconds up to a full second. If need be regulators could mandate an increase in the time of each auction during a market crisis, this would allow for more liquidity to be sourced for each trade. In addition, for high volume traders, access to the auction market process could be tied to commitments to make continuous markets under all circumstances, if the requirements are not meet access to the auction process would be restricted or eliminated.
Summary of Benefits
- Creates electronic crowd
- Empowers market efficiencies
- Fosters competition among dealers and algorithms
- Can create new liquidity