No need to queue for order execution
Since Interactive Brokers announced their new service rivals E*Trade and TD Ameritrade have announced their own commission-free trading initiatives. So, the landscape of retail broking stateside has dramatically shifted in less than a week.
Notwithstanding the regulatory barriers to a similar scheme here in the UK, what happens in the US generally tends to travel over the pond as they say, and we will be on the lookout for the emergence of any comparable services here.
Exchange initiatives for zero commission brokers
However, it’s not just brokers that are keen to win retail order flow it seems, exchanges are now getting in on the act and major exchanges at that. The Cboe, which is one of the world’s largest exchange operators have made a very interesting announcement regarding the order book priority of certain retail orders.
The Cboe is probably best known for its ownership of the VIX, that tracks the aggregate volatility among the constituents of the S&P 500 index. The VIX is often referred to as the Greed and Fear index because changing levels in volatility and said to reflect changes in investor attitudes towards risk. As volatility rises risk appetite wanes and vice versa.
Founded as an options exchange in 1973 the Cboe has a history of innovation and organic growth but in more recent times it has been happy to grow through acquisition as well, moving into areas such as US & European equities trading as well as institutional FX.
And it’s in equity trading that the Cboe has chosen to move the goalposts by giving retail orders an enhanced priority on the order books in their EGDX exchange. One of the largest alternative execution venues for US and European equities, that was formed through the merger and acquisition of BATS Trading and Direct Edge.
In Q2 2019 the Cboe had a 15.7% market share in US equities execution and a 20.30% market share in European equities, according to its earnings release.
So, what does this mean in practice and how might it benefit retail traders?
First, let’s explain what we mean when we talk about order book priority.
Most modern electronic marketplaces use an order book which is effectively a live ledger displaying lists of bids and offers, or if you prefer orders from clients wishing to buy or sell a given amount of an instrument at a certain price point.
To maintain an orderly market these lists of orders need to be ranked or prioritised in some way that is they need to be put into that most British of institutions the queue. To do that the exchange ranks the orders using two criteria: Firstly, the length of time they have been there and secondly the price at which the order can be executed. This is known as time and price priority.
Under time and price priority if we have five orders at the same price waiting to be executed then the order that was placed in the queue first will take priority and more recent arrivals will wait behind that order.
However, if a new order appears with a better price or the price of an existing order is amended to reflect a higher bid or a lower offer, then that order will move to the top of the queue on the relevant side of the order book. That means that price trumps time, though time will be used to rank orders that are submitted at the same price.
What the Cboe is proposing to do is to allow retail clients to jump the order book queue by putting their limit orders straight to the top of the order book with a view to those orders being executed ahead of others in the queue, subject to the price of course.
Having your name on the list of priority orders
Think of this as having your name down on a guest list of an exclusive party or club there is a long line of hopefuls outside the venue, you pull up, step out of your car have a discreet word with the doorman and are let inside. Now if two or more guests arrive at the same time then the doorman will probably let the biggest tipper in first, that is price takes priority, but you are still not queuing with the rank and file.
What’s in it for the Cboe?
Why is the Cboe doing this? Well, a few things occur to me, first, the chance to attract additional flow from retail stock brokers. The businesses that were merged to form the EGDX exchange were largely institutional execution venues which may occasionally have seen some aggregated retail flow, so there is an opportunity to attract new business.
Secondly, by offering this facility the Cboe will be keeping their order books tidy, shorter in length and more applicable to institutional traders.
Lastly, it seems to me that if the Cboe can attract additional retail volume through this initiative they are also likely to attract business from the same market makers, hedge funds and high-frequency traders whose payments for order flow are subsidising the commission-free dealing services we mentioned above.
As with the commission-free dealing services, this is unlikely to be the only attempt to enhance the status of retail orders on exchanges, that will emerge. And this may open up a wider conversation about just how retail orders are routed and executed and how judgements are made about whether those channels are always in the best interest of the underlying clients.
In listed equities that’s probably quite easy to justify but much less so in the opaque world of FX and CFD execution. We believe that the more transparency there is around that area the better, as far as retail clients are concerned.
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