Making the Case for Locked Markets

Ending the ban against locked markets could benefit our national market system.

Manoj Narang

Manoj Narang

The SEC’s recently issued “Concept Release” paints a distorted picture of equity markets, where innocent long-term investors are pitted against technologically armed and dangerous high-frequency traders (HFTs). The Commission’s regressive views on technology are troubling. HFTs are the liquidity backbone of the market, and use technology primarily to compete against each other, not against long-term investors. As it is the case in all industries where firms use technology to automate their services, this has resulted in margin compression for liquidity providers and lower costs for consumers.

In finance, as in every other industry, technology confers a competitive advantage, not an unfair one. Nowadays, buy-side investors themselves increasingly use sophisticated algorithms to execute their trades. These algorithms employ the same data, signals, and tools used by HFTs. Characterizing such investors as disadvantaged, or preferring their algo’s over those of HFTs, is sheer nonsense.

In fact, if regulators are truly serious about uncovering unfair advantages, they need look no further than their own regulations. SEC’s Reg NMS (Regulation National Market System), which is the cornerstone of our national market system, is a case study in how HFTs can exploit regulatory inefficiencies at the expense of long-term investors.

Reg NMS is the SEC’s attempt to create a synchronized “national market” out of the assortment of far-flung exchanges that comprise the equity market. The glue that holds everything together is the standardized feeds (SIPs) to which all exchanges must publish their quotes. Reg NMS stipulates that exchanges may not accept orders that lock or cross the best prices at other exchanges. The problem with this setup is that the SIPs are slow, so the exchanges usually have a very poor idea of where the other exchanges’ quotes really are in real time.

Reg NMS imposes significant inefficiencies on trade execution by buy-side investors. In a fast market, a SIP is likely to display stale (obsolete) prices, making it very difficult for investors to trade, even if they have direct feeds. Exchanges will continually decline to execute investor orders because SIPs will tend to show “better” (but obsolete) quotes on other exchanges. In the mean time, the price will continue to move away from the investor.

Not all traders are similarly impacted. HFTs, particularly those operating as B/D’s, may send orders to the exchange with the “ISO” designation, effectively allowing them to circumvent the ill effects of Reg NMS. This gives them a huge competitive advantage over the vast majority of investment managers, who cannot use this order type.


Reg NMS is insidious even in slow markets. Suppose 1,000 shares of the stock XYZ are offered at a price of $20.00 on both the Nasdaq and ARCA. An investor trying to buy 1,500 shares at $20.00 at both exchanges would rightly expect that 1000 shares would immediately be filled at each exchange, and the balance of 500 unfilled shares would post on each exchange as the new best bid. The investor would be wrong.

Most likely, the 500 shares would be prevented from posting, because the SIP would still show the obsolete $20.00 offer, creating a “locked market.” By the time the time the SIP has caught up, allowing the exchange to post the investor’s order, many HFTs will have been able to detect that an investor was trying to buy, and used ISO orders to jump in front of the investor’s $20.00 bid.

This loss of time priority has real economic consequences. Empirically, the profitability of an executed order varies by over a penny per share depending on its position in the queue of orders. Conservatively, investors are losing tens of millions of dollars per year (likely more) in increased execution costs as a result of this artifact.

At 520 or more pages, Reg NMS is such a complex monstrosity that few professional investors even realize they are being taken to the cleaners. As the regulators contemplate reforms to the market microstructure, they should be aware that adding even more complexity to the regulatory regime is certain to backfire. Regulators are sure to lose a battle of wits with HFT’s, who are highly motivated to exploit the shortcomings of their regulations.

As an alternative to more rules, I propose the more humble approach of “addition by subtraction”. The most deleterious aspects of Reg NMS, such as the example above, can easily be rectified by relaxing the prohibition against “locked markets.” The ban is entirely superfluous to the regulation’s objective, which is to prevent trading at inferior prices.

Furthermore, a “locked market” is not really locked. Due to liquidity fees and rebates, there is over a half-cent per-share difference between getting filled on a $20.00 bid and taking a $20.00 offer. Investors should be allowed to chose between these economically distinct alternatives.

Eliminating the ban would have significant spillover benefits. It would significantly lower average bid-ask spreads (since locked markets have zero spread), a principal source of transaction costs for investors. It would decrease “pinging” and cancellation rates, which are partly symptoms of efforts by investors to minimize the damage caused by the Reg NMS. It would significantly curtail the technology arms race, minimizing the need for HFTs to optimize their connectivity between exchanges. It will dramatically reduce the ability of HFTs to unfairly anticipate investor orders, which the Commission professes to care about.

Most importantly, this simple adjustment would avoid unintended consequences. Complex rules often backfire. Because of Reg NMS, markets have gotten more fragmented, and fast traders more entrenched. If regulators insist on heavy-handed tactics to make the market more “fair,” investors should receive the heightened concern for their welfare with trepidation.

Manoj Narang is the founder of Tradeworx, Inc., a financial technology and trading firm whose mission is to democratize the role of advanced technology in the financial markets.