IEX recently proposed a new order type, the D-Limit order, that would apply its Crumbling Quote Indicator (CQI) to lit orders. The CQI uses a sophisticated empirical model that predicts when prices are about to change, effectively replicating the approach used by high frequency market makers and some broker algorithms to avoid being “picked off”. Specifically, as with their hidden D-peg order, the D-limit order would be re-priced to a less aggressive price whenever the CQI signals a deteriorating quote.[1] . Adjusting limit prices in the face of imminent adverse price changes helps to reduce adverse selection and enhance limit order performance. Indeed, IEX provides some compelling statistics to support the effectiveness of CQI, evidence which strongly supports the claim the CQI can be a useful tool in managing adverse selection.
On its face, the D-Limit could add significant value by providing the broader trading community a means to compete with the more sophisticated, high-frequency traders when posting limit orders. But, as discussed below, some unanswered questions exist surrounding how D-Limit varies across stocks, how it would perform in volatile markets – especially in times of market stress –and what impact a broad adoption of these types of tools across protected venues would have on the market as a whole.
Da Pros of D-Limit
The big draw of the D-limit is that it provides limit order traders access to similar tools used by market makers, helping to level the playing field. Indeed, one of the key drivers of limit order performance is management of adverse selection, so tools that help mitigate adverse selection should provide meaningful improvements to performance. But one additional aspect of D-Limit that makes it especially helpful is that the D-Limit is done at the exchange level natively, whereas HFTs and other low-latency traders must have their signals reside on their own servers. Further, these other traders must pass through the famous IEX speedbump, whereas the D-Limit responds without delay. The net effect is a sophisticated pricing engine with a speed advantage that is available to all limit order traders.
With this in mind, one can’t help but compare this mechanism to other proposed changes, such as the EDGA asymmetric speedbump. The IEX D-Limit is like an asymmetric speedbump since it benefits liquidity providers at the expense of liquidity takers. The key difference is that exploiting the benefits of EDGA requires the traders to proactively reprice their own orders in a very short time horizon (milliseconds), a benefit that is generally not useful to many traders. The benefits of the IEX D-Limit is available to all traders, without the need for low latency machinery. And as we noted in our discussion of the EDGA asymmetric speed bump, reducing adverse selection risk may actually lead to greater liquidity offered.[2]
But questions remain…
The biggest question to me is what impact this will have on IEX quotes of individual stocks. The IEX quotes that the CQI is “on” less than 1% of the day, while 24% of the trades occur when it is on. The IEX also notes that much of the trading that occurs when the CQI is on is done by just a few firms. While these stats suggest that CQI is a targeted means of improving limit order execution quality, these stats provide only an aggregate view of CQI. Use of such high-level, aggregated numbers is generally not overly useful in a marketplace with such broad variation across stocks. The U.S. equity market is characterized by highly liquid and highly illiquid stocks (and everything in between), stocks whose prices rarely move during the day with those whose prices change several times within the same second. Basing decisions on such aggregate numbers is like choosing which jacket to wear today by looking at the average temperature of Earth!
I suspect most market participants and the regulators will want to see more details to better understand how specific groups of stocks – or even individual stocks – would be impacted by this proposal. Nasdaq, for example, put out a remarkably detailed analysis of its Intelligent Ticks proposal with sufficient details that commenters like yours truly can sit in a corner and throw rocks. But jokes aside, having such detailed information helps inform the debate and is critical in helping market participants and regulators appreciate the impact of proposals before any decision is made.
The more detailed analysis should also include how D-Limit, and the IEX quote in general, would behave in periods of high volatility. Presumably, volatility is a key factor determining whether CQI is on or off. Clearly, then, putting D-limit in the context of different volatility regimes is key since the statistics surrounding how often CQI is on, for example, would clearly be a function of the volatility regime. Of course, one could argue that HFTs and others utilize these tools already, including in times of stress. But as the D-limit orders would be part of IEX’s quote, which in turn is a protected quote disseminated in the SIP feed, it is important to understand its behavior across securities and in different market environments.
And stepping back, the IEX proposal raises some potential broader concerns about market quality under broad adoption of these tools. The fact that IEX’s D-Limit is available to all and its CQI logic is applied uniformly to all (relevantly priced) D-Limit orders increases the correlation of liquidity provision across traders. Specifically, since IEX would update all the affected D-Limit orders in unison, the IEX quote itself becomes more “fluid” as market prices change. Consider the extreme case where D-Limit is so wildly successful that all IEX traders use D-Limits. In such a scenario, the entire IEX quote would move once the CQI was on. And if other markets were to adopt similar order types, which also become popular trading tools, a huge chunk of the consolidated quote may fade at the same time, potentially when market liquidity is needed most. While I may be getting ahead of myself with excitement about this order tool, such issues need to be considered since, if the SEC approves the D-Limit order on IEX, presumably they would have to also approve identical (or sufficiently similar) order types.
Conclusion
The D-Limit proposal is one of the most interesting and thought-provoking proposals to come along in some time, perhaps since the introduction of their IEX speed bump. While its introduction does raise some questions, the fact that IEX is pursuing tools aimed at enhancing liquidity and improving performance by leveling the playing field a bit is quite encouraging. Definitely a good way to start the New Year! [3]
Jeff Bacidore is the Founder and President of The Bacidore Group, LLC.
